Succession Planning Transfer Strategies - Gifting
THE COUNSELOR
Volume 11 • Issue 3 • March 2021
The Counselor is a newsletter of Hallock & Hallock dedicated to providing useful information on estate planning and business planning issues. This month's issue is the first in a series discussing transfer strategies that can be employed as part of a succession plan. If you are interested in learning more about the ideas and processes discussed in this newsletter, please contact us for an initial consultation.
In transferring ownership of a family farm or ranch, from the current owners to the incoming generation, there are several strategies that people can follow:
Gift of the Farm or Ranch During Owner’s Lifetime
Bequest of the Farm or Ranch at the Owner’s Death
Sale of the Farm or Ranch During Owner’s Lifetime
Sale of the Farm or Ranch at the Owner’s Death
Each of these strategies can be valuable in its own right, however, more often than not multiple strategies will be employed, consecutively or concurrently, in the ultimate transfer of the business. Below is a discussion of the role of lifetime gifting as a strategy for transferring the farm or ranch to the next generation.
Lifetime Gifting
While bequests at death are often what comes to mind first in estate planning, the use of gifts during a person’s lifetime is also an important strategy. This is especially true when one of the assets is a family business, such as a farm or ranch. According to Professor Neil E. Harl in his book Farm Estate & Business Planning there are several purposes of lifetime gifts:
Reduce death taxes;
Cut estate settlement costs;
Ease the total family income tax burden by moving assets into the hands of family members in lower tax brackets;
Transfer a family business to successors; and
Benefit family members or charities that occupy a place of priority.
While lifetime gifting can be a great solution and can be accomplished very simply, a great degree of care and attention should be given to analyzing how the gift is made and the consequences of the gift.
What Are You Gifting?
The first question that should be considered is — what are you gifting?
Are you gifting a direct ownership interest in land, equipment, or livestock?
Are you gifting an ownership interest in a business?
Are you gifting the entire interest?
Are you gifting a fractional interest?
When transferring ownership of a business it is often advisable to transfer interests incrementally, over a period of years. Transfers of a fractional interest in assets such as land, equipment, or livestock can be problematic. Such transfers can be difficult to document and difficult to administer. If you are transferring less than all of an interest in an asset, it is much easier to do so if the asset is owned in a business entity. In such a case, the results of a transfer of a fractional share in a business is much more straightforward and controllable. For example, how do you address an owner with a 9.675% interest in a combine? Well, not very easily. Here are some examples of problems that can arise in such a situation:
No one has clear authority to manage the combine.
No clear rules exist for who pays for maintenance of the combine.
Multiple signatures and unanimous agreement will likely be required on any transaction involving the combine.
Because of poor documentation, as memories fade, it becomes unclear who owns what percentage of the combine.
The co-owner could sell his/her interest in the combine to another without permission of the other co-owner.
On the other hand, how do you deal with a 9.675% interest in an LLC that owns the combine? The rules are fairly clear and straightforward.
The company operating agreement will establish who has authority to manage the assets of the LLC such as the combine, including a sale of that asset.
The company operating agreement will set forth whether or not people are required to contribute additional money towards company expenses.
The company operating agreement will identify the individuals authorized by the company to sign documents and make decisions regarding the combine.
The ownership percentages will be set forth in the company operating agreement, maintained on the company books, and tracked by your accountant on an annual basis in the tax return.
Therefore, in determining what you will be gifting, if you are gifting only a percentage of the asset, consider using a business entity to own the asset(s) and give a fractional interest in the business instead.
Maintain Control
In conjunction with determining what you are giving away, another issue to consider when gifting an interest to another is maintaining control. Prior to beginning any gifting of interests in a farm or ranch, if the entity has not been established it must be created with proper governing documents, such as an operating agreement for an LLC. If the entity already exists, the governing documents should be updated to reflect the forthcoming gifting of ownership interests. Here is an example of why this is so important. There once was a farmer who was advised by his accountant that he should start gifting shares in his farm corporation to help avoid potential estate taxes upon his death. Each year, he dutifully gifted a small interest to each of his children as recommended. Unfortunately, no one was monitoring the fact that he eventually gifted away in excess of 50% of the shares in the farm corporation. This was problematic because no shareholder agreement existed allowing him to remain in control with less than a majority interest. Eventually there was a falling out with his children. Lawsuits ensued. Now he has a minority interest in a farm, but he has no control over it. He lives under the dysfunctional rule of his estranged children.
Such an outcome would have been easily avoidable by proper planning for how much would be given away and when actual control of the entity would transfer. So take care to plan for how control will be transferred and how you will maintain an income after the transfer of such control.
Tax Consequences
When gifting an interest in a family business, it is important to remember that tax consequences will result from the gift. The gift tax is a tax on transfers of money or property to other people while getting less than full value in return. Currently, the gift tax only applies to gifts that exceed $15,000 in value to a single person in a single year. The $15,000 threshold is known as the “annual exclusion” amount. The annual exclusion only applies to a gift of a present interest. A present interest gift is one in which the recipient has all immediate rights to the use, possession, and enjoyment of the property and income from the property gifted. If you are giving the gift into a trust, you must first give the recipient notice of the gift and an opportunity to take the gift from the trust. These are referred to as Crummey Notices after a court case involving this issue.
