Estate Planning Ideas for Angel Investors

As an angel investor, you have spent a lot of time growing your own business and then lending your expertise to help other entrepreneurs.  That hard work has enabled you to increase your net worth but oftentimes means that a large portion of that net worth is illiquid.  What if something were to happen to you?  Would your family know how to value your business interest(s)?  Would they have money to pay for estate and income taxes?  Who would control the interest(s) in your various business investments? 

These are real issues that can leave families struggling for liquidity while arguing over succession planning strategy.  Having a plan in place to assist with the smooth transfer of assets upon your death is important when the assets you hold are not easily marketable.  Therefore, here are a few tips we believe will help you create an estate plan today that will work to keep the wealth you have created in your family. 

 

1.     Annual Meetings of your “Brain Trust”: At Stratus, we like to have an annual meeting with our client’s various service providers (e.g., accountants, lawyers, business partners, etc.) so that everyone is aware of major developments and can share any concerns they have with the key advisers and decision makers.  Below are a few questions we try to answer at each meeting:

a.     Who will value your business interest(s)?  Do you have a control or minority stake in these businesses and how will that impact the value you receive?  What are the restrictions on the sale of your ownership interest and how will that impact the value you receive?

b.     What new tax regulations are pertinent to your business and how do these affect your short- and long-term planning?

c.     Are all your contracts with employees, vendors, etc. up to date?

d.     Who, if anyone, will succeed you in your business?  Who will own your stakes in any other businesses or business investments?

e.     If you have children that are interested in the family business is it time to bring them on as an employee?  If so, at what point do they begin to acquire an ownership stake and how is that stake valued and paid for?

2.     Life Insurance: Angels investors don’t fit a typical profile or age cohort, but life insurance can be an important liquidity tool for any angel investor.  We suggest setting up your estate planning documents carefully so that insurance proceeds will be available to your spouse first (if applicable) and then to settle your estate. 

a.     Younger Investors: How long would you like to protect against the risk of illiquidity?  Periods under 20 years are typically associated with term life insurance whereas the most beneficial protection over longer periods may be cash value insurance such as whole life. 

b.     Older Investors: What is your life expectancy and allocation to private businesses?  In general, shorter policies, such as 10-year term insurance, may provide the liquidity protection you need while keeping premium payments relatively low.  Investors with lower allocations to start-ups and/or those who have more stable sources of cash flow may want to purchase cash value life insurance, such as 10-pay whole life, which front loads policies with larger premiums over a finite period (e.g., 10 years).  These policies can provide the dual benefit of liquidity during your life and liquidity following your death.   

3.     Family Trusts, Partnerships and LLC’s: We believe that it is important for angel investors to use legal entities to either hold their current businesses and/or investments or to create provisions for these assets to flow in to legal entities upon their death.  Different kinds of legal entities fit different scenarios but having a discussion with your “brain trust” can help you set specific parameters for how your assets are distributed and who operates them after your death or if you become incapacitated. 

4.     Loans Between Trusts: Many trust documents allow for loans between the different trusts that are created as part of your estate plan.  We highly recommend that these provisions be included in any angel investor’s estate planning documents.  This can allow for money to be loaned from a more liquid trust to the deceased’s estate to pay taxes, liabilities and other final expenses.

5.     Letter of Intent: We only suggest pursuing a letter of intent in very rare circumstances.  Angel investors who are heavily exposed to illiquid investments can work with one or more of their portfolio companies to set parameters for selling shares back to the company should the angel suddenly die or become incapacitated.  These letters of intent can create liquidity in an emergency but typically at a discount, so it is necessary to review these documents on an ongoing basis to see if they are still relevant given the angel investor’s current financial situation. 

 

While never the most fun process, spending time today personalizing your estate plan and subjecting that plan to an annual review will greatly enhance the legacy you leave for your loved ones. 

Year-End Tax Notes for Angel Investors - What You Need to Know

As 2018 comes to a close we have gained additional clarity on the provisions included in the new tax law and many of these will have an impact on small business owners and entrepreneurs.  While the IRS will continue to update regulations, we believe now is a good time to review some of the most pertinent changes to you.

