As family business owners often are advised, business succession planning should include some form of estate planning. This advice is especially true when an owner wishes to transfer a business to future generations by gift or inheritance, instead of planning for a sale of the business to an unrelated third party. An owner wishing to make a donative transfer must consider the impact of transfer taxation (primarily meaning estate and gift tax) on the transition.
But here’s the dilemma: The concepts of estate planning and succession planning may, at times, conflict with to each other.
On the one hand, the sooner an owner gifts the business to a younger generation, the greater the potential transfer tax savings realized, usually in the form of the removal of future appreciation out of the owner’s estate. On the other hand, though, the owner may not have identified a likely family successor yet, may not be ready to give up control of the business or, importantly, may still need the income from the business to live and to fund the owner’s retirement.
Fortunately, there are estate planning techniques that can align these interests such that ownership succession does not necessarily have to mean management succession. These techniques allow for a business owner to transfer ownership of a business and mitigate transfer taxation without immediately ceding control of the business, while also providing an income stream to the owner for a period of time. Two of these techniques are a Grantor Retained Annuity Trust (GRAT) and a sale to an Intentionally Defective Grantor Trust (IDGT).
Grantor Retained Annuity Trusts (GRATs).
The utilization of a GRAT to gift business interests to a future generation works well during times when interest rates are low, as they are now, and allows for an owner to retain control over, and income from, the transferred interest for a period of time.
A GRAT is an irrevocable trust created by the business owner, into which the owner transfers all or a portion of a business (or other asset) in exchange for a fixed payment, or annuity, for a term of years chosen by the owner (the “annuity term”). At the expiration of the annuity term, the business interest in the GRAT automatically transfers to the beneficiaries designated by the owner in the trust agreement, usually the owner’s family. Although the family members don’t take actual ownership of the interest until the expiration of the annuity term, the “transfer” of the interest for gift tax purposes occurs when the owner transfers the interest to the GRAT, and so the appreciation on the interest post-transfer to the GRAT may be removed from the owner’s estate. The amount of the annuity paid to the owner during the annuity term is determined by the owner, but must meet certain minimum amounts mandated by the IRS.
Importantly, the owner can be the trustee of the GRAT during the annuity term and, as such, can retain control of the business interest in addition to maintaining an income stream from the business in the form of the annuity.
In order to realize the benefit of the GRAT, the owner must live for the entire annuity term. Further, the business interest in the trust should be expected to generate enough income to cover the annuity payments, and so GRATs work well only for businesses that are predicted to appreciate and generate steady income during the annuity term.
Sale to an Intentionally Defective Grantor Trust (IDGT).
The use of an IDGT provides similar benefits to that of a GRAT. The business owner establishes the IDGT and gifts to the trust “seed money” that will be used as a down payment for the purchase of a business interest by the trust. The amount of this “seed money” should be at least 10% of the value of the interest to be purchased. The grantor then sells the business interest to the IDGT in exchange for the cash down payment and a promissory note from the IDGT, with the purchase transaction being a bona fide arm’s-length transaction. Since the IDGT is a grantor trust (meaning the business owner is considered the owner of the IDGT assets for income tax purposes) the sale does not result in the recognition of income tax.
The business owner, as the holder of the note, may choose to forgive the note payment each year as a further gift and, if the amount of the payment forgiven each year is below the owner’s annual gift tax exclusion, such additional gifts may result in no gift tax liability at all to the owner. Alternatively, the owner may choose to receive the payments to provide an income stream during the note term. The owner may serve as the trustee of the IDGT, thereby retaining control over the business interest in the trust. At the end of the note term, the portion of the business interest held in the IDGT in excess of the amount owed under the note, which may be the entire interest, passes to the trust beneficiaries, usually family members, free of gift and estate tax.
There are critical compliance requirements for formation of a GRAT or an IDGT, and competent advisers should be consulted. But, bottom line, the use of GRATs and IDGTs are two techniques a business owner may utilize to transfer a business with maximized transfer tax efficiency, but while also retaining, for a time, control over and financial benefits from the transferred interest.
Matt Loftin counsels individuals, families, and businesses on a broad range of trust and estate matters, including business planning. He advises clients on tax-efficient wealth and property transfers made during lifetime and at death through the utilization of client-specific planning techniques, including charitable planning, business-succession planning, and special needs planning. In addition, Matt represents personal representatives, executors, and trustees in the administration of trusts and estates. Matt can be reached via email at firstname.lastname@example.org or directly by phone at 425.646.6118.