Marital deduction is both friend and foe

Just as night follows day, when the grim reaper takes dad, someday mom will follow. Sometimes mom goes first and dad follows. Either way, after both mom and dad are gone, the IRS almost always gets a big payday. Since the business is usually the biggest dollar-value asset of a family business owner, its value is critical to the transfer and estate plan. Thats the question the kids ask. Heres the sad

Just as night follows day, when the grim reaper takes dad, someday mom will follow. Sometimes mom goes first and dad follows. Either way, after both mom and dad are gone, the IRS almost always gets a big payday.

Since the business is usually the biggest dollar-value asset of a family business owner, its value is critical to the transfer and estate plan.

“Why?” That’s the question the kids ask. Here’s the sad answer: When dad’s (let’s call him Joe) estate plan was done, he received a small mound of papers containing a traditional estate plan. Typically, a will and a trust. And a mirror set of instructions for mom (let’s call her Mary).

Just what is a traditional estate plan? If your estate plan is done, I’m 95% sure that your plan documents make only two significant tax moves:

Saves the unified credit. In 1999 your first $650,000 (rising gradually to $1 million in the year 2006) passes tax-free because of unified credit. For example, if in 2006 Mary and Joe each have title to $1 million or more in assets, the first $2 million ($1 million for Joe, $1 million for Mary) of the family wealth is protected from the clutches of the IRS. Typically, each $1 million is set aside in a separate trust for the benefit of the children.

Uses the marital deduction. The marital deduction can be friend or foe. Let’s use an example. Joe dies in the year 2007. Let’s assume Joe is worth $9 million (assets titled in his name) and Mary (who survived Joe) has $1 million in assets in her name.

At Joe’s death Mary gets $8 million (remember the first $1 million was set aside for the kids). Mary gets the entire $8 million — typically in a marital trust. Thanks to the marital deduction there is no tax. Terrific! The marital deduction is a friend.

So the kids go to the lawyer with Mary. They ask, “What happens when Mary dies?” The lawyer answers, “The tax will be about $4 million.” Panic! Anger! The truth is out: The marital deduction is a foe. A terrible and tragic foe. All that the marital deduction can do is defer the tax. It gave a false sense of security to Joe.

Ok, now here’s the question you (mom and dad) should ask your professional while you are both alive. “Will our estate plan get the entire value of our wealth — including our business — to the children intact?” For example, if you are worth $6 million (fill in your number), will the entire $6 million go to your family, all taxes paid in full? If the adviser says anything like “no,” “maybe” or “uhh,” you know you should get a second opinion.

The second option, if done correctly, will draw a “yes” to the last question (all your wealth to your family). But you need more than a will and a trust. You need a plan that takes effect during your life using such strategies as a grantor retained annuity trust for your business; a subtrust if you have money in a rollover ira, a profit-sharing plan or similar plan; a qualified personal residence trust for your home; and a family limited partnership for your other assets. The plan should also use strategies that get you into a tax-free environment — life insurance, charitable trusts or both — immediately.

And what if dad (or mom) has already died? Can mom get out of the marital deduction tax trap? Yes! But again, the answer lies with a new lifetime plan for mom starting with the same strategies listed when mom and dad were both alive.

Succession/transfer planning

The stock market is volatile. Getting a bank to finance growth or a business acquisition is tough. Try to sell your business and you will find that the number of willing and able buyers is not only smaller, but such buyers are offering less than you could have received two or three years ago. Does this type of business environment have any positive tax impact on closely held businesses?

The answer is a resounding yes! In what area? Transfer planning. How do I know? My transfer/succession/estate planning seminars are pulling larger audiences. But more importantly, owners of family businesses are calling my office, consulting, then implementing plans to transfer their businesses to their kids.

Whether your transfer plan is a sale of the business to the kids (usually a tax disaster), a gift, a redemption or some other method or combination of lifetime transfer methods, the same big question stands tall — what is your business worth? And the question does not change if you want to wait to transfer all or part of your business after death.

Since the business is usually the biggest dollar-value asset of a family business owner, its value is critical to both the transfer plan and the estate plan. I still find the following numbers hard to believe, but these are the facts based on my experience of working with hundreds of business owners through the years.

About 5% really know what their business is worth (usually the result of an appraisal), about 50% greatly over-value their business and about 45% use book value (rarely the right method).

You wouldn’t set the price of an item or service you were about to sell until you determined the cost. The same logic applies to developing a transfer-your-business plan. The fair market value of your business dictates your potential estate tax cost. You must know this cost. If you plan to sell or transfer your business, it is essential to have your business appraised.

Once you know the value of your business, you can compute the range of damage the estate tax can cause. Best of all, you are in a position to create a transfer plan that can reduce (almost always even eliminate) the estate tax, yet keep you in control of the business for as long as you live, and provide you and your spouse with a source of retirement income.

Deduct lunch with employees

Nothing pains me more than when a client loses what should be a legitimate meal deduction to an examining IRS agent. An old but still important and controlling case (John D. Moss Jr., CA-7, 1985) gives the IRS a big edge. This is what the case holds: The cost of a working lunch between company executives where important business is discussed is not necessarily tax deductible.

Here’s the sad story. Partners, associates, clerks and secretaries of a law firm lunched daily at the same restaurant. At the lunches, the firm’s litigation was discussed. The attorneys reviewed pending cases with the head of the firm whose approval was needed for any settlements. Each partner deducted his share of the lunch as a business expense. The IRS disallowed the deduction and, worse yet, the court agreed.

The court noted that the daily luncheon meetings were necessary to conduct the firm’s business, but that did not automatically make them deductible as ordinary and necessary business expenses.

The court’s logic seems impeccable — personal activities such as lunch should not be awarded a tax windfall. To do so would entitle a commuter to deduct the cost of his commute because he happens to discuss business with a fellow worker during the trip. True, the activities may be related to business, but for tax purposes they are really a matter of personal choice.

But take heart, all is not lost! The court said lunch with co-workers could be deductible. And this is the crux of the logic behind the court’s decision: The frequency and the circumstances of the particular working lunch situation control its deductibility as a business expense.

In this case, the frequency of the meetings was too much for the court to stomach. Sorry, but daily sojourns to your favorite trough or watering hole to discuss business may be pleasant, but the cost is not tax deductible.

But, the court suggested that monthly lunches would be deductible. Clearly, an occasional meeting (breakfast, lunch or dinner) with one or more of your co-workers is deductible, provided business is discussed. But remember an allowable deduction for meals only gives you a 50% deduction of the tab (food, drink and tip).