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The information contained on this website is provided for informational purposes only and should not be construed as legal advice on any subject matter.  If you wish to discuss the topics addressed on this website, or other estate planning issues, please contact Lara Sass & Associates, PLLC.

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A family-owned business is often an individual's primary source of wealth.  Accordingly, it is critical to plan carefully for the transition of ownership from one generation to the next.


For those individuals whose estates are expected to significantly exceed the lifetime exemption amount, estate tax reduction is one of the primary concerns.  Following is a summary of three sophisticated strategies that may be employed to transfer a family business, while minimizing gift and estate taxes:


1.  Sale to an Intentionally Defective Grantor Trust


Where a grantor has income producing assets (for instance, commercial real estate subject to a long-term lease) that the grantor expects to appreciate significantly in value, a sale of that property to an income tax defective grantor trust is an attractive estate planning technique.  Such a trust is deemed defective for income tax purposes because the grantor is considered to be the owner of the trust for income tax purposes, such that the grantor and the trust are deemed to be the same person with respect to income tax issues.  Consequently, the sale of assets to the trust by the grantor does not result in any taxable capital gain.  While the grantor is deemed the owner of the trust for income tax purposes, the trust is designed so that the trust assets are not includable in the grantor's taxable estate for estate tax purposes.


Typically, such a transaction takes the form of an installment sale over an extended term, with the trust's payment obligation to the grantor being evidenced by a promissory note.  For tax reasons, the term of the note should not exceed the grantor's actuarial life expectancy.  However, the note may contain a provision providing for the termination of the repayment obligation in the event the grantor dies prematurely.  This provision presents the opportunity for a windfall to the grantor's beneficiaries in the event of an untimely death.  However, the use of this provision requires that a premium be attached to the promissory note, either in the form of an increased principal amount or above-market interest rate.


This estate planning technique is useful where the property being sold will generate enough income to offset the promissory note payments.  It is often wise to combine such a sale with a concurrent gift of other assets to the trust, in order to give the trust other means of repaying the note.


The benefit of this technique is that it presents the opportunity to transfer property at no gift or estate tax cost to the beneficiaries, while having the asset pay for its own transfer by applying the income stream to the promissory note payments.  Moreover, since all of the income produced by the asset is taxed to the grantor, the grantor's payment of that income tax liability is, essentially, an additional tax-free gift to the beneficiaries of the trust.


2.  Grantor Retained Annuity Trust (GRAT)


A grantor retained annuity trust (GRAT) is a highly effective estate planning tool to be used with assets likely to appreciate in value.  A GRAT is an irrevocable trust from which the grantor retains the right to receive annuity payments for a specified term of years.  At the end of this retained term, assets contained in the trust pass to other remainder beneficiaries.  The annuity payments made to the grantor during the term dramatically reduce the value of the gift of the remainder interest when the GRAT is established, so that only the net present value of the remainder interest is subject to gift tax.  A GRAT produces estate and gift tax savings if the assets placed in the GRAT produce a total net return (net income and appreciation) in excess of the assumed discount rate under the Internal Revenue Code.


The annuity payments may be set sufficiently high so as to create a "zeroed-out" GRAT.  With a zeroed-out GRAT, the net present value of the retained annuity payment stream equals 100% of the value of the assets placed in the trust.  If the assets in the GRAT appreciate in value beyond the amount necessary to produce the retained annuity payments, then the value of the trust remaining at the end of the term of the trust will pass to the designated beneficiaries free of gift and estate taxes.


There is virtually no downside to creating a GRAT.  If the grantor dies before the expiration of the term of the GRAT, the assets remaining in the trust will be included in the grantor's taxable estate, with an appropriate credit being given for any gift tax paid when the trust was created.  Similarly, if the trust assets decrease in value, so that there is nothing remaining in the trust at the expiration of the term, the grantor is returned to the same position as he or she was in prior to creation of the GRAT, with no tax costs having been incurred.  In both instances, the grantor's loss is limited solely to the costs associated with establishing the GRAT.


A zeroed-out GRAT is an excellent estate planning tool for an individual who has exhausted his or her applicable exclusion amount under the federal estate and gift tax laws and who is already maximizing annual exclusion gifts.  The GRAT presents a way to pass excess growth and appreciation in assets to children without incurring gift or estate tax.  While such a technique works only if the assets placed in trust appreciate beyond the applicable federal discount rate, the grantor is generally able to identify which assets are likely to do so.  A GRAT generates the greatest transfer tax benefit in a low interest rate climate because it is more likely

that the return on assets held by the GRAT will exceed the low interest rate.


