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Case Study: Selling the Family Business
Gerald and Eileen live a very modest lifestyle. Although they have not planned for retirement, they are fortunate to have recently inherited a closely-held business. The downside is their estate lacks adequate liquidity, does not incorporate their charitable giving, and does not consider the problems a significant inheritance might have on their troubled daughter.
Gerald and Eileen Fitzsimmons are 58 and 54 years old respectively. They are in good health. They have four grown children, two from Eileen’s first marriage. Their daughter has been in and out of rehab several times.
Gerald owns 50% of a business that he inherited from his father. His mother and sister own the other 50% and Gerald is in the process of buying them out. Their agreement is for a price well below what the company would sell for on the open market. None of their children has shown any interest in the business nor is it anticipated that any of them will ever join Gerald. Gerald also co-owns a couple of rental properties that he inherited and would like to keep those in the family. He wants his children to receive the income from the properties but doesn’t want them to be able to sell them.
Gerald and Eileen are extremely charitable and would like to give a great deal of their wealth to their favorite causes.
Gerald has been in negotiations to sell part of his company to an outside buyer. His first offer for 20% of the company was for $5 million. He anticipates that he will sell the entire business over the next five to seven years.
Family Limited Partnership and Grantor Deemed Owner Trusts
The Fitzsimmons will first establish a Family Limited Partnership (FLP). Gerald and Eileen will retain both the General (GP) and Limited Partner (LP) interests at the outset. In fact, the GP interests will be held by a new Limited Liability company (LLC) that