The federal tax reform law Congress passed and President Trump signed in December has ramifications for family-owned businesses and how they are ultimately transitioned from one generation to the next.
Among the changes the Tax Cuts & Jobs Act brought was a doubling through 2025 of the estate and gift tax exemption to $11.18 million for an individual and $22.36 million for a married couple. The amounts will increase annually for inflation.
“That creates an opportunity for owners of family businesses to take advantage of,” said attorney Mark Harder, a partner at Warner Norcross & Judd LLP in Holland who chairs the firm’s private client and family office group.
Harder has several clients who own family businesses and are taking a look at whether to “make substantial additional gifts over the next several years to try and transfer more of the business for the next generation, free of any gift tax or estate tax, at the senior generation’s death,” he said.
“There’s now a window to make substantial gifts to your family members of your family business interests and shelter those with gift tax exemptions,” Harder said. “There’s an opportunity now to make some large transfers of family business interests and get the assets out of the estate, and pass that interest on now without the estate tax later becoming an issue.
“They can transfer millions of additional dollars to their children or trusts for their children that will not be part of the estate for estate tax purposes and can be done without a transfer tax.”
The changes to the gift and estate taxes that the reform law ushered in may ease the process of succession planning for some owners of family businesses, said attorney Neil Kimball, a partner at Mika Meyers PLC in Grand Rapids who specializes in business, estate and gift tax planning.
“That has taken the pressure off of some businesses because you don’t have to worry about the estate tax and liquidity,” Kimball said.
The federal tax reform law also lowered the top tax rate for businesses classified as C Corporations from 35 percent to 21 percent. That change to lower the tax rate “might make it more palatable” for a company to retain or move to a C-Corp classification, Kimball said.
Under the prior federal tax code, income from S Corps and LLCs passed through to owners on their individual taxes and got taxed up to a top rate of 39.6 percent. To make up the difference in the tax rates between C Corps and S Corps, the law created a temporary 20-percent deduction for so-called pass-through entities.
To qualify for the full deduction, owners of S Corp businesses must have taxable income below $157,500 if they are single, or $315,000 if married. The law places limits on the deduction for income that exceeds those thresholds.
The deduction also is only temporary and, unless renewed by Congress, expires at the end of 2025.
Changes in the top tax rate for C Corps — which are taxed at the corporate level and shareholder level — and the creation of the 20-percent deduction for S Corp entities has led some businesses to begin analyzing whether to revert to a C Corp, Harder said.
Part of that conversation with clients is that some planning techniques work much better when their companies are taxed as an S Corp since owners have the ability to take tax-free distributions.
“The lower rate that applies to C Corporations appears very attractive to them,” Harder said. “There’s now a pretty wide gap between the rate that applies year in and year out for a C Corporation versus the rate that applies if you’re an S Corporation, especially with all of the uncertainty about whether or not you’re going to qualify for that 20-percent deduction.
“It certainly has added some complications to the succession planning. Just about all of the family businesses that I’ve been working with, when we’ve had conversations in the last three months, it’s come up that they’re actively re-evaluating their choice of tax entity or tax classification.”
Business owners should have a detailed analysis conducted by their advisers to determine whether to make the switch, he said.
The sunset provisions for the 20-percent deduction for S Corps and the estate and gift tax exemptions further complicate long-term planning. If Congress flips and Democrats take control in the midterm elections this year or in 2020, and if they win the presidency, they’re likely to make changes to the tax reform law, Harder said.
“That adds another complication. How permanent are the changes going to be? We don’t really know,” he said. “What will happen to all of these rules? Are they going to be undone or not? That makes planning very difficult because you don’t have any certainty.”
Another consideration: Changing a company’s tax classification has ramifications for at least 10 years.
Once a company revokes an S Corp classification and elects to become a C Corp, it cannot go back for five years, “and there are consequences” for another five years afterward, Harder said.
“If your exit strategy for your family-held business is that sometime in the relatively near future you’re going to sell the company, then keeping the S selection for most people is going to be a relatively easy decision to make,” he said.