 

Pass-Through vs. Corporation

The bill allows a deduction of up to 20% of pass-through income that is considered “qualified business income”.  For example, if you make $100,000 in profit you could take a deduction of $20,000, which means you will be taxed on only $80,000 of profits.  However, there are limitations to this deduction, including for certain service businesses (accountants, lawyer, financial advisors, physicians, etc.) as well as for those who make more than $207,500 per year as a single filer or $415,000 as a joint filer.  Therefore, it is important that you talk to an accountant or advisor who understands your unique situation before you take any action. 

An alternative is to think about changing your corporate structure to that of a C Corporation[1].  The new tax law imposes a 21% tax rate on corporate profits so small business owners in high tax brackets, and especially those running a service business, may consider talking with their accountant about whether the C Corporation structure is more beneficial than their current pass-through structure.  Keep in mind that the double taxation of profits, on corporate income and on dividends to owners, still applies.

 

Update Your Estate Plan

One of the more prominent pieces of the tax law for estate planning purposes was the doubling of the estate tax exemption to ~$11.2 million for single filers and ~$22.4 million for joint filers[2].  While the temporary increase may cause individuals and families to question the need for estate planning there are still important items to consider.

 

1.     Make sure to check your trust documents to see if they use a formula to set up a lifetime exemption gift because you may want to re-think this provision given current and potential future tax law changes.

2.     Have you set up both revocable and irrevocable trusts?  If so, you may want to look at the cost basis of assets in each type of trust because low basis assets in an irrevocable trust can be swapped for an equal amount of high basis assets in a revocable trust so your heirs receive the step-up in basis upon your death.

3.     One of the few deductions that became more favorable was the charitable deduction (now up to 60% of Adjusted Gross Income).  If you are charitably inclined and/or worried about losing other deductions, you may consider setting up a Charitable Remainder Trust or using a Donor Advised Fund.   These vehicles allow you to accelerate your charitable giving for deduction purposes without having to immediately specify which charity receives your money.

4.     If you are a small business owner, now may be a good time to think about having an updated valuation of your business so you can make decisions about succession planning and the tax consequences associated with selling or gifting a portion or all of your business to family members or a third party. 

Where do I Look for Deductions?

One of the biggest changes with the passage of the new tax law is the removal or reduction of popular deductions, such as the $10,000 cap on the deduction of state and local taxes (which includes property tax).  Here are a few thoughts on possible deductions to discuss with your accountant:

1.     Business Related Deductions

a.     Depreciation: Businesses will now be able to expense up to $1 million of equipment purchases.

b.     Real Estate Related Equipment: Upgrades to items such as roofs, HVAC systems and security systems can now be immediately expensed.

c.     Net Operating Losses: You can no longer carry-back losses and losses created in 2018 and all future years can only be carried forward at 80% of taxable income.  However, losses claimed by December 31, 2017 can be carried forward at 100%.

2.     Charitable Deduction: As discussed above, the charitable deduction is now good up to 60% of your Adjusted Gross Income.  You can use this deduction each year or front-load charitable contributions into a Charitable Remainder Trust or Donor Advised Fund.

3.     Retirement Plans: Setting up a retirement plan for your small business or current venture is a great way to take advantage of the tax-deductibility of retirement plan contributions while also saving for your future.

4.     Roth Conversions: If you are now in a lower tax bracket and have cash on hand to pay conversion taxes and/or have made previous non-deductible contributions to a traditional retirement plan, now may be a good time to think about converting these assets to post-tax Roth assets.  This may be an especially pertinent move for high-income taxpayers who have paid tax on assets in a traditional retirement account because the Roth conversion can remove these assets from future RMD calculations and thus can shelter your hard-earned money as it grows for distribution to your heirs. 

AMT Is Not Dead

Although there was talk about repealing the AMT completely, the final tax bill repeals the corporate AMT and temporarily increases the AMT exemption and phase-outs for individuals.  This is another good reason to discuss whether incorporating your business would be beneficial.  As always, please make sure to discuss your specific situation with an accountant or advisor who knows you and your business.   


[1] One potential benefit of incorporation is that the corporate tax cut is permanent while the individual tax cuts are set to expire on December 31, 2025.

[2] These lifetime exemption amounts are set to be reduced to the 2017 levels adjusted for inflation on December 31, 2025. 

Will Your Loved Ones Have Cash to Settle Your Affairs?

