Now Is the Time To Review Your Estate and Succession Plans
HARRY FOX, CPA
Every business owner needs an exit plan. In light of potential tax changes on the horizon, you might want to review your plan this fall. Perhaps most significant, the federal gift and estate tax exemption will be cut drastically at the end of 2025 — or much sooner if recent proposals become law. Therefore, if you plan to leave your manufacturing business to your family or transfer it to an unrelated third party, consider taking proactive measures today to help achieve your long-term estate and succession planning goals.
Related Read: Family Businesses: Choosing the Right Exit Strategy
Give business interests to family
If you plan to transfer your manufacturing business to your children or other family members, consider gifting business interests to them as soon as possible. For 2021, the federal gift and estate tax exemption allows you to transfer up to $11.7 million tax-free ($23.4 million for gifts you split with your spouse). But, this generous exemption is set to expire at the end of 2025 and return to its previous level of $5 million (adjusted for inflation).
It may be reduced even more, and sooner, under certain proposals being considered by Congress. One proposal, for example, would lower the estate tax exemption to $3.5 million and the gift tax exemption to $1 million. It would also replace the current 40% estate and gift tax rate with graduated rates reaching 65% for the wealthiest Americans. Plus, there is a proposal to eliminate valuation discounts for lack of marketability and control for transfers of business interests between members of a family that control the business.
It is likely that these changes will apply prospectively, so there may still be time to transfer substantial amounts of wealth on a tax-advantaged basis under current rules. IRS regulations issued in 2019 confirmed that the Service would not attempt to “claw back” a portion of gifts made before January 1, 2026 and subject those amounts to estate taxes after the current exemption amount sunsets. It is generally believed that a similar rule would apply in the event the exemption is reduced earlier.
Related Read: Tax Tips: Take Advantage of the Temporary Gift Tax Break
Consider capital gains issues
Another reason to act quickly is that recent proposals would eliminate an income tax incentive to hold onto business interests for life. Under current rules, a person who inherits appreciated property receives a “stepped-up” basis equal to the property’s fair market value on the date of death, allowing all appreciation to that point to escape capital gains tax.
In contrast, assets transferred by gift retain the donor’s basis. There are proposals to eliminate the stepped-up basis for assets transferred at death and for both gifts and bequests to provide for immediate taxation of the unrealized gain (subject to a $1 million lifetime exclusion and an exception for certain family-owned and operated businesses).
Look outside the family
There are many ways to exit a business. In addition to transferring your interest to family members (either by sale or by gift or bequest), other methods include:
- Selling the business to a third party;
- Selling the business to your management team;
- Selling your interest to your co-owners; or
- Conducting an initial public offering.
If you are not interested in selling the business or transferring it to your family, another option to consider is an employee stock ownership plan (ESOP). ESOPs are qualified retirement plans that invest in the company’s stock.
Although ESOPs can be somewhat complex to set up and administer, they offer substantial benefits. They allow business owners to create liquidity by selling some or all of their stock to the plan while retaining control and sharing equity with employees. They also generate various income tax benefits for the company, the owners and the employees.
Each of these options presents different tax and nontax implications. Identify your preferred approach as early as possible so you can begin to formulate a strategy.
Have a comprehensive plan
While this article focuses on ownership succession, it is also important to address management succession in your exit plan. Contact your ORBA CPA to learn more about both.
Is It Better for Manufacturers To Buy or Lease Equipment?
JOEL A. HERMAN, CPA
Manufacturing is an asset-intensive business, so deciding whether to buy or lease equipment or machinery is a critical financing decision. This article reviews some of the factors you should consider as you make this decision.
Advantages of buying
One of the biggest advantages of buying over leasing is the ability to deduct the full cost of eligible equipment purchases upfront for income tax purposes, using 100% bonus depreciation or Section 179 expensing. These accelerated deductions are available whether you finance the purchase or pay for it in full.
