Transferring Ownership While Retaining Control:

If a large portion of your wealth is tied up in a family business, you may find that your estate planning goals conflict with succession-planning goals. If the value of your business is substantially greater than the gift and estate tax exemption (currently $5.43 million), traditional estate planning techniques would have you transfer the business to your children or other family members as early as possible in order to remove future appreciation from your estate.

From a succession-planning perspective, however, handing over the reins to the younger generation may be premature. Perhaps the next generation of leaders isn’t yet ready to take over the business. Or maybe you’re not ready to give up control.

Fortunately, there are several trust-based tools that allow you to transfer business interests to your successors now — minimizing gift and estate taxes — while maintaining control of the business. Two to consider are the grantor retained annuity trust (GRAT) and a sale to an intentionally defective irrevocable trust (IDIT).

Take advantage of GRATs

With GRATs, you transfer business interests to an irrevocable trust, which pays you a fixed annuity for a set number of years. When the trust term ends, the assets are transferred to your children or other beneficiaries. You control the business during the trust term and continue to earn income in the form of annuity payments. For this technique to work, the business must generate sufficient income to fund the annuity payments.

In addition to removing future business appreciation from your taxable estate, a GRAT minimizes any gift tax liability on your initial transfer of interests to the trust. That’s because the value for gift tax purposes is equal to the actuarial value of your beneficiaries’ future interest in the trust. By adjusting the length of the trust term and the size of the annuity payments, you can reduce the value to a very low amount — even to zero in some cases.

The main disadvantage of a GRAT is mortality risk. In order for you and your family to enjoy the tax benefits of this technique, you must survive the trust term. If you don’t, trust assets will be pulled back into your taxable estate.

Harness the power of IDITs

Another powerful tool for obtaining tax benefits while retaining control of your business is a sale to an IDIT. Also known as an intentionally defective grantor trust (IDGT), a properly designed IDIT is an irrevocable trust for gift and estate tax purposes, but it’s treated as a grantor trust for income tax purposes. (That’s the “defect.”) Because the trust is irrevocable, business interests you transfer to it are considered to be completed gifts, so any future appreciation in their value escapes estate taxes. At the same time, grantor trust status offers two important benefits:

1.      As grantor, you pay income taxes on the trust’s earnings, allowing trust assets to grow tax-free, leaving more for your beneficiaries (essentially, an additional tax-free gift).

2.      For income tax purposes, a grantor trust is considered your alter ego rather than a separate entity, so any payments you receive from the trust are treated as tax-free payments to yourself.

Structuring the transaction as an installment sale rather than a gift offers additional benefits. So long as the business generates enough income to cover the installment payments (or is able to borrow the necessary funds), selling the business to an IDIT avoids gift taxes. Once the note is paid, trust assets pass to your beneficiaries tax-free. During the trust term, the installment payments provide you with a tax-free income stream.

Installment sales should be structured carefully to ensure the transaction passes muster with the IRS. Also, while the assets won’t be included in your estate if you don’t survive the trust term, your estate may be subject to tax on the note’s unpaid balance.

What’s your succession plan?

If you own a family business, it’s critical to have a succession plan that covers both the transfer of ownership and, ultimately, the transfer of control. Bear in mind that the ownership-transfer strategies we’ve discussed are complex, and all of the nuances aren’t covered here. So be sure to work with your tax advisor. He or she can help to determine which — if any — is appropriate for the specifics of your circumstances.  Whether you use these tools or other techniques, your tax advisors can help you design a plan that meets your business, financial and estate planning needs.

Sidebar: Avoiding mortality risk with a BIDIT

As noted in the main article, GRATs — and, to a lesser extent, IDITs — present some mortality risk. That is, your death before the end of the trust term will trigger certain adverse tax consequences.

To eliminate this risk, some estate planners have started using “business intentionally defective irrevocable trusts,” or BIDITs. A BIDIT is similar to an IDIT, except that it’s established by the business entity rather than the owner. According to its proponents, BIDITs offer tax and asset protection benefits similar (or superior) to those of an IDIT, without the mortality risk.

In essence, the idea is to have the business sell the assets. Payments are made to the business, which, as a separate legal entity, survives even after the death of its owner(s).  This is designed to have the upside while eliminating the downside.

There’s one important caveat, however. BIDITs are new and untested, so there’s a risk that the IRS will challenge their tax benefits.

© 2015