Estate tax: How to avoid or minimize the government’s take of your estate

JAMES DUNN,

We interviewed Jay Silverstein, leader of the Moss Adams Wealth Services practice, about how business owners can avoid or minimize estate taxes.

Silverstein, previously a tax attorney, has been with Moss Adams since 2001 and works out of both Santa Rosa and San Francisco offices. He is also a member of the company’s wineries and vineyards practice.

The 2017 exemption for estate taxes is $5.43 million and twice that, or $10.86 million, for married couples. When an estate exceeds those amounts, the remainder is subject to estate taxes of 40 percent. The high current exemptions mean that only affluent business owners with substantial assets are subject to estate taxes. In 2013, fewer than a fifth of 1 percent of estates had to pay any estate taxes, amounting to about 5,000 estate-tax returns that year.

With the exemption at $5.43 million, estate taxes are not bad compared to what they were a few years ago?

That’s absolutely correct. When I started 30 years ago, it was $600,000 (exemption).

These days, the tax affects a much smaller number of businesses, but it still could affect folks in the North Bay, especially wineries and vineyards with significant assets in land, wineries and production equipment. It is possible to hit $10.9 million easily?

That’s correct. It’s 40 percent on everything over and above that.

Do you see that in clients regularly?

It’s almost $11 million for a couple. The percentage of estates nationally that exceed that threshold is low. But around here, I do a lot of transactional work in the wine space. The value of land and of operating wineries and the brand can exceed that pretty quickly. We have a fair number of clients where we still plan to minimize the estate tax.

If a vineyard has 100 acres planted, each acre is worth $100,000 in this area?

Yes, at least.

Plus the winery and equipment easily takes the assets to the $20 million range?

Absolutely. We see a lot in that range and well in excess of that. The monkey wrench in all the planning is uncertainty around estate taxes and tax reform in general, whether there will be an estate tax going forward. Until that happens, we still plan with clients according to the law that is in place.

Your assumption is that the exemption and tax rate will stay at current levels?

Yes. That’s where things are. Given dysfunction in our federal government, nothing may come of tax reform. If the estate tax went away completely, it might come back in the future. Or if the estate tax goes away, there might be some kind of capital-gains tax on death, as in the Canadian system.

The planning is similar for clients with assets significantly in excess of $11 million. There is no downside to moving assets out of your estate unless you need those assets or the cash flow those assets are generating for your own personal financial needs. We plan to minimize a tax liability while looking at what the husband and wife need in future cash flow.

It’s important to make sure people have sufficient wealth and capital produced from that wealth to meet their needs. We determine the most efficient way to transition excess wealth.

To the heirs?

Yes, to heirs in a way that will minimize estate tax but leave the older generation with the comfort and security that they are going to have enough for their life.

For the remainder of their retirement?

Right.

Suppose an estate is worth $50 million — a winery and vineyard operation — and the couple who own it need $5 million or $10 million of assets to cover their retirement. Nearly $40 million will be subject to the estate tax if they do nothing. What can they do ahead of their demise to minimize the tax?

We look at how we can best move as much as possible of that existing wealth out of their estate. We use discounts. If you have a winery valued at $50 million and the husband and wife own that asset, they each own 50 percent of it. As you gift that or sell that to the next generation, under current law, if you have a $40 million winery and $10 million in cash, the value of a minority interest in the winery is worth less than that. We can discount the value of a minority interest in a business and move that asset out at a lower value.

How would you accomplish that — have the owners sell a portion of the business?

Right. We do a lot of it with an intentionally defective grantor trust. We create a trust for the children. They essentially buy the winery from the parents at a discount in exchange for a promissory note. Instead of $40 million, for instance, they buy it for $27 million. We might create one trust for the husband’s share, another trust for the wife’s share. Each trust buys a 50 percent interest in the operating entity.

While it might sell in the market for $40 million, the valuation rules allow you to discount that — maybe by a third (two thirds of $40 million is about $27 million). They would use the cash flow from the business to pay off that $27 million).

The business generates the cash flow to pay the note?

Right. The way grantor-trust rules work is that the parents are still liable for income taxes on that income. Let’s say the winery is producing $3 million of cash flow and $3 million of taxable income every year (net income might be different than cash flow if, for example, the winery recorded depreciation, used prepaid expenses or wrote off bad debt). The trust would get the $3 million cash. The trust would pay that cash to mom and dad, who have the income-tax liability. That’s the benefit of using grantor trusts. They have paid down the purchase price by $3 million in year one.

Each year they might knock $3 million off the asset valuation?

Right. In theory, in about nine years they could pay off $27 million. You have to apply an interest-rate charge to that, but in the whole transaction, the benefit of the grantor trust is that it isn’t treated as a sale to the kids for income-tax purposes. They are using pre-tax dollars to buy that asset. The parents are paying $1.2 million to the government (federal income taxes at nearly 40 percent) and keeping the net cash.

