Focus shifts to long-term financial planning
NORTH BAY — This year marks a time of relative stability after a long period of tenuous wrangling over federal estate tax policy, following Congress’s decision in January to extend a temporary and historically large exemption for estate and gift taxes, said North Bay experts in estate and succession planning.
While many taxes did increase following the so-called “fiscal cliff” in early 2013, financial planners pointed to the preservation of the exemption as having a significant impact for the long-term tax strategy of business owners and high-net-worth families into the foreseeable future.
“It’s probably safe to assume that it will be in place for the next few years, without the fear of ‘use it or lose it.’ Congress has other battles to fight,” said Joseph Kitts, tax partner at the Santa Rosa office of BPM — Accountants and Consultants. “That’s what made estate planning so difficult for the past 10 years — that the rules for estate planning were so much in flux.”
It was in January that congressional debate over the fiscal cliff reached a climax, with the signing of the American Taxpayer Relief Act giving financial planners clarity as to which tax breaks — many originally intended to be temporary — would remain intact.
High on the list of provisions expected to be affected was the linked exemption for estate and gift tax. The heightened provision of more than $5 million for individuals and $10 million for couples had been a boon for estate and succession planning since going into effect as part of broader economic stimulus in 2010, making it easier to pass on a business or a wealthy estate without a significant estate tax burden.
Closely-held wine industry companies and other ventures with high-value assets have been able to benefit directly from the exemption. But the amounts also create a cushion for appreciation of ownership assets in the future, a notable benefit as an improving economy helps push business valuations upward.
Financial planners had advised clients that the provision could be significantly reduced in 2013, down to the previous $3.5 million or even the traditional $1 million exemption for individuals as Congress looked to reel back some of the breaks it extended to taxpayers over the past few years. Many individuals hurried to pass on their businesses and estates before the anticipated deadline, generating a huge flow of demand for estate planning groups working to finalize plans before the end of 2012.
Yet in what many said was a surprising turn, Congress chose to continue the exemption essentially as-is, along with a handful of other provisions meant to stimulate investment by business owners.
Individuals seeking to craft an estate plan did not escape entirely unaffected, as higher income taxes remain a factor in overall planning. Yet the preservation of the estate exemption extends what has become a valued tool for passing business ownership to the next generation or gifting a large estate to beneficiaries, while also providing greater clarity for financial planners going forward, those experts said.
The extension has created something of a new normal for estate and business succession planning — those with assets above $10.5 million, and everybody else. It is higher income taxes that have received a greater focus, as failure to anticipate them could leave business owners with significantly less in take-home pay than anticipated after a sale, said Mr. Kitts and others.
While business owners may not be in the highest income brackets during their careers, revenue from a business sale has the potential to propel them into higher brackets and diminish what might be their primary nest egg in retirement. Adding income taxes in California for the highest income earners and a federal 39.6 percent rate for individuals above $400,000 in income, a combined income tax rate exceeding 50 percent is a very real possibility, Mr. Kitts said.
Capital gains income has also become a greater factor, with implications that include the way assets and revenue flow through a trust for beneficiaries, said Jay Silverstein, wealth services partner at the Santa Rosa office of the accounting firm Moss Adams.
In general, taxes on investment, appreciation and similar income have increased. California does not have a separate capital gains rate, meaning a maximum rate of 13.3 percent when considered with ordinary income. Coupled with a top federal capital gains rate of 20 percent and a 3.8 percent capital gains tax to help fund health care reform, that income could face a combined marginal tax rate of more than 37 percent.
Though many individuals will avoid that highest tax rate, the burden becomes more imminent when a trust is used as part of a business succession or estate plan, Mr. Silverstein said. In the 2012 tax year, trusts with gross income just over $11,000 were subject to the new 3.8 percent tax on undistributed investment income — a far lower threshold than for an individual.
In the case of a trust designed to isolate business assets from a beneficiary that will not inherit a business or estate for many years, those taxes can have a significant cumulative impact, he said.
“3.8 percent may not seem like a lot. But 3.8 percent year after year after year starts to add up to real dollars,” Mr. Silverstein said. “It’s created a situation where the usage of trusts to protect the beneficiary from getting too much money might be subject to a higher tax.”
Continuing questions include whether distributions to beneficiaries that are not directly involved in the day-to-day operations of the business will still be subject to the tax, with further direction expected from the Internal Revenue Service in the near future, he said.
While the sense of urgency has diminished in the current tax environment, estate and business succession planners said they have had no shortage of demand for services. A generation of entrepreneurial baby boomers that had put off their plans during the recent recession is now looking to pursue its exit strategy, with renewed optimism as an improved economy has put their businesses on stronger footing.
That group faces a different outlook than previous generations in a number of ways, including a long life expectancy and the likelihood that their heirs will have a lower earning potential over the course of their lives, said Ronald Wargo, partner at law firm Friedemann Goldberg. As the rules for estate planning enter a period of greater certainty, those concerns are looming larger on the horizon.
“Many people who thought they needed to engage in estate tax planning now need to look at long-term financial planning,” Mr. Wargo said. “The traditional model is that the kids take care of their parents. But now, parents may need to hold on to their assets to support their children.”
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