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June 2012

Jun 03, 2012

Family Businesses

Now’s The Time for Estate Planning

The combination of historically low gift tax rates, historically high exemption amounts and favorable interest rates makes it an ideal time for family business owners to share the wealth. But be sure to start planning soon — there’s no guarantee these conditions will last.Currently, the top gift and estate tax rates are each 35%. There’s also a unified gift and estate tax exemption of $5.12 million ($10.24 million for married couples). You can transfer up to the exemption amount — through either lifetime gifts or bequests at death — tax-free. Unless Congress passes new legislation, however, in 2013 the exemption will drop to $1 million ($2 million for married couples) and the top tax rate will jump to 55%.The challenge for business ownersFor family business owners, estate planning and succession planning are often at odds with each other. On the one hand, the sooner you transfer assets to the younger generation, the greater your ability to remove future appreciation from your taxable estate. On the other hand, you may not have identified a likely successor — or, even if you have, you may not be ready to hand over the reins to your businesAnother challenge you’ll need to deal with is funding your own retirement. It’s not unusual for owners to have most of their wealth tied up in the business. But if you give your business to your kids, there may be little left for your golden years.

Fortunately, several planning vehicles can help you meet these challenges. Two in particular — a grantor retained annuity trust (GRAT) and a sale to an intentionally defective grantor trust (IDGT) — can be highly effective in the current environment. They allow you to separate  ownership  succession from  management succession and thus transfer business ownership without giving up control. And they also can help fund your retirement.

The advantages of a GRAT\Here’s how a GRAT works: You transfer business interests or other assets to an irrevocable trust. The trust then pays you a fixed annuity for a specified number of years, and at the end of the trust term the trust assets are transferred to your children or other beneficiaries. GRATs offer several important advantages, including:

Minimal gift taxes. Gift tax is based on the actuarial value of your beneficiaries’ future interest in the trust assets. Depending on the size of the annuity payments and the length of the term, this value can be very low and can even be “zeroed out.”

Control. You remain in control of the business during the trust term.

An income stream. The annuity payments provide a source of income to fund your retirement or other needs.

Establishing a GRAT while tax rates are low and the exemption is high will help you minimize or eliminate gift taxes. Keep in mind that for a GRAT to succeed you  must  survive the trust term, and the business must generate enough income to cover the annuity payments. Also, be aware that legislation has been proposed that would limit the benefits of a GRAT.

The benefits of selling to an IDGT

An IDGT is an irrevocable trust designed so that contributions to the trust are considered completed gifts for gift tax purposes even though the trust is considered a “grantor trust” for income tax purposes. (That’s the “defect.”) Selling your business to an IDGT rather than to your beneficiaries outright allows you to retain control over the business during the trust term while still enjoying significant tax benefits.

Maintaining grantor trust status is important for two reasons: First,  you  pay income taxes on the trust’s earnings. Because those earnings stay in the trust rather than being used to pay taxes, you’re essentially making additional tax-free gifts to your beneficiaries. Second, because a grantor trust is considered your “alter ego” for income tax purposes, payments you receive from the trust generally will be tax-free.

You can simply give your business to an IDGT, but an installment sale to the trust offers two key advantages:

  • Selling the business avoids gift taxes: Once the note is paid off, the remaining trust assets pass to your beneficiaries tax-free.
  • Regular installment payments provide you with a tax-free income stream.

To help ensure that the IRS won’t challenge the sale as a disguised gift, it’s important to structure it as a legitimate business transaction. The interest rate, payment schedule and other terms should be commercially reasonable.

You’ll also need to contribute some “seed money” to the trust so that it has the resources it needs to make a reasonable down payment (typically, at least 10% of the sale price). The seed money is a taxable gift, but you’ll likely be able to avoid the gift tax by using your gift tax exemption.

As with a GRAT, the success of a sale to an IDGT depends in part on the business generating enough income to cover the note payments — something that’s easier to achieve in a low-interest environment.

The need for a plan

For family business owners, business and personal planning go hand in hand. To achieve your goals, it’s important to develop an integrated family business plan that addresses ownership and management succession issues together with estate planning issues. •More options for transferring a family business

In addition to GRATs and IDGTs (see main article), there are several other options for transferring family business interests to the younger generation, including:

Outright gifts.  If you’re willing to relinquish control, you can transfer substantial interests tax-free using the $5.12 million exemption.

Installment sales to family members.  These offer significant gift and estate tax savings, provided you’re ready to part with the business.

Self-canceling installment notes.  A SCIN requires the buyer to pay a significant premium, but if the seller dies before the note is paid off, the remaining payments are canceled without triggering additional gift or estate taxes.

Family limited partnerships.  FLPs enable you to transfer large interests in the business to family members at discounted gift tax values, while retaining management control.

This material is generic in nature. Before relying on the material in any important matter, users should note date of publication and carefully evaluate its accuracy, currency, completeness, and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances.

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