Once that note is finally paid off, the kids own the asset. They can turn off the grantor-trust aspect and they have essentially moved $27 million of wealth without eating into your $11 million exclusion at all.

Once the grantor trust is set up, the parents can move the asset to heirs with no tax consequence?

Yes. The flip side is that now that the winery is out of the estate, if the kids were to sell it, they’d have very little tax basis in that asset if it has been in the family for a long time, they get their parents’ carryover (and would owe capital-gains taxes on the difference between sale price and basis).

This works well for assets that have positive cash flow and positive income, and that you’re likely to keep in the family. You are trading future potential income-tax dollars for estate-tax savings. If it’s clear that they want to keep the business in the family, the basis step-up is not as important.

But if the kids want to sell the asset, then the strategy is not as attractive?

You are offsetting a 40 percent tax with the parents versus 33 percent capital gains.

So you are saving there?

You are probably saving there. We use that (intentionally defective grantor trust) a lot for operating businesses. The trust owns the asset for estate- and gift-tax purposes, but for income-tax purposes, the parents still own it. They are still paying the tax on the income.

The way the parents pay that income-tax obligation is that the kids owe them money. They keep funneling money to the parents so they can cover their tax obligation. You are essentially using tax obligations to move wealth. The IRS doesn’t particularly like that strategy, but they haven’t been able to effectively stop it.

That’s ingenious. The strategy has been challenged in tax court, and the court has upheld the strategy?

Yes. People have been using it for the past 15 years or so. The more wealth somebody has, the more ability they have to spend money to do this kind of planning to minimize estate taxes. Very wealthy people are able to move a significant amount of wealth using this strategy if an asset is producing a fair amount of cash flow and taxable income.

Is it also applicable for somebody who owns a manufacturing business?

Absolutely. You just need taxable income and cash flow to make it work.

It requires cash flow of about 8 percent to make it work?

It’s driven from cash flow. You want to be able to pay it off in 10 or 15 years. The other benefit of doing it is that if the asset appreciates (from $40 million for the winery to $70 million or $80 million), you not only have gotten the value but the appreciation in the value. Clients that have smaller estates around the $11 million or maybe $15 million who don’t want to do something as sophisticated could use the $11 million exclusion during their lifetime.

In a simple example, if a husband and wife own an $11 million business that they thought was going to be worth $20 million in a few years, they may want to gift now, use up part of their exclusion now and do a straight gift. You can use that $11 million exclusion during your lifetime or at death. The appreciation in the value of that asset would then be outside their estate.

It would go to the heirs?

Yes.

That’s counting on the appreciation, which may or may not come true?

Right. We want to make sure they have enough left (to live on during retirement). In a business context, whenever we are transferring ownership, we want to know where we ultimately want the ownership to end up.

With the kids?

Yes. Do we want it in a trust. Can the kids work together if it’s going into a trust for all of them. Do they have the ability to manage the business. If we are trying to maximize the value of what we are transferring and minimize taxes, we want to be able to preserve that wealth.

If your kids don’t get along and are not capable of running the business, you have gone through all this rigmarole and the business starts to go downhill. Ownership and management of the business going forward is important.

You want to assess the management talent in the children, and their level of interest?

Right. (After gifting part of the business) you look around at your kids, who own a part of your business, and they don’t get along, they want to get cashed out, and you’re wondering what the hell you did.

You are creating your own nightmare?

Right. There are a lot of ways to minimize the estate tax, including the standard $14,000 annual exclusion (gifting), paying tuition and medical expenses for kids.

The calculation becomes not just numbers and dollars, but emotional and psychological?

Absolutely. It is part numbers and part counseling.

Do most of your clients have assets over $50 million?

I have clients from $2 million to $500 million. Most are in the $10 million to $40 million range. In about 2012 they introduced portability. Spouses used to each have their own $5.4 million exclusion. With portability, if I have a husband and wife with a $5 million estate, $2.5 million each.

The old way was, if the husband died, he would use up his $2.5 million exemption. He could put that property into a trust for his wife. She would have her $2.5 million. When she died, her estate would be $2.5 million because you would not include the husband’s ($2.5 million). She would have no estate tax and would get a basis step-up on her $2.5 million, but the $2.5 million from the husband would not get a second basis step-up because it was not included in the wife’s estate.

With portability, if the husband left everything to the wife, his taxable estate would be zero. The wife would now have a $5 million estate. She gets to take his $5.4 million exemption and a basis step-up for the entire amount. As long as the estate didn’t grow above $11 million, the estate tax would be zero.

For people whose estates are below the $11 million threshold, if they haven’t had their wills or trusts reviewed, they probably should to see if they can at least have the flexibility of portability. They can potentially get that second step-up (in basis of the asset).

James Dunn covers technology, biotech, law, the food industry, and banking and finance. Reach him at: james.dunn@busjrnl.com or 707-521-4257