3.  Beneficiary Defective Inheritor's Trust (BDIT)


A Beneficiary Defective Inheritor's Trust (BDIT) is an irrevocable trust that freezes the value of assets for gift and estate tax purposes when such assets are sold to the trust by a beneficiary, who is also eligible to receive future discretionary distributions from the trust.  The beneficiary-seller also enjoys asset protection with respect to the assets in the trust, and may even leverage the value of assets for gift and estate tax purposes, while having no impact on the beneficiary-seller’s lifetime exemption amount.


In general, a BDIT is set up by the nominal grantor of the trust, typically a family member of the beneficiary-seller, who contributes his or her own cash (usually $5,000) or other equivalent property to the trust, but retains no powers or strings of control over the trust that would cause the trust to be taxed to him or her.  The trust is structured so as to not cause the assets to be included in the estate of either the nominal grantor or the beneficiary-seller, and typically names an independent third-party as trustee, who controls discretionary distributions. 


The beneficiary-seller is given a Crummey withdrawal right over the initially contributed funds, typically for 30-60 days, which the beneficiary-seller typically allows to lapse.  Under the Internal Revenue Code, this withdrawal right allows the beneficiary-seller to be considered the grantor of the entire trust for federal income tax purposes, even after his or her withdrawal right has lapsed.  Because the BDIT is a grantor trust to the beneficiary-seller for federal income tax purposes, neither gain on the sale itself, nor the interest paid on the note, generates any taxable income.  Moreover, any income of the BDIT is taxed to the beneficiary-seller, resulting in a further reduction of the beneficiary-seller’s taxable estate and allowing the trust assets to grow at an incrementally faster rate.


Following the lapse of the withdrawal right, the beneficiary-seller sells a considerable amount of assets to the trust – preferably assets that are expected to appreciate significantly in value, such as interests in a closely held business.  The sale is in exchange for a promissory note with an interest rate equal to at least the applicable federal rate.  This transaction locks in the value of the transferred assets at their transferred value plus the interest rate required by the note.  Any appreciation in the value of the transferred assets in excess of that rate will occur outside of the estate of the beneficiary-seller, instead accruing to the benefit of the trust.  This transaction can also generate an immediate financial benefit if the transferred assets are minority interests and/or subject to transfer or other restrictions, for which a valuation discount might reasonably be applied, freezing the value of the asset to the beneficiary-seller at the discounted value plus the applicable interest rate.


Despite the sale, the beneficiary-seller can serve as an investment advisor of the trust and/or in a managerial position with the business in which the interests were sold to the trust, thus maintaining a considerable degree of control over the assets.  The terms of the trust also enable the beneficiary-seller, and perhaps family members, to receive discretionary income or principal distributions.  Unlike with the intentionally defective grantor trust (described above), the beneficiary of a BDIT can even maintain a right to receive mandatory income distributions without adverse estate tax consequences.


In addition, as referenced above, the BDIT can provide a significant degree of asset protection.  Since the beneficiary-seller does not make any gratuitous transfers to the trust, the BDIT would not be considered self-settled for bankruptcy (and most state law) purposes.  Furthermore, a transfer to a BDIT should not be vulnerable to fraudulent transfer claims or spousal claims in a divorce, particularly if the trust is established and the assets sold to the BDIT prior to the marriage.


Because the transaction with the beneficiary-seller does not involve any gratuitous transfer by the beneficiary-seller, no allocation of his or her lifetime exemption amount is required.  As a result, the BDIT is an excellent estate planning tool for an individual whose lifetime exemption amount has been consumed by prior gifts or other planning strategies.


Despite the myriad of benefits offered by the BDIT structure, there are important caveats.  As is the case with sales to intentionally defective grantor trusts, the IRS does not look favorably upon BDITs.  The possibility exists that the characterization of the settlor as the true transferor of the property may be questioned and, instead, the beneficiary-seller, presumably having arranged for the creation and funding of the trust, may instead be deemed the transferor.  If the beneficiary-seller were determined to be the real settlor of the BDIT, the asset protection advantage could be forfeited or reduced, and all or part of the BDIT property could be included in the beneficiary-seller’s gross estate for estate tax purposes.  Finally, a BDIT sale could be viewed as lacking in economic substance when structured such that initial funding is too small in relation to the magnitude of the subsequent sale, or there is no (or insufficient) beneficiary guarantees of note repayment.   If the BDIT sale is viewed as lacking in economic substance, then the transaction will be includible in the beneficiary-seller's gross estate for estate tax purposes.  Despite these caveats, there are measures that can be taken to minimize these risks.


Please contact Lara Sass & Associates, PLLC for assistance with structuring and implementing the successful transfer of your family-owned business.