By John M. Goralka
Sacramento, CA
The family business, in the best of times, faces unique challenges, particularly with business succession and estate planning. Moreover, the family business is often not merely a business but a lifestyle. The hard work, long hours and heightened risk can be common challenges. The business owner’s very identity is more likely to be tied to the success, or failure, of the family business.
This is particularly evident for agricultural or farm businesses. The family farm is connected to the land, which is critical to success. In California, where our firm is based, the news is replete with stories of fires and critical water shortages. In addition to such forces of nature, family farms and other family businesses face another threat: a changing tax environment.
Let’s look at the main provisions in the Inflation Reduction Act of 2022, also known as IRA, signed into law in August 2022 by President Biden:
- Creation of a 15% corporate minimum tax rate: Corporations with $1 billion or more in income will have a new tax rate of 15%, but taxes on individuals and households will not change.
- Prescription drug price reform: Medicare will now be able to negotiate the price of certain prescription drugs, which should lower the price beneficiaries will pay for their medications. Medicare recipients will have a $2,000 cap on annual out-of-pocket prescription drug costs starting in 2025.
- IRS tax enforcement: The IRA invests $80 billion in the IRS to be used to hire more staff and invest in technology over the next 10 years.
- Affordable Care Act (ACA) subsidy extension: Currently, medical insurance premiums under the ACA are subsidized by the federal government to lower premiums. These subsidies were scheduled to expire at the end of 2022, but will now be extended through 2025.
- Energy security and climate change investments: The bill includes numerous investments in climate protection, including tax credits for households to offset energy costs, investments in clean energy production and tax credits aimed at reducing carbon emissions.
This new law on its own will probably not adversely affect most small-business and farm owners. This is welcome news since there continues to be a plethora of other obstacles to circumnavigate. However, many provisions of the Tax Cuts and Jobs Act of 2017 will begin to sunset or terminate, triggering higher tax bills for businesses.
Businesses Lose Favorable Tax Provisions
- The use of 1031 like-kind exchanges was revised effective for the 2021 tax year to limit its application to real property and not personal property or intangible property.
- Starting in 2022 and continuing through 2026, businesses face several tax changes scheduled as part of the Tax Cuts and Jobs Act (TCJA), including the switch to five-year amortization of research and development expenses, the graded phaseout of 100% bonus depreciation and restricted interest deduction limitation. The deduction for business net interest expenses will be limited to 30% of earnings before interest, taxes, depreciation and amortization (EBITDA) or adjusted gross income (AGT) and not earnings before interest and taxes (EBIT).
- Perhaps the most significant change is the phaseout of 100% bonus depreciation, which allows businesses to immediately deduct the full cost of equipment and machinery. Farmers and other many businesses are increasingly dependent upon substantial equipment and machinery.
The changes, particularly the phaseout of 100% bonus depreciation, may have a great effect on farm and agricultural business. Business owners should also consider tax proposals that are not yet law. The changes to 1031 exchange requirements and the loss of the stretch IRA were on the government’s radar for a number of years prior to the enactment of the SECURE Act of 2019.
What Are Some Planning Alternatives for Family Business Owners?
What can you, as a business owner, do to deal with all these changes? Plan, plan, plan. The changes underscore the need for careful planning with all members of your team. Your attorney, tax professional and financial adviser each have a different perspective and different contribution to your long-term survival and success. Here are some things to keep in mind:
1. Think Long-Range When Contemplating a Sale of Your Business
Planning for the sale of a business should happen well before the desired sale date. First, planning is needed to position the company to receive the highest possible value at sale. A team should be established to review how a buyer would value that business, and then the current operations should be adjusted to enhance that value.
2. Income Tax Planning
Some family businesses will be affected more than others with these income tax changes. For example, the use of a 1031 like-kind exchange was revised effective for the 2021 tax year to limit its application to only exchanges of real property and not for personal property or intangible property. The phaseout of 100% bonus depreciation will limit the ability to write off or depreciate equipment. Coupled with the changes to property tax (and for those in California, the virtual loss of the parent-child exclusion for property tax), these changes may have a greater effect in particular on the farming and agricultural (AG) businesses. These changes may also have a synergistic effect, creating greater challenges to business.
AG businesses are dependent on land ownership and are often designed for multiple generations. We already lost many retirement planning opportunities with the Secure Act of 2019, which took away the ability to stretch and defer tax on retirement benefits for multiple generations. The elimination of stretch IRAs will make it more likely for the business owner to be subject to those higher taxes, causing a cascading effect. In addition, a proposal under the Biden administration would have restricted the ability to exchange real property on a tax-free basis under IRC Section 1031 for amounts over $500,000. While not law, these proposals could be problematic for the family business owner if enacted, particularly for AG businesses, which are tied to the land, and should be considered as they may be indicative of changes to come.
But there are ways to help blunt those tax effects. Certain tax-advantaged devices or tools, many that we have used for years, will become more effective with higher tax rates and changes. Many of these tools will be used differently or in combination with other techniques. These tools are often broken into charitable and non-charitable techniques:
- Traditional charitable tools include charitable lead annuity trusts (CLATs), charitable remainder trusts (CRTs) and pooled income funds (PIF).
- Traditional non-charitable tools would include intrafamily installment sales, qualified personal residence trusts (QPRT), grantor retained annuity trusts (GRAT) and NING trusts (which stands for Nevada incomplete-gift non-grantor trusts).
3. Lesser-Known Tax Strategies to Consider
Enhanced Installment Sale: For AG or farm businesses, an enhanced installment sale permits the client to defer capital gains taxes for 30 years. This approach can provide approximately 93.5% of the sale price in cash to the seller without the need to invest in like-kind property. This strategy, while effective for AG and farm businesses, is generally not appropriate at this time for other types of businesses.