Bonus depreciation is generally preferable because, unlike Sec. 179, it is not limited to your net taxable income (which means it can generate or increase an overall tax loss). Sec. 179 also imposes a limit on depreciation deductions (currently, $1.05 million) and is phased out once total fixed-asset investments exceed a certain threshold (currently, $2.62 million). However, keep in mind that under current law 100% bonus depreciation is available only for assets placed in service through the end of 2022 (with certain exceptions), after which this tax incentive will gradually be reduced and then eliminated after 2026.
Deducting the full cost of newly purchased equipment can be a valuable tax break. But sometimes it makes sense to forgo these immediate deductions and recover the cost over time through depreciation (typically over five, seven or 15 years). For example, if you believe that the government will increase tax rates or that you will be in a higher tax bracket in future years, depreciation deductions may be worth more in later years down the road than they are today.
If your company is structured as a pass-through entity — such as an S corporation, limited liability company or partnership — you and the other owners may be eligible to deduct up to 20% of your qualified business income (QBI) from the company. The QBI deduction is up to 20% of your adjusted taxable income from the business. However, taking accelerated depreciation deductions reduces your taxable income, so it may reduce your QBI deduction as well. Note that under the current law, the QBI deduction is scheduled to expire after 2025.
Advantages of leasing
Despite the tax breaks associated with buying equipment, leasing also has its advantages. Leasing can provide cash flow and financing benefits, with greater access to capital, lower down payments and lower monthly payments. Leasing can also provide a hedge against the risk of obsolescence. Outdated equipment can be returned and/or upgraded at the end of the lease term, though this advantage tends to diminish as the lease term increases. A long-term lease does little to reduce the risk of obsolescence and may even increase your risk since your obligation to make lease payments continues even if you cease using the equipment. In addition, buying allows you to keep the asset indefinitely, while leasing requires you to repeatedly renew a lease or negotiate a new one when it expires and thus, continue making payments.
Review lease accounting rules
Traditionally, another advantage of leasing has been the ability to keep operating leases off the company’s balance sheet. But new lease accounting rules taking effect soon will eliminate this advantage for companies that follow the U.S. Generally Accepted Accounting Principles (GAAP). Under the new rules, companies will be required to report the “right of use” of the lease as assets and the present value of the lease payment obligations as liabilities on their balance sheets for all leases with terms of a year or longer. By increasing the amount of debt on a company’s balance sheet, this change can impair loan covenants and cause lenders and investors to view the company’s financials less favorably.
The original effective date of implementation has been deferred, but private companies are now required to adopt the new lease accounting rules for fiscal years beginning after December 15, 2021 and interim periods within fiscal years beginning after December 15, 2022. One option for companies that wish to preserve their ability to keep leases off the balance sheet is to adopt an alternative, non-GAAP financial reporting framework (see “Sidebar: Consider Alternative Accounting Methods”).
No one right answer
There is no universal “right answer” in the buy versus lease debate. The answer depends on your particular circumstances, a number of variables and an analysis of the relative advantages and disadvantages of each option. Your ORBA CPA or CFO can help you weigh the pros and cons.
Sidebar: Consider alternative accounting methods
As noted above, companies can avoid reporting operating leases on their balance sheets (as well as avoid adopting the new revenue recognition standards and other new topics) by adopting an accounting method that does not conform to the U.S. Generally Accepted Accounting Principles (GAAP). Common accounting framework alternatives include the cash basis and income tax basis of accounting.
Another option that has become popular amongst private companies and has been gaining acceptance among lenders is the AICPA’s Financial Reporting Framework for Small- and Medium-Sized Entities (FRF for SMEs). This alternative, also known as “Legacy GAAP”, is viewed by many owners and lenders as more reliable than the cash and income tax basis of accounting in part because it is derived primarily from “old GAAP” standards. By combining traditional GAAP accounting principles with certain accrual-based income tax principles, FRF for SMEs produces financial statements that highlight the most relevant information without much of the complexity of GAAP-compliant reporting, which may be unnecessary for smaller businesses and a hardship for smaller businesses to implement.
A significant difference between the two methods is that FRF for SMEs does not require operating leases to be reported on the balance sheet. Thus, manufacturers that switch from GAAP to FRF for SMEs can save substantial amounts of time, effort and money while preserving an important advantage of equipment leasing.
Related Read: Is it Time to Switch Accounting Methods?