If the gift is not of a present interest, or it exceeds the amount of the annual exclusion in any year, then the lifetime gift tax exemption applies. The lifetime gift tax exemption is the amount of taxable gifts a person can give away over his/her lifetime to any number of people without paying a gift tax. That amount is presently $11.7 million per person. So, for example, if you and your spouse give your son and his spouse a present interest in the farm valued at $60,000 in 2021, you have not used any of your lifetime exemption. You have given $15,000 in value each to your son and his spouse ($30,000 combined) and your spouse has given $15,000 each to your son and his spouse ($30,000 combined). However, if you and your spouse give your son and his spouse a present interest in the farm valued at $160,000 in 2021 you have used $100,000 of your lifetime exemption and therefore your remaining lifetime exemption is now $11.6 million. Further, this also results in estate tax exemption remaining at death being reduced by the same amount.
One consequence of gifting that must always be remembered is the loss of the income tax basis step-up. While determining tax basis can get very complicated, the original tax basis of an asset is, generally speaking, its cost. For example, if you purchased a parcel of farm ground for $100,000, your tax basis is $100,000. This tax basis may be adjusted over time. But, assuming it has remained the same and you subsequently sell the parcel for $500,000, your taxable gain is the difference between your adjusted tax basis and the sales price, or $400,000. When you give a lifetime gift of property, the recipient retains your basis. Therefore, if, instead of selling the farm ground, you give it to your daughter during your lifetime, your daughter’s income tax basis is the same as yours. This is known as carry-over basis. If your daughter then sells the property for $500,000 she will likewise have $400,000 of gain.
If, instead of giving the property away to your daughter during your lifetime, you give it to her at your death a different rule applies. Retention of the asset until your death subjects the property to potential estate taxes, but the potential gain or loss on the sale of the property is eliminated and your daughter takes the property with a new income tax basis equal to the fair market value of the property on your date of death. Therefore, if you pass the above property to your daughter at your death and the fair market value is $500,000, the new tax basis is $500,000. If she then sells the property for $500,000 there is no taxable gain – a potentially significant tax savings.
In many farm transitions, it is not the intent to ever sell the farm, so the above consequence may never be realized. But, it is important to understand because you never know.
Valuation
The Internal Revenue Code mandates that whenever property, such as a business, is transferred, the fair market value must be determined for income, gift, and/or estate tax purposes. If the transaction involves an insider, such as a family member, the valuation will help to know what part of the transaction is a gift and what part is a sale. If you will be using a portion of your lifetime gift exemption to transfer all or part of the business, a gift tax return will be required. As part of that gift tax return, a valuation of the business must be included to support the value of the gift and any discounts.
Fair market value seems fairly straight forward. It is defined as what a willing buyer would pay a willing seller if neither were under any compulsion to buy or sell and both are in possession of all relevant information. The fair market value of a publicly traded company is fairly easy to ascertain by looking at the price the business is trading at on the particular exchange. However, a closely held company can be much more difficult to assess as markets are much more limited and information can be hard to come by. When transferring ownership to a family member, it is often the case that the interest is being transferred at less than full fair market value. This means that some gifting is involved which will reduce the owner’s lifetime gift tax exemption. The goal will be to transfer as much of the business as possible while using as little of the gift tax exemption as possible.
Further, it is a well-established principle of valuing a business that non-controlling or non-marketable interests in a closely-held company are not as valuable as a controlling interest in such a company or an interest in a publicly traded company. Therefore, in valuing the interest an appraiser will discount the value to take into account the fact that it is a minority interest or it lacks marketability. In estate planning and business succession planning, this discount in the value can allow an individual to transfer larger amounts during his/her lifetime in order to avoid a greater death tax on the asset. For example, assume you own a 10% interest in a business that is valued at $10 million. If you try to give that interest to your son or daughter without a discount, the gift is worth $1 million and reduces your lifetime gift tax exemption by that amount. However, if you could claim a 30% discount because you lack control of the company, that gift is now only $700,000, leaving you an additional $300,000 to gift. The ability to claim a discount is important for several reasons. First, it allows you to give away more of the existing estate. Second, all the growth on those gifts is happening outside of your estate. Finally, it reflects the reality that owning a minority interest or one that cannot be marketed makes the interest less valuable on the open market.
The Psychological Effect
While much of the planning around gifting involves analysis of the tax considerations, there are other psychological effects that should be considered before gifting.
Gifts with Strings. How will the successor children respond to a gift of less than all of the farm? Often these gifts come with strings and a feeling that nothing is really changing. Therefore, the incoming generation can be reluctant to assert itself for fear of losing future gifts.
Something for Nothing. Often a gift comes with the stigma that the person received something for nothing. This can change how that person perceives himself or herself and how they are perceived by the parents or other siblings.
Fair or Equal. Whenever gifting is involved, it increases the underlying desire to equalize the gifts with gifts to the other children. This can create a reluctance to engage in appropriate gifting.
Given the high value of land and the high cost of debt service in relation to the ability of farms to generate income, it is often very difficult to sell the farm for full value to the incoming generation. Therefore, gifting is almost always part of the succession planning equation. While it seems simple, lifetime gifting is a sophisticated and complex undertaking with many issues to consider. Before making a gift, you must:
Determine what is to be gifted;
Understand the motives of the different players;
Consider the tax consequences; and
Protect everyone with contractual agreements.
While it can be a perilous endeavor, nevertheless, lifetime gifting should be an important tool in the succession planning tool box.
This Newsletter is for informational purposes only and not for the purpose of providing legal advice. You should contact an attorney to obtain advice with respect to any particular issue or problem. Nothing herein creates an attorney-client relationship between Hallock & Hallock and the reader.