You already know that owners of small businesses can mean big business for you. But are you aware of the tax-planning strategies--some unique in their value to small-business owners--that can enhance cash flows to fund business and shareholder investment objectives?
First and foremost--especially with a new client--check the structure of the business to determine whether it's the right one. Limited liability companies remain a popular choice because of their flexibility and tax efficiency. They are followed in popularity by subchapter S corporations and partnerships. While a C corporation is another alternative, it can incur double taxation and is more difficult to transfer as part of an estate or asset protection, or ownership succession plan.
Clients who are thinking about sharing ownership with employees should look into an Employee Stock Ownership Plan (ESOP), a tax-effective vehicle for business financing and shareholder liquidity. An ESOP is an employee benefit plan operating through a trust that accepts tax-deductible contributions from the company to accumulate company stock, which is then allocated to the accounts of the individual participants. The ESOP can acquire both new and existing stock. The trust can borrow money to purchase the stock, with the company repaying the loan by making tax-deductible contributions to the ESOP. Among the variety of ESOP benefits is buying the shares of an owner in a closely held company, which enables the selling shareholder to defer the gain from the sale by using the proceeds to reinvest in qualified stocks and bonds. Furthermore, an ESOP can borrow money to buy new or existing company shares, with the company repaying the loan in pre-tax dollars by making contributions to the ESOP. Loan proceeds can be used to finance new capital, refinance existing debt, or for any other business purpose. An ESOP can also be used to create an employee benefit plan comprised of stock in the company on a tax-deductible basis.
More tax issues arise when clients decide to transfer a business to family members. Grantor Retained Annuity Trusts (GRATS) can be effective in shifting post- transfer value (and ownership) to intended parties. Basically, assuming the applicable published federal interest rate is 5.8 percent, any business equity interests that appreciate in excess of this amount during the term of the GRAT can be transferred to family members, devoid of any gift or estate tax. LLCs, partnerships, and S corporations work neatly with GRATs (with proper GRAT terms), which can be implemented on an accelerated basis or over a number of years and take into account entity control and management issues.
Risk management also has its tax issues, and the use of life insurance to fund transition costs in the event of the death of a key shareholder or executive can be prudent. By using an irrevocable trust to acquire and own life insurance, coupled with shareholder buy-sell agreements, the insurance proceeds can be expended for intended purposes without the risk of creditor access or the imposition of estate tax. Insurance proceeds can be used to acquire business equity interests or assets, or to partially fund the costs of hiring successor key employees. Long-term disability insurance should be considered; when the premiums are paid with after tax monies by the insured party, benefits on receipt are not taxable.
Advisors can also add value by helping clients with their companies' retirement plans. While required to satisfy certain tests prohibiting that benefits inure to highly compensated employees on a discriminatory basis, employer tax-deductible contributions can also reduce income tax liabilities. Through 2010, consider investing in dividend-producing equities outside of retirement plans, to take advantage of the 15 percent federal tax rate on capital gains and qualified dividends; this is because retirement plan distributions are taxed at higher federal ordinary income tax rates, with no tax rate benefit obtained.
Finally, advisors should be aware of the following opportunities:
o When investing in new business equipment, be aware that qualifying property acquired can be either depreciated over its useful life or expensed immediately under Internal Revenue Code Section 179. The maximum Section 179 deduction was $108,000 in 2006, and it is $112,000 in 2007.
o Harvest 2007 tax losses to offset 2007 capital gains. If the investment sold has appreciation potential, you can repurchase it after thirty days. Limited liability companies and partnerships, combined with grantor trusts, could protect investment assets from estate-tax exposure.
o If material, knowledge of estimated income amounts can assist in determining required cash flow needs to fund those tax liabilities. Determine the ability to trigger unrealized losses (including passive losses), and determine that adequate basis exists in order to deduct losses from partnerships and other flow-through activities.
o Review compensation agreements to ensure objectives are attained in a tax-efficient manner, attending to economic and corporate financial statement objectives.
o Consider deferring directors' fees by utilizing non-qualified (deferral) plans. Be aware, however, that deferred compensation plan balances are not protected by ERISA and are subject to creditor attachment. Proper recordkeeping could minimize state income tax exposures.
Timothy P. Speiss, MST, CPA/PFS, is the partner in charge of the Personal Wealth Advisors Practice at Eisner LLP in New York. (www.eisnerllp.com).
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