Two-Year Related-Party Installment Sale: This strategy allows a seller to sell all or a portion of the business to a “related-party” trust for the benefit of the kids and/or grandkids. If the trust holds the property for at least two years and one day prior to the sale to a third-party buyer, the trust can employ the installment sale method and defer the capital gains taxes for up to 30 years.
Basis Shifting: The partnership basis allocation rules in the Internal Revenue Code provide a unique opportunity to avoid capital gains of the sale of an appreciated asset. This solution may be appropriate for the sale of an appreciated asset with a low-income tax basis purchased by or contributed to a limited liability company (LLC) or a partnership more than seven years ago. This method is for assets being sold that have been held by the partnership for at least seven years.
This strategy is effective without regard to whether the business was inherited. The key is to distribute a high-basis asset to the partners prior to the sale coupled with an election under IRC Section 754 seeking adjustment under IRC Section 734(b). The high-basis asset may even be acquired. With that election, the high basis of the asset distributed is allocated between the asset distributed and the low-basis asset to be sold. Essentially, 50% of the gain otherwise taxed can be insulated from tax.
A Custom-Defined Benefit Plan: A defined benefit plan can be custom designed and built. People all too often think that all plans or techniques with a common name will provide the same benefit. Depending on the circumstances, a specialist may be able to design a plan with large deductible contributions that far exceed typical retirement plan contribution limitations. This may offer a tremendous way to accumulate wealth.
(Free) No-Cost Life Insurance: A client with a net worth in excess of $10 million may have the ability to obtain millions of dollars in life insurance with no out-of-pocket cost. The cost of the insurance is entirely paid by the issuance of investment-grade bonds. The client posts collateral but would have no out-of-pocket cost whatsoever. The insurance would build a cash value over time.
That cash value can provide substantial after-tax (tax-free) streams of income in later years as well as provide future benefits to the family in addition to the death benefit. This can be used for estate planning or business succession purposes.
Qualified Opportunity Zone: Qualified opportunity zone investments (QOZ) can be used to avoid or even eliminate capital gains tax. Many believe that QOZ investments must be tied to a professional manager, which results in losing control over your funds and investments.
We successfully created LLCs for QOZ funds to be managed by our clients so they retain complete control over all investments and funds. For these clients, they maintain complete control, and their funds and investments are not mixed with the investments for other people.
Qualified Small-Business Stock: IRC Section 1202 provides that certain C Corporations can take advantage of the qualified small-business stock exemption from federal capital gains up to $10 million or 10 times the aggregate basis. Many advisers are unaware of this benefit and fail to determine if the shares qualify or consider that in the sale negotiations.
Charitable Lead Annuity Trust (CLAT): In the charitable arena, a charitable lead annuity trust (CLAT) can be designed to generate a charitable income tax deduction equal to 100% of the contribution. The CLAT makes annual distributions to charity for a defined term, typically around 20 years. At the end of the term, the assets in the trust are returned to the client or passed to the client’s family.
The client chooses which charity or charities receive the annual distributions, and the client can maintain control over the assets during the term. The client can retain control over the investment throughout the entire trust term.
Pooled Income Fund: A pooled income fund is another often overlooked charitable tool that can provide the appropriate client a greater income tax deduction than a charitable remainder trust. The client retains all income for life (or, on a multigenerational approach, the client, their spouse and their kids). The client would be able to retain control of the investments throughout the pooled income period.
What All This Means for the Next Generation of Family Business Owners
There are many challenges to the success and even continued viability of the family business in the years to come.
First, a recognition that for many, the family business is a lifestyle. The restriction on 1031 exchanges, the phaseout of the 100% bonus depreciation and the continuing high tax rates continue to be a significant challenge. High maximum federal and state tax rates continue. California residents can pay a combined rate of 50.3%. New Jersey residents can owe 47.75%, and Oregon residents could owe 46.9%. There are many more challenges with equal or perhaps greater impact. The real issue is the synergistic effect of all of these changes coming together. California experienced a version of this with the atmospheric rivers and bomb cyclones combining to create disastrous conditions. Planning can help protect the business owner from unexpected taxes.
This is happening now when the greatest transfer of wealth between generations is in its infancy. Baby Boomers are expected to transfer $30 trillion of wealth to younger generations in the next few years.
All of this underscores the need for flexibility in your income, tax planning and family estate planning. Financial planning for business owners will become increasingly complex. This type of planning should be team-based and multidisciplinary, including the lawyer, tax professional, accounting professional and financial adviser, as each brings an important yet different perspective. Above all, the focus should be on the client’s overall business succession planning and not simply on lower taxes.
Even though the tax environment seems to be constantly changing and challenging, there are still many opportunities available. Taking advantage of these opportunities requires more initiative for clients to seek competent counsel and to get out in front of their transaction deadlines.
One bright note in 2023 is that the spending bill signed in December (often referred to as the SECURE 2.0 Act). This year, the age for mandating distributions from retirement accounts is 73, up from 72. The age for mandating distributions will rise to 75 in 2033.
While the increase of a year does not seem significant, a 72-year-old holding $1 million in a 401(k) could delay a required minimum distribution of approximately $36,500 this year. This delay allows the business owner to hold the funds within to group tax-free until withdrawn. However, fewer forced distributions result in larger plan balances with fewer years to spread taxation over.
More important, retirement accounts are subject to income tax at distribution and estate tax at death. With a 40% estate tax rate and a 40% to 50% maximum combined federal and state income tax rate, 60% to 70% of the account balance could be lost to taxes for accounts with a balance of over $5 million, then advanced planning may be available to mitigate those high taxes.
