Business owners should always know their options when it comes to their company and its relation to their estate plans. Let’s take a look at some commonly chosen vehicles for transferring ownership interests in a business.
The great GRAT
With a grantor retained annuity trust (GRAT), 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 free of any additional gift tax, even if the property has appreciated while held in trust.
GRATs offer several important advantages. Gift tax is based on the actuarial value of your beneficiaries’ future interest in the trust assets at the time the trust is funded. 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.” Also, you remain in control of the business during the trust term. And the annuity payments provide a source of income to fund your retirement or other needs.
Keep in mind that for a GRAT to succeed you must survive the trust term, and your 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 intriguing IDGT
An intentionally defective grantor trust (IDGT) is an irrevocable trust designed so that contributions to the trust are considered completed gifts for gift and estate tax purposes even though the trust is considered a “grantor trust” for income tax purposes. (That’s the “defect”)
But the trust is very effective because the trust assets won’t be included in your estate.
Selling your business to an IDGT, rather than giving it 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, distributions you receive from the trust generally will be tax-free.
The need for a plan
For business owners, strategic planning and estate planning should go hand in hand. To achieve your goals, develop an integrated approach that addresses ownership and management succession issues together with estate planning issues. For help gathering the right information and making the best choice for you, please contact us.
Sidebar: 4 more options for transferring ownership interests
In addition to GRATs and IDGTs (see main article), there are several other options for transferring family business interests to the younger generation, including:
1. Outright gifts. If you’re willing to relinquish control, you can transfer substantial interests tax-free using the $5.45 million exemption.
2. Installment sales to family members. These offer significant gift and estate tax savings, provided you’re ready to part with the business.
3. Self-canceling installment notes. These require 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.
4. Family limited partnerships. These arrangements enable you to transfer large interests in the business to family members at discounted gift tax values, while retaining management control. The IRS does scrutinize them closely, however.