If you own a business, planning for future transitions and taxation should start now.
- Business structure matters for taxes, whether it’s a pass-through entity, S or C corporation, or another entity
- The Tax Cuts and Jobs Act lowered the corporate tax rate, and it also created the qualified business income deduction for pass-through entities
- The gift tax exemption was increased by the TCJA, but the increase sunsets in 2025
By now, you may have secured your estate plan and tax planning responsibilities. But what about your succession plan?
If you own a business and don’t put the right plan in place, you can leave it vulnerable to unnecessary taxes and possible conflict about who owns what. The brand, company reputation, and wealth you’ve built could be put in the balance long term. You’ve worked hard to create a successful business. So, why not ensure the company is valued and passed on properly once you’re out of the picture?
Taxes are one of the most important factors that play a role in succession planning. Keep these considerations in mind when you’re working through your plan.
Business structure and taxation
The type of business structure you operate as matters a great deal for taxes. You want to ensure that your entity will set up your business for many years of success into the future.
Of course, succession planning shouldn’t be the only thing to consider when deciding on the right structure, but it’s still an essential piece to the puzzle. The structure is a major factor that significantly impacts personal and business taxation when business ownership is being transferred.
Closely held businesses can be sole proprietorships, partnerships, LLCs, S corporations, and C corporations. Let’s walk through some considerations for each entity type.
Sole proprietorships (and default LLCs)
The sole proprietorship is for single business owners, and there is no separation of personal and business assets and liabilities. An LLC offers liability protection, but it is still taxed like a partnership unless the owner(s) elects to become a corporation. Sole proprietorships and some LLCs dissolve if the owner dies, but a succession plan can ensure that business assets pass to an intended inheritor.
Partners within a general partnership have unlimited personal liability that can negatively impact personal assets. Those in a limited partnership have liability only as much as their investment. Sometimes, these reasons are enough to avoid the general partnership setup.
However, the owner of a family limited partnership can help lower the tax burden when wealth is transferred to the next generation. Family limited partnerships help you reduce your tax burden because they minimize your taxable estate when you transfer some business value to your heirs. When you pass on limited partnership interests, they are eligible for the annual gift tax exclusion, so shares can legally be reduced when transferred.
Many businesses are C corporations, with an essential characteristic being that the business is a very distinct entity from the business owners. This means the liability is not on the owners, both financially and legally, so it’s a form of protection that sole proprietorships and partnerships don’t offer. For succession considerations, it can be more tax-efficient to have personal affairs completely separate from the business’s affairs.
S corporations also offer that separate-entity protection like a C corporation. But they are taxed as a pass-through entity, meaning that the business doesn’t pay corporate taxes, and any income or losses are reported on the individual income returns of shareholders. Companies must not have more than 100 shareholders to convert to an S corporation.
As a pass-through entity, there are several tax advantages when succession planning and transferring ownership. It’s easier to move funds from the business entity to a shareholder, and ownership transfer is easier with fewer tax and regulatory requirements.
However, keep in mind that if an initial public offering (IPO) could be in a business’s future, the benefits of instead choosing a C corporation may outweigh these other succession considerations.
Impacts of the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act (TCJA) of 2017 implemented a few changes that may affect a succession plan. The C corporation federal income tax rates were lowered from 35% to 21%, and the individual tax brackets were also reduced from between 10% to 39.6% to between 10% to 37%. You can use these new numbers and estimate personal income, business income, and dividends to see which structure would benefit you the most.
The TCJA also created a qualified business income (QBI) deduction, which allows qualifying pass-through entities to deduct 20% of qualified business income, but it includes phase-out limits. There are a few ways to lower income to stay below the phase-out limit, including retirement plan deductions.
For example, you could set up a retirement plan like a SEP or 401(k) and contribute up to the plan’s limit, lowering income to qualify for the deduction. A defined benefit plan will allow you to make the biggest contributions while taking advantage of tax deferment and additional asset protection from creditors.
Gift and estate taxes
Creating a succession plan now keeps you ahead of the game for substantial taxes associated with the business, including estate and gift taxes. The right strategy for a transfer of ownership can help you reduce or even eliminate some of them.
If you decide to sell your business before you die, you may have to pay capital gains tax. However, no matter when you sell, proceeds could help cover your current lifestyle or future estate taxes. The gift tax won’t apply to the sale as long as the price is at least equal to the full fair market value.
There is currently an increased estate and gift tax exemption from the TCJA, now at $11.7 million per person or $23.4 million per couple for 2021. Transfers of interests made within a limited partnership are eligible for the gift tax exclusion, and the value of shares can be lowered when they’re transferred. This means your heirs will be able to reduce the taxes they have to pay. However, keep in mind that the increase is currently set to sunset on January 31, 2025.
Another option of note is the grantor retained annuity trust (GRAT), which may allow you to transfer business assets to your children. They will still be able to earn income, and a GRAT may also make sure that your business isn’t subject to high taxes as its value appreciates. Just keep in mind that a GRAT must be held for a certain number of years, and you must outlive that term to receive all the estate tax benefits.
Working with a tax professional
All of these moving parts will impact how you approach succession planning. There is no one right strategy, and choosing one requires weighing multiple factors about your business structure, future plans, and family goals.
Work with a tax professional who can help you customize a succession plan that will lower your tax burden and set up your company’s new stewards for success. You’ve worked long and hard to create your business—make sure things go smoothly when it’s time for you to step aside.
Contact Provident CPA and Business Advisors to talk with our team about succession planning and taxes.