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.

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