The taxation of privately owned businesses and their owners is always in flux. Several developments are worthy of note:

Small Business Jobs and Credit Act

On September 27, 2010, the Small Business Jobs and Credit Act (the "Act") became law. Among its key provisions are the following:

  • One hundred percent (100%) of the capital gain from the sale of "qualified small business stock" is excluded from both regular capital gains tax and alternative minimum tax ("AMT") if the stock is acquired through a new investment in a "qualified small business" made before January 1, 2011. A "qualified small business" is a C corporation running an active business with assets not greater than $50 million. The stock must be held for at least five years before sale to qualify for the exclusion. This is a very short time frame within which to develop a meaningful business plan and attract investors, but does present an opportunity.
  • The §179 expense deduction for depreciable property placed in service during 2010 and 2011 is increased to $500,000, and the definitions of qualifying property are temporarily expanded. In addition, 50% first-year bonus depreciation is now available for 2010, and the deduction for business start-up expenses is doubled to $10,000.
  • C corporations that convert to S corporations generally must pay tax on "built-in gains" from the sale of assets during the "recognition period." The Act shortened the recognition period to five years, meaning that beginning in 2011, S corporations that converted in 2006 may sell appreciated assets without incurring the built-in gains tax.
  • The general business credit carryback is extended from one year to five years starting in 2010 and may be used to offset both regular tax and AMT.
  • Self-employed business owners may deduct the full cost of health insurance from self-employment income for purposes of computing self-employment tax for tax years starting in 2010.

Federal Estate Tax

This is an unusual year for federal estate, gift and generation-skipping transfer ("GST") tax purposes in that the federal estate and GST taxes do not apply to estates of persons who die this year. Federal gift taxes do apply to gifts made during 2010, however. Under current law, on January 1, 2011 the estate, gift and GST taxes will revert to their status in 2001. There has been much discussion about whether Congress would pass legislation to change this result. The options include (i) an amendment applicable retroactively to January 1, 2010, (ii) giving taxpayers a choice of the law as it was in 2009 or the law as it is now, or (iii) allowing the January 1, 2011 reversion. Many business owners concerned about family business succession have been paralyzed by this uncertainty. However, the gift tax law applicable to the remaining months of this year actually creates an opportunity for forward thinking business owners who want to assure that the business is preserved for future generations of family members.

Prior to 2010, the top federal estate and gift tax rate was 45%. Decedents were given an exemption for the first $3.5 million of assets passing to non-spouses, and an unlimited deduction for assets passing to spouses. This generally meant that with careful planning, a married couple could transfer $7 million of assets to children and grandchildren with no federal estate tax. Up to $1 million of a person's $3.5 million exemption could be used during life to shelter gifts from the federal gift tax. These tools went a long way toward eliminating the threat to many privately owned businesses whose owners wished to provide for continued family ownership through the generations without the need for a sale or heavy borrowing to provide the liquidity needed to pay estate taxes.

No estate or GST taxes apply to the estates of persons who die during 2010. Gift taxes continue to apply during 2010 after lifetime taxable gifts exceed $1 million per transferor (or effectively $2 million per married couple), but at the reduced top rate of 35%. Next year, the estate tax exemption will fall back to its 2001 level of $1 million, and the top tax rate will be 55%, unless Congress acts.

The 2010 top gift tax rate of 35% actually creates an opportunity for those business owners whose estates are large enough to pay an estate tax under any likely legislative scenario that would either change the otherwise draconian 2011 reversion to 2001 tax laws, or leave things as they are. Simply put, gifts in 2010 of interests in family business entities could save 20% in transfer taxes when compared to the estate tax burden that would apply if the business passed to children at the death of the owner in 2011 or thereafter.

In addition, paying gift taxes on a "tax-exclusive" basis generally allows more wealth to pass to family members than does paying estate tax on a "tax-inclusive" basis. This is because the gift tax is paid from the donor's other assets and not from the gifted assets, whereas the estate tax is levied on the full value of assets passing at death, and must be paid from those assets.

Further, the future appreciation in gifted assets accrues to the benefit of those who receive the gifts without the imposition of any transfer tax on that appreciation, whereas keeping a growing business until death subjects that appreciation to estate taxation and could jeopardize the business and continued family ownership.

Careful planning is required when considering the making of taxable gifts of business interests. First, if the value of gifted property exceeds $1 million (or $2 million for a married couple), then cash will be required to pay the 35% gift tax by April 15, 2011. Second, the tax basis for calculating capital gains on gifted assets is "carried over" from the donor to the recipients. In contrast, assets passing through an estate acquire a new basis equal to their fair market value on the date of the decedent's death. Thus the income tax impact on the recipients of gifts of business interests must be taken into account in the analysis. Third, many are wary of actually paying a gift tax if they believe that there is any possibility, even if remote, that estate taxes will be repealed. We feel that total repeal is highly unlikely, but only your Congressperson knows for sure (perhaps).

There are many other tax as well as non-tax succession planning considerations that are beyond the scope of this discussion. Please contact us if you would like to explore these and design a business succession plan to achieve your goals.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.