By Jeffery B. Levi and M. Brooke Wilson, Wendel, Rosen, Black & Dean LLP
Critical to the longevity of the family business is the ability to pass interests in the business to the next generation in a tax-sensitive manner. Several techniques allow senior generation owners to minimize or reduce the transfer-tax consequences of passing ownership to the next generation.
Current Transfer Tax Laws
Unlike the income tax system, the federal transfer tax system is comprised of three separate taxes: the gift tax, the estate tax, and the generation skipping transfer tax (“GST tax”). Currently, the amount that is excluded from estate tax (the “estate tax exclusion”) is $5,450,000 per person, adjusted annually for inflation. The gift tax exclusion and GST tax exemption are also $5,450,000, adjusted for inflation annually. The tax rate on transfers of assets that exceed the gift, estate and GST tax exclusions is 40 percent.
Business owners intending to keep a business within the family often must minimize the impact of the estate and GST tax at death in order to avoid the sale of the business or its assets to pay the tax liabilties. An outright gift of an interest in the business is the simplest approach and may be appropriate where the next generation is seasoned and involved. However, business owners who anticipate estate tax liability at death are often focused on transitioning some or all of the business to the next generation in a tax-sensitive manner before further appreciation increases their tax burden. This can be achieved in a number of ways.
Grantor Retained Annuity Trust
A grantor retained annuity trust (“GRAT”) allows the business owner (the “grantor) to transfer business interests that will appreciate substantially over time while retaining an interest in the business for a stated term. During the term, the grantor retains the right to a stream of payments, which can consist of cash earned by the business interests or even the interests themselves. At the end of the term, any remaining business interests are distributed to the trust beneficiaries, who can be the next generation of owners.
The grantor is treated as having made a gift of the remainder interest when the GRAT is established. The value of that gift is determined by subtracting the actuarially determined value of the interest retained by the grantor from the total value of the property transferred to the trust. This permits a gift to be made of the remainder at the discounted present value. Any future appreciation in excess of the amount of the annuity payments escapes gift and estate taxes. This provides an effective way to magnify the value of the business owner’s gifts, while also reducing estate tax liability. However, the grantor must survive the term for this mechanism to succeed.
Sale to Intentionally Defective Grantor Trust
The sale of interests to an intentionally defective grantor trust (“IDGT”) in exchange for a promissory note is another technique for transferring business interests to the next generation in a tax-advantaged manner (don’t worry, there is nothing “defective” about this procedure). The IDGT’s beneficiaries can be members of the grantor’s family. The IDGT is treated as being owned by the grantor for income tax purposes, but not included in the grantor’s estate for estate or gift tax purposes. Typically, the grantor contributes cash to the IDGT, which consumes some of the grantor’s gift tax exemption amount. Then, the trust purchases business interests from the grantor for their fair market value (as determined by appraisal) using a cash down payment that is funded with the grantor’s contribution to the trust and a promissory note bearing interest at a rate set by the IRS. No gain is recognized on the sale of the asset to the trust.
Similar to the GRAT, the asset that is used should be one that is expected to appreciate and generate sufficient income to fund the debt service on the note. If the asset appreciates at a rate faster than the interest rate on the note, the “excess” appreciation and the income generated by the asset are removed from the grantor’s estate with no estate or gift tax consequences.
The sale to an IDGT produces results similar to a GRAT, but has several advantages: (i) the interest rate that the asset must outperform is generally less than that of a GRAT; (ii) the grantor need not survive the term of the trust for the transaction to be successful; (iii) GST exemption may be allocated to the trust on its creation; and (iv) the sale does not constitute a taxable gift. Any income earned by the trust is taxed to the grantor. This further magnifies the gift to the grantor’s descendants, because the growth in the value of the property in the trust belongs to the next generation while any income tax generated on it is paid by the grantor.
Real Estate Holding Businesses
Instead of holding real estate through an entity, many family businesses own income-producing real estate directly. When limiting liability through use of an entity (such as a limited liability company) is not a concern, the GRAT and sale to an IDGT can be used to transfer interests in the real estate to the next generation.
For management of the real estate after transfer of interests to the next generation, the family owners should consider entering into a tenancy-in-common agreement. Such agreements typically address who manages the property, how capital calls should be handled, and when distributions of income should be made, among other issues. They can also include restrictions on transferring interests in the real estate to non-family members and assurances that family members can compel the purchase of their interests if they need liquidity.
Leveraging With Discounts
Many of these gifting techniques involve the intra-family transfer of a partial interest in the business. One benefit of partial-interest transfers is the well-accepted practice of discounting the value of the transfer based on the lack of marketability of the transferred interests and lack of control of the business. These discounts result in reducing the full pro-rata value of the transferred interest (after all, who would pay the full pro-rata value for an interest in a family business that is difficult to sell or in which the minority owner has no control over the business?). For gifting purposes, discounts reduce the amount of gift tax exclusion used on the transfer. For sale purposes, they reduce the overall purchase price of the interest (thereby reducing both the amount of the required interest payments to the grantor and the risk that the asset will not appreciate at a rate that exceeds the debt service on the promissory note).
However, proposed IRS regulations released August 2, 2016, seek to limit the availability of these discounts for family-owned businesses. If adopted without change, these proposed regulations would significantly reduce, and perhaps eliminate, valuation discounts for intra-family transfers of partial interests in businesses. That would increase the transfer tax associated with certain transfers. At this point, the regulations are still in draft form, but it is possible that the regulations will become effective as early as the first quarter of 2017. Anyone considering a transfer of a family-owned business under the current rules should consider completing the transfer promptly.
Note: This article originally appeared in the September 2016 issue of Financial Advisor magazine.
Jeffrey B. Levi is an attorney with Wendel, Rosen, Black & Dean LLP. He practices in the areas of estate planning and corporate and transactional law. Levi works with individuals and families to plan and structure their estates. He prepares revocable trusts, irrevocable generational trusts, wills, durable powers of attorney, and advance health care directives. With his corporate and transactional skills, Levi frequently forms and prepares the organizational and operating documents for family businesses (such as family limited partnerships and limited liability companies) to meet clients’ business and estate planning objectives. He can be reached at 510-834-6600 or email@example.com.
M. Brooke Wilson is an attorney with Wendel, Rosen, Black & Dean LLP. Wilson concentrates her practice in the fields of estate planning, trust and estate administration, and federal estate and gift taxation. She advises clients on all aspects of estate planning, including guiding clients with family-owned businesses on succession planning, assisting with philanthropic goals, and preparing plans for traditional, non-traditional and blended families. Through the use of sophisticated estate planning techniques, she helps clients minimize their tax exposure and facilitates wealth transfers between generations. She also routinely handle trust administration and probate matters. She can be reached at 510-834-6600 or firstname.lastname@example.org.