Succession Planning is Critical

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In order to minimize or eliminate a potential 50% estate tax and 40% income tax, the Grantor Retained Annuity Trust (GRAT) should be incorporated into the succession plan for your Company. The GRAT is specifically approved under the Internal Revenue Code and can be customized to save you tax dollars and complete your succession planning. See also the Wall Street Journal articles dated Jan. 21st, 2009 and Feb. 10th, 2009.

There are over 12 million family owned businesses in the United States and many of them in DuPage County. Historical figures indicate that only one in three survive the transition to the second generation. There are essentially three succession planning methods:

• Sale to an outsider such as a strategic buyer
• Sale to an insider such as a family member or key employee(s)
• Going public
• Employer Stock Ownership Plan (“ESOP”)

The existence of a 50% estate tax and potential 40% income tax can be the largest impediment to succession planning. The estate tax is based on the value of all of your assets and life insurance proceeds including the fair market value of your Company. Planning ahead for either of these approaches will drastically reduce the financial cost of transferring your Company.

When identifying the right plan to reduce this financial cost, the objective is to minimize the transfer tax and income tax cost. The transfer tax is imposed through either federal gift taxes or federal estate taxes.

AVOID THE 50% FEDERAL ESTATE TAX

Each person is entitled to a lifetime and death time exemption against gift and estate tax (the "Applicable Exemption Amount"). Congressional action has set forth the following table for the Applicable Death Exemption amount over the coming years:

• For Decedents Applicable
• Dying and Gifts During Death Exemption Amount
• 2009 $3,500,000
• 2010 Tax repealed
• 2011 and thereafter Tax reinstated: $1,000,000

As of January 1, 2009 each individual is entitled to pass free of the federal estate tax an amount equal to $3,500,000. However as of 2011, this amount could be $1,000,000. Therefore, your entire net worth including life insurance proceeds is potentially subject to 50% estate tax over $2,000,000 for married couples and $1,000,000 for single individuals.

You will see Congress debate the proper Applicable Exemption sometime during 2009. During that debate, it is possible (and some say probable) that taxpayer favorable valuation formulas will be repealed thereby significantly increasing your eventual estate tax liability. The exemption amount can also be used during lifetime instead of at death up to $1,000,000 in order to generate powerful leveraging advantages through lifetime gifts.

Moreover, since the federal estate tax is a progressive tax with the highest marginal tax rate at 50%, the value of the transferred asset as well as the subsequent appreciation is removed from the gross estate at the marginal estate tax rate.

Estate freezing and/or leveraging your unified credit involves not only estate and gift tax planning, but also income tax planning combined with an understanding of your objectives and family values. The primary strategies center around “freezing” the value of certain assets and ultimately shifting the value to other family members while always remaining sensitive to your non-tax objectives, such as control and financial security.

As you would expect, the value of a gift is subject to federal gift taxation. However, through various planning vehicles the value can be discounted so as to decrease the amount of taxes which would have been payable had the asset remained in the individual’s gross estate until death.

For example, non-voting stock of an “S” Corporation can be contributed to a GRAT.

CONTRIBUTE NON-VOTING STOCK TO A GRAT

Voting power in the corporation can be retained by the patriarch while stock without voting rights can be given to inactive shareholders, such as children, without violating the S corporation’s “one-class-of-stock” rule. This rule means that each share of S corporation stock must be identical to every other share of stock with respect to the profits and assets of the corporation.

Under the 1982 revision of the Subchapter S rules, differences in voting rights are permitted. The creation of a non-voting class of stock is a powerful technique because it allows the patriarch to shift value of the Company to children, yet the patriarch still retains complete control via the voting stock. The value of the transferred stock is discounted because of not only lack of voting rights, but also lack of marketability. In real economic terms, however, the liquidation value of the non-voting shares is the same as the voting shares. Thus, the patriarch is able to discount the value of the gift of non-voting shares for gift tax purposes yet transfer the full fair market value of those shares (i.e. if you consider the full fair market value available in the overall family context).

WHAT IS A GRAT?

A GRAT is a special type of irrevocable trust which has two parts, an “annuity interest” (or “income interest”) and a “remainder interest.” The “annuity interest” is the right to receive a fixed stream of payments for a specified term of years. You determine the amount of the payment which usually is based on the anticipated profits of the Company so that you retain all of those profits. You also determine the number of years you retain those profits (e.g. 7 years).

At the end of the term, the trust terminates and the trust property passes to the remainder beneficiaries, presumably the patriarch’s children or perhaps remains in trust for the spouse.

You may incorporate a shareholder’s agreement irrespective of whether the stock ultimately passes to a family member, employee, outside purchaser or ESOP.

The remainder interest represents the taxable gift for IRS gift tax purposes. If the patriarch should die prior to the expiration of the retained annuity term, at least a portion, and perhaps all, of the value of the trust assets will be includable in the patriarch’s gross estate for estate tax purposes.

SUMMARY

The GRAT can accomplish the following

1. Avoid estate taxes when transferring shares to desired individuals;
2. Avoid income taxes when transferring shares to desired individuals;
3. Complete your succession plan by designing and controlling the transition of Company stock to the desired individuals.

Contact your attorney to discuss your options.