As an angel investor, you spend a lot of time focusing on the merits of each company founder, the sustainability of their business plan and the underlying fundamentals of the company and industry.  You work hard to invest your money in companies that will help grow your wealth.  At the same time, cash invested in a start-up is not available for emergencies, including incapacitation and death.  While no one likes to focus on their own demise, Stratus believes it is important to make sure your hard-earned money is protected, available for your loved ones to settle your affairs and, most importantly, for your legacy to be carried forward.

Therefore, here are a few tips we believe will help you create an estate plan for today and for the future you envision.

1.     Life Insurance: Angels investors don’t fit a typical profile or age cohort, but life insurance can be an important liquidity tool for any angel investor.  We suggest setting up your estate planning document carefully so that insurance proceeds will be available to your spouse first (if applicable) and then to settle your estate. 

a.     Younger Investors: How long would you like to protect against the risk of illiquidity?  Periods under 20 years are typically associated with term life insurance whereas the most beneficial protection over longer periods may be cash value life insurance such as whole life. 

b.     Older Investors: What is your life expectancy and allocation to private businesses?  In general, shorter policies, such as 10-year term, may provide the liquidity protection you need while keeping premium payments relatively low.  Investors with lower allocations to start-ups and/or those who have more stable sources of cash flow may want to purchase cash value life insurance, such as 10-pay whole life, which front loads policies with larger premiums.  These policies can provide the dual benefit of liquidity during your life and when you die.   

2.     Loans Between Trusts: Many estate planning documents allow for loans between the different trusts that are created both during and after your life.  We highly recommend that these provisions be included in any angel investor’s estate planning documents.  This can allow for money to be loaned from a more liquid trust to the deceased’s estate to pay taxes, liabilities and any other final expenses.

3.     Letter of Intent: While not ideal, those angel investors who are heavily exposed to illiquid investments may want to discuss the option of selling their shares back to the issuing company at a discount in the case of their untimely death.  These letters of intent can create liquidity in an emergency and need to be reviewed on an ongoing basis to see if they are still relevant given the angel investor’s current financial situation.

4.     Trusts: We believe that it is important for angel investors to use trusts to either hold their current businesses and/or investments or create provisions for these assets to flow in to trusts upon their death.  There are many kinds of trusts but all of them can help an angel investor set specific parameters for how their assets are used after their death.  Trusts can help heirs pay for expenses following your death and guide those same heirs through the process of dividing assets between beneficiaries according to your wishes.   

While never the most fun process, spending time today personalizing your estate planning will greatly enhance the legacy you leave in the future. 

Could Your Angel Investment Exit Receive an Exclusion from Capital Gains Tax?

As an angel investor, one of the most important pieces of your investment is the company’s exit strategy.  However, with the excitement of a successful exit comes the corresponding tax liability.  However, did you know that the 1993 Revenue Reconciliation Act, Section 1202 of the tax code and subsequent acts may provide partial and sometimes full exclusions from capital gains for the sale of stock in a qualifying small business?  While not exhaustive, we believe the questions and answers below provide a good starting point for determining whether some or all of your investment gains may be excluded from capital gains tax.

What is a qualifying business?

This is the trickiest area of the law since the definition is narrow and subject to interpretation.  Businesses that perform services in areas such as law, health, engineering, architecture, accounting, consulting, brokerage and farming are not eligible for the capital gains exclusion.  However, technology companies that provide support to these fields may be eligible, which creates opportunities for many angel investors.

What are the eligible capital gains exclusions?

For stock purchased directly from the issuing company prior to February 18, 2009 the capital gains exclusion is up to 50%.  For stock purchased directly from the issuing company after February 18, 2009 and before September 27, 2010 the capital gains exclusion is up to 75%.  For stock purchased directly from the issuing company after September 27, 2010 the capital gains exclusion is up to 100%. 

Are there other parameters to consider before I can receive the capital gains exclusion?

Yes, below is a list of items to consider.

-       The stock must be issued by a C Corporation;

-       The stock must be purchased directly from the company;

-       No stock buybacks within a 4-year period beginning 2 years before the issuance of the stock from either the taxpayer or a related person;

-       The company must have aggregate gross assets of $50 million or less at the purchase date and immediately thereafter;

-       At least 80% of the assets must be used in one or more qualified trade or business; and

-       In general, the capital gain is limited to the greater of $10 million or 10 times the aggregate adjusted basis of the stock disposed of by the taxpayer during the tax year.

There may be other issues to consider because each transaction is unique and needs to be treated individually.  However, we believe this list provides a good starting point for angel investors to potentially reap the full benefit of their investment in certain small businesses.  We encourage anyone who is thinking about taking one of these capital gains exclusions to consult with their accountant, financial advisor and/or lawyer before proceeding. 

Tax Law Changes - What You Need to Know

We have gained some clarity on the provisions included in the new tax law and many of these will have an impact on small business owners and entrepreneurs.  While the IRS still has many regulations and guidelines to write, we believe now is a good time to review some of the most pertinent changes.

Pass-Through vs. Corporation

The bill allows a deduction of up to 20% of pass-through income that is considered “qualified business income”.  For example, if you make $100,000 in profit you could take a deduction of $20,000, which means you will be taxed on only $80,000 of profits.  However, there are limitations to this deduction, including for certain service businesses (accountants, lawyers and engineers among others) as well as for those who make more than $157,000 per year as a single filer or $315,000 as a joint filer. 

An alternative is to think about changing your corporate structure to a C Corporation[1].  The new tax law imposes a 21% tax rate on corporate profits so small business owners in high tax brackets, and especially those running a service business, may consider talking with their accountant about whether a C Corporation is more beneficial than their current pass-through structure.  Keep in mind that the double taxation of profits, on corporate income and on dividends to owners, still applies.

Update Your Estate Plan

One of the more prominent pieces of the tax law for estate planning purposes was the doubling of the estate tax exemption to ~$11 million for single filers and ~$22 million for joint filers[2].  While the temporary increase may cause individuals and families to question the need for estate planning there are still important items to consider.

1.     Make sure to check your trust documents to see if they use a formula to set up a lifetime exemption gift because you may want to re-think this provision given current and potential future tax law changes.

2.     Have you set up both revocable and irrevocable trusts?  If so, you may want to look at the costs basis of assets in each type of trust because low basis assets in an irrevocable trust can be swapped for an equal amount of high basis assets in a revocable trust so your heirs receive the step-up in basis upon your death.

3.     One of the few deductions that became more favorable was the charitable deduction (now up to 60% of Adjusted Gross Income).  If you are charitably inclined and/or worried about losing other deductions, you may consider setting up a Charitable Remainder Trust or using a Donor Advised Fund.   These vehicles allow you to accelerate your charitable giving for deduction purposes without having to immediately specify which charity receives your money.

Where do I Look for Deductions?

One of the biggest changes with the passage of the new tax law is the removal or reduction of popular deductions, such as the $10,000 cap on the deduction of state and local taxes (which includes property tax).  Here are a few thoughts on possible deductions to discuss with your accountant:

1.     Business Related Deductions

a.     Depreciation: Businesses will now be able to expense up to $1 million of equipment purchases.

b.     Real Estate Related Equipment: Upgrades to items such as roofs, HVAC systems and security systems can now be immediately expensed.

c.     Net Operating Losses: You can no longer carry-back losses and losses created in 2018 and all future years can only be carried forward at 80% of taxable income.  However, losses claimed by December 31, 2017 can be carried forward at 100%.

2.     Charitable Deduction: As discussed above, the charitable deduction limit increased to 60% of your Adjusted Gross Income.  You can use this deduction each year or front-load charitable contributions into a Charitable Remainder Trust or Donor Advised Fund.

3.     Retirement Plans: Setting up a retirement plan for your small business or current venture is a great way to take advantage of the tax-deductibility of retirement plan contributions while also saving for your future.

AMT Is Not Dead

Although there was talk about repealing the AMT completely, the final tax bill repeals the corporate AMT and temporarily increases the AMT exemption and phase-outs for individuals.  The repeal of the corporate AMT is another good reason to discuss whether incorporating your business would be beneficial. 

[1] One potential benefit of incorporation is that the corporate tax cut is permanent while the individual tax cuts are set to expire on December 31, 2025.

[2] These lifetime exemption amounts are set to be reduced to the 2017 levels adjusted for inflation on December 31, 2025.