How to shrink your estate without harming the value of your business

You’ve put everything you have into your business, spending years to create something of value. But what’s going to happen to it after you’re gone? If you don’t plan for that eventuality, the value of your estate could be greatly diminished, and even create a financial hardship for your heirs, says Douglas Sockman, CFP®, ChFC, CLU, a financial advisor at Skylight Financial Group.

“Developing a plan is key,” says Sockman. “Plan for what you know today; then monitor it and make changes along the way.”

Smart Business spoke with Sockman about how to shrink your estate without harming the value of your business.

What steps can business owners take to shrink the value of their estate?

One of the easiest things to do is to make gifts. Every U.S. citizen can give $13,000 per year to each and every family member — or anyone else for that matter — without paying a federal gift tax. If you are married, your spouse can do the same. The gift can be in the form of cash, bonds, stocks, securities, business interests, real estate, etc.

Can you reduce your estate by a larger amount?

In addition to ‘annual gifting,’ every U.S. citizen can make tax-free gifts during their life totaling $1 million; so a husband and wife could make additional tax-free gifts of $2 million. But, any post-gift appreciation is not included in your taxable estate.

If a business owner has a $2 million business and it is growing by 30 percent a year, he or she could get that $2 million out of the estate — as well as the appreciation on it — by gifting it to his or her children. Once you use that $1 million exemption, it is gone, although you can still make $13,000 gifts each year.

However, these tax-free gifting opportunities might not completely ‘do the tax trick’ when the value of the business or the estate is very large. Even after all this tax-free gifting, a significant estate may remain subject to estate tax rates of up to 55 percent. Also, a downside to giving property away is that you’re giving up complete control of what you give away.

Are there other ways to reduce the value of an estate?

Another gifting technique is to set up a grantor retained annuity trust (GRAT) to which you gift assets, especially those that are highly appreciating or income producing. The GRAT will pay you income over a set number of years (within limits). At the end of the term, any remaining assets pass to the beneficiary of the GRAT, typically children. If you survive the term, then the GRAT assets are not included in your estate and any appreciation has escaped estate taxation. Because of the way GRATs work, you make a ‘discounted gift,’ due in part to the time value of money.

Assume you have a $5 million business and you want to gift the entire amount to a GRAT that lasts for ten years and pays you 7 percent every year, which is $350,000. As a result, that $5 million business is ‘discounted’ down to almost $2 million gift-tax value.