Success for Succession Planning
Planning The Transition To The Next Generation
SUCCESS FOR SUCCESSION PLANNING
There are over 12 million family owned businesses in the
United States. Historical figures indicate that only one in
three survive the transition to the second generation. Factors
of failure include financial stress, business and organization
failure, and stress on family relationships. A breakdown of
any of these factors can lead to failure of the entire business.
The existence of a 55% (and sometimes 60%) estate tax is generally
the largest impediment to financial success. A combination
of estate planning vehicles may drastically reduce the financial
cost of transfer-ring business interests to the next family
generation.
In identifying vehicles to reduce this financial cost, the
objective is to minimize the transfer tax cost. The transfer
tax is imposed through either federal gift taxes or federal
estate taxes.
As of 1999, each individual can give away $650,000 free
of estate taxation and Congress has increased this amount
to $1,000,000 by the year 2006. In any event, the exemption
amount can be used during lifetime instead of at death in
order to generate powerful leveraging advantages through lifetime
gifts. This concept is commonly referred to as a “freeze”
since the value of the gifted asset and its subsequent
appreciation is removed from the donor’s gross estate
for federal estate tax purposes. Moreover, since the federal
estate tax is a progressive tax with the highest marginal
tax rate at 60%, the value of the transferred asset as well
as the subsequent appreciation is removed from the gross estate
at the marginal estate tax rate.
As you would expect, the value of a gift is subject to federal
gift taxation. However, through various estate planning vehicles
the value can be discounted so as to drastically decrease
the amount of taxes which would have been payable had the
asset remained in the individual’s gross estate until death.
One effective technique involves both the use of a Grantor
Retained Annuity Trust (“GRAT”) and some other technique depending
on the type of entity. One such technique involving S corporations
is to create a non-voting class of stock.
Non-Voting Stock
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).
Layered Grantor Retained Annuity Trusts (“GRAT”)
GRAT Background
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. At the end of the term, the trust terminates and
the trust property passes to the remainder beneficiaries,
presumably the patriarch’s children. 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.
Most assets may be transferred to the GRAT including subchapter
S corporation stock. Moreover, there is no requirement that
the contributed asset be income producing. If sufficient income
is not generated by the trust in order to fund the required
percentage payout, principal (i.e. a portion of the assets
contributed to the GRAT) would be distributed back to the
patriarch as “payment” of the required annuity payment needed
(this obviously would partially defeat the purpose of the
trust). The use of a GRAT can be a powerful planning device.
This type of trust allows for the making of a gift on a
discounted basis so that the full fair market value of
the gifted property is not subject to either gift tax or estate
tax.
The creation of non-voting stock and the corresponding reduction
in the value of those shares further discounts the value of
the gift for either gift tax or estate tax purposes (see related
discussion regarding funding the GRAT below). The real benefit
of the GRAT is realized if the property contributed to the
GRAT will appreciate at a faster rate than the discounted
rate utilized under the IRS tax tables.
The gift to the GRAT is considered a gift of a future interest
for federal gift tax purposes and therefore does not qualify
for the annual exclusion. However, a portion or all of the
remaining unified credit can be utilized to potentially eliminate
the gift tax. You may consider structuring the transfer so
that a small gift tax is paid so as to ensure beginning the
IRS’ statute of limitations.
There are two unique and powerful planning strategies which
make the GRAT extremely valuable.
(1) Layered GRATs
The first involves incorporating a technique called “layered
GRATs.” The economic effect of this technique is no different
than creating a single GRAT, however, it provides additional
flexibility. A layered GRAT acts as a hedge against the possibility
that the patriarch may die prior to the expiration of the
retained annuity term thereby causing the trust assets to
be included in the patriarch’s gross estate. For example,
by creating four GRATs with a 5-year, 8-year, 11-year, and
14-year term, respectively, the patriarch ensures that if
he dies within twelve (12) years after creating these GRATs,
the assets in the 5-year GRAT, 8-year GRAT, and 11-year GRAT
will not be included in the patriarch’s gross estate for estate
tax purposes.
By contrast, if the patriarch had placed all of the property
in a single GRAT with a 14-year term, all or most of that
property in the GRAT (including any appreciation) would be
pulled back into his estate and subject to the 55% estate
tax rate.
(2) Funding the GRAT
As previously mentioned above, a powerful advantage of the
GRAT is realized by funding the GRAT with S corporation non-voting
stock. As such, the patriarch is able to pass a tremendous
amount of property to the children at a relatively minor gift
tax cost. For purposes of computing the gift tax liability,
the value of the GRAT property (i.e. the non-voting stock)
is reduced as a result of the lack of voting, minority and
lack of marketability discounts. This discounted value
is used in calculating the taxable remainder interest in the
GRAT thereby resulting in a “double discount.” The discounted
value of the GRAT property also allows the patriarch to take
lower annuity payments thereby shifting even more appreciation
of the GRAT property to the children.
Example: You capitalize a $3,500,000 closely held
corporation so that there exists a one percent (1%) voting
interest and a ninety-nine percent (99%) non-voting interest.
Because of lack of marketability and non-voting characteristics,
the ninety-nine percent (99%) non-voting interest are granted
a fifty percent (50%) discount so that their value is approximately
$1,750,000. By simply gifting the $3.5 million business to
your children, the gift tax cost would be $1,373,000. Alternatively,
by gifting the ninety-nine percent (99%) non-voting interest,
outright the gift tax cost would be $475,000 for an initial
tax savings of $897,500. However, by instead contributing
the ninety-nine percent (99%) non-voting stock to three GRATs
with 5-year, 7-year, and 10-year terms respectively, and an
eight percent (8%) retained annuity, the gift tax cost can
be reduced to $125,134 for a total savings of $1,247,866.
Therefore, you are able to transfer the value of the entire
business, except for the one percent (1%) voting interest
which you retain, to your children by only utilizing $125,134
worth of your $650,000 exemption.
Taxable Gift
There are three basic assumptions that determine the amount
of the taxable gift: (i) the term of each of the GRATs; (ii)
the value of the property contributed to each of the GRATs;
and (iii) the retained annuity percentage. These three factors
can drastically affect the “taxable” gift, thereby allowing
the patriarch to control the taxable gifts.
Personality Trust
At the end of the GRAT term the patriarch may decide to
create a so-called Fore-of-Personality Trust. Such a trust
causes children to contribute property (e.g. the non-voting
stock) to an irrevocable trust in which the patriarch or the
patriarch’s spouse may act as the trustee. The trustee could
have broad discretion in making principal and income distributions
to children. Thus, the patriarch is provided a certain level
of control over the assets. Alternatively, should the stock
pass outright to the children since the stock is non-voting,
the patriarch can feel assured that he or she retains control.
