James Barger, BridgeTower Media Newswires
The Tax Cuts and Jobs Act, now just over a year old, represents the greatest shift in American tax policy since the Reagan years. Yet, for all the press reports, it can be difficult for business owner-operators to take a step back and identify what some of the most important things they can do to both capitalize on the provisions of this legislation, as well as maximize the after-tax benefits of their businesses. Here are some methods entrepreneurs can apply to make this happen.
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Maximize retirement plan contributions
The statistics remain sobering. By some estimates, one in three Americans have less than $5,000 saved for retirement. Ironically, at the same time that corporations are paying lower taxes than any time in recent memory, individual taxpayers and even entrepreneurs are failing to make use of many simple vehicles explicitly designed to help them ensure financial independence in retirement. We’ve heard the narrative: savings and investment pay. A 30-year-old earning $50,000 per year who defers 6% of income and is matched on 3% can sock away over $500,000 by age 65.
What about entrepreneurs already saving in traditional retirement plans who have contributed the full amount—employee deferrals, matches, and profit sharing contributions? Many might be eligible for higher-dollar savings vehicles, such as cash balance plans. A 50-year-old entrepreneur with sufficient income could save over $200,000 per year using cash balance plans with a 401(k) offset. With these levels of contributions, it’s possible to amass a sizeable nest egg in a relatively short time—this business owner, compounding at 6%, would have over $4.6 million by age 65—all of which would have reduced taxable income by the full contribution given each year (within limits).
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Tax-free gifts
Many entrepreneurs are income tax-wise and transfer-tax foolish: they see the benefit of deferring $1 into a retirement plan to save $.21 in taxes now, but they won’t gift $1 now to save $.50 in estate taxes later. Why is this? It’s because estate planning forces business owners to confront the singularly unpleasant prospect of dying. Yet entrepreneurs willing to consider intra-family business transfer strategies have an opportunity unlike any in the past century of American tax law: the ability to transfer enormous amounts of wealth entirely tax-free to their family members.
One way is to use a grantor retained annuity trust (GRAT).
GRATs are relatively simple. If an entrepreneur has a rapidly appreciating business and a net worth high enough to approach the federal lifetime exemption amount of $11.4MM, she can set up a two-year trust. The trust can be funded with the shares of the business—LLC, C corp, S corps (possibly, check with counsel), or partnership interests. Say the owner funds the GRAT with $5MM on day one, and the business grows at 10% per year. The owner receives a payment back (that’s the “annuity” in the acronym) of $5,256,518 at the end of year one—basically the $5MM plus a preset amount of interest that the IRS determines is reasonable. The same occurs a year later, at the end of year two; the owner receives another $5,256,518.
If the business grew at 10% each year, as mentioned, there will be $1,061,312 left in the GRAT that can transfer directly to another family member without using any transfer tax exemption amount. This amounts to a $1MM free gift to family members! Compounded over a period of years, the GRAT can provide incredible tax savings.
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Pre-transition tax planning
It’s estimated that 250,000 private middle market businesses—essentially, companies with sales between $5MM and $100MM—will attempt to go to market in the next decade or so. Yet of these 250,000, only 50,000 will be deemed market ready. Of these 50,000, only 30,000 will actually transact; of those who do, more than half will sell with concessions. This means that 14,000 or so—one in 18 businesses—will sell at their desired value.
Why is this? The main reason is that most entrepreneurs are too busy working in the business to be working on the business. Yet presale tax planning in particular, and transition planning in particular, are indispensable for any entrepreneur at least three to five years away from transitioning their business. There are many resources out there for this. One is to talk with your own advisory team about business transition and what resources they might have to assist you in this area.
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Conclusion
Media reports are replete with sensational headlines about wealth redistribution, government officials proposing a top individual rate that would nearly double the current 37 percent rate, and the impact of everything from interest rate volatility to tariff concerns on the personal financial destiny of individuals. Yet the simplest solution may be just to talk with your advisor. Ask:
• What do I expect to amass from saving through my business?
• Am I using it as efficiently as I could be to accumulate these savings?
• Am I at a point where my business or net worth is approaching $11.4MM (single) or $22.8MM (married)?
• If so, have I done all that I can to ensure I don’t lose half or more of my wealth to transfer taxes?
• Do I have a timeline or plan for transitioning my business?
• Is it feasible?
• Am I implementing it?
In the public space, over 25,000 companies have traded on the U.S. exchanges since 1926. About 1,000 of them produced virtually all of the investor value during that time. Thirty of them produced almost one-third of this value. It’s difficult to succeed in business. Making use of these strategies—and engaging a credentialed and experienced professional team—is your best chance of reaping the rewards available to the American taxpayer today.
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James Barger is president of KeyBank’s Rochester Market. He may be reached by phone at 585-238-4121 or email at james_r_barger@keybank.com.
