Tax Benefits of Advance Planning

Estate planning strategies for founders typically focus on minimizing income taxes and inheritance taxes. Income tax savings can be realized by creating and funding multiple trusts with company stock that replicate all available QSBS exemptions and designing trusts where possible to be exempt from state income taxes and premises which might otherwise apply to the Founder personally. Estate tax savings can be realized by designing trusts that are not included in the founder’s estate on death and can benefit children or future generations without estate tax.

Because these strategies typically require the founder to donate shares of the company to trusts, and the value of those donations will count toward lifetime exclusions from gift and estate tax, these tax goals are almost always easier to achieve earlier in the life cycle of a business. .

To understand the major tax advantages of estate planning, let’s look at both the income and estate taxes faced by two hypothetical co-founders with identical circumstances, Jill and Kate. Jill and Kate are married, live in New York and have two children. They will each realize a cash gain of $100 million on a hypothetical exit. The shares of each are eligible for QSBS and have been held for more than 5 years. Jill has done no prior estate planning and holds 100% of her shares in her own name. Kate worked with her legal team at Patterson Belknap several years ago to implement estate planning designed to reduce taxes. His shares are held 70% in his name and 30% divided equally between three separate trusts for the benefit of his spouse and two children which have been carefully designed to achieve the objectives described above. Because Kate did this planning early (i.e. at a time when the valuation was lower), the shares she offered to the trusts several years ago were worth $3 million at the time of the donation, $1 million per trust.

Let’s see where Jill and Kate ended up. (Note that for illustrative purposes, dollar amounts and tax rates are rounded and use simplified assumptions about Jill and Kate’s tax situations.)

Jill’s release (no planning)

Income tax analysis

  • The first $10 million received by Jill should be exempt from federal, New York and New York taxes as QSBS.
  • Balance subject to 23.8% federal tax and 14.8% New York State and New York City taxes, for a total rate of approximately 39%.
  • The tax on the $90 million not protected by QSBS is approximately $34 million.
  • Jill’s after-tax net proceeds would be approximately $66 million.

Inheritance tax analysis

  • Suppose Jill and her spouse made no lifetime donations, had no other assets, and the value of their after-tax proceeds remained constant over their lifetime after the liquidity event.
  • The current federal estate tax exclusion is approximately $24 million for a married couple. Amounts over $24 million are taxed at approximately 50%, including federal and New York estate taxes.
  • Jill’s estate is $66 million and the combined estate tax would be around $22 million
  • The net after-tax proceeds received by Jill’s children would be approximately $44 million.

Katie’s Exit (With Confidence Planning)

Income tax analysis

  • The first $10 million received by Kate and each of the trusts ($40 million in total) should be excluded from federal, New York State and New York City taxes as QSBS.
  • Balance subject to federal tax of 23.8% and New York State and New York City taxes of approximately 14.8%, for a total rate of approximately 39%.
  • The trusts will pay no income tax since each trust receives $10 million in proceeds from the sale, all of which is protected.
  • The tax on the $60 million not protected by Kate’s QSBS exemption is $23 million.
  • Kate’s after-tax net proceeds are said to be around $47 million.
  • Including the $30 million received by the trusts, Kate’s family received $77 million in total.
  • That’s $11 million more in total than what Jill received.

Inheritance tax analysis

  • Assume that Kate and her spouse made no donations other than the shares donated to the trusts, had no other assets, and the value of their after-tax proceeds remained constant over their lifetime after the liquidity event.
  • The current federal estate tax exemption is around $24 million for a married couple, but Kate and her spouse only have $21 million available at death since they used $3 million. when they donated to trusts.
  • Amounts over $21 million are taxed at approximately 50%, including federal and New York estate taxes.
  • Trust funds are not subject to estate tax, so Kate’s estate is only $47 million and the combined estate tax is around $14 million.
  • The net after-tax proceeds received by Kate’s children would be approximately $33 million from her estate and $30 million from trusts, for a total of $63 million.
  • That’s $19 million more in total than what Jill’s family received.

As you can see, the tax savings from early estate planning can be significant. However, this is only the beginning of the story, as our assumptions did not take into account asset appreciation in the years or decades following the liquidity event. If the money from the trusts created by Kate is invested after the liquidity event, the assets will continue to appreciate without being subject to New York State and New York City income tax d about 14.8%. The cumulative effect of these tax savings over a long period could be enormous. What’s more, all of this appreciation is outside of Kate’s estate and can benefit her children, grandchildren and future generations without estate tax or generation skipping. If these long-term tax advantages are taken into account, the difference between the after-tax proceeds received by Jill’s family compared to Kate’s family would be well over $19 million.

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