BUSINESS SUCCESSION PLANNING USING AN INTENTIONALLY DEFECTIVE GRANTOR TRUST

 

Warren M. Yanoff, Esq.

 

            Small businesses fail at a very high rate. Only about 30 percent of family- owned businesses survive to the next generation. Of those, only one-half make it to the third generation. One of the reasons for this high failure rate is that the owner neglects to plan in advance for the smooth transition in the event that he or she retires, becomes disabled, or dies.

             Without proper planning, the sale or transfer of a business can have significant tax consequences. What happens if the owner of a business fails to appropriately plan for his or her succession? The owner’s unforeseen disability, death or retirement could trigger a forced sale or liquidation, netting the owner less money and increasing his taxable estate.

            Depending on the circumstances, an orderly succession plan could provide the owner with a reliable cash flow, a reduced estate tax burden, and the peace of mind knowing that he or she has done one’s best to keep the business thriving.

            One way to effectuate an orderly transition with significant tax benefits is to have the owner sell the business to an Intentionally Defective Grantor Trust (IDGT). An IDGT allows the grantor to freeze the discounted value of the asset at sale and be taxed on trust income, but part of the current value and all of the appreciated value of the assets of the trust will not be included in the grantor’s estate.

            In order to properly establish an IDGT, the grantor must gift to the trust liquid assets or cash equal in value to 10 percent or more of the value of the property, in this case the grantor’s business, to the IDGT. The grantor then sells the business at fair market value, less a valuation discount, to the trustee of the IDGT using an installment note.  The grantor does not need to make any additional gifts to the IDGT.

            Under this arrangement it is usual for the trustee to give the grantor an installment note providing for interest payments only for a set number of years with a balloon payment of principal at the end of the term[1]. Usually The note  can be for a term less than the grantor’s life expectancy or for life. The interest rate of the note should be at or above the Applicable Federal Rate (AFR) published monthly by the IRS. The short term AFR can be used for notes of 1-3 years, the mid-term rate can be used for notes 3-9 years and the long term AFR can be used for terms longer than 9 years.

            During the term of the note, the asset held in the IDGT generates income that is used to repay the note. The grantor is taxed on the income, thereby allowing more money to accumulate in the trust. At the time of the grantor’s death, only the principal balance of the note as of the date of death is included in the grantor’s estate. All of the appreciation passes estate tax free to the heirs.[2]

How can an IDGT help business owners plan for a successful succession?

           

Assume that the Grantor, 65 years old, has an estate of 9 million dollars. The most significant asset of the estate is his 100% interest in an S Corp business valued at 5 million dollars that generates 8% net cash flow. The Grantor, who is not married, has three children, but only one of them is actively involved in the business. The Grantor wants to treat his children equally upon his death, and simultaneously, insure that the child active in the business is able to run the business without interference from his other children.

Without planning, the Grantor’s estate would owe approximately $4 million dollars in federal estate tax if he were to die in 2011 or later.[3]  After paying the estate tax, the only remaining asset is the business that would be owned equally by his three children. This would necessitate the active child to purchase two-thirds of the business in order to have complete ownership and fairly compensate his siblings. The business might not be able to afford the buyout, forcing a sale at a greatly reduced price. Or, the other children would have to remain owners of 2/3 of the business.

To avoid that situation the Grantor could, first, recapitalize the S Corp and establish two classes of stock, 10% voting shares which would be retained by the Grantor and 90% non-voting shares which would be sold and transferred to the IDGT.

The Grantor establishes an IDGT. Using part of his lifetime gift exemption, he could gift $315,000 (10% of the value of the non-voting shares business after applying a 30% discount factor) to the trust. The Trustee could execute a promissory note in the amount of $2,835,000, payable interest only with a balloon payment due in 15 years.

Assuming the IDGT generates income of $360,000 per year, It pays the Grantor $123,322 in interest payments[4]. The Grantor pays income tax on the trust income, but receives the interest income tax free. The balance of $236,678 can be used to purchase a life insurance policy that would be available to pay estate taxes and equalize the children’s inheritance without forcing the sale or refinancing of the business. A second benefit is that any growth in the value of trust over the Grantor’s lifetime will not be included in the Grantor’s estate. At a modest 2% growth, using an IDGT would shield approximately another $1.5 million from estate taxes.

By understanding the client’s desire to continue the business and equalize his estate among his children, using an IDGT and life insurance can help realize his goals.

 

 

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[1] The terms of the note are flexible from interest only to fully amortized.

 

[2] The heirs’ basis in the property is the grantor’s basis and they do not receive a stepped-up basis upon the death of the grantor.

 

[3] Assumes no growth and the estate tax in effect in 2011 does not change.

 

[4] The long term AFR was 4.35% as of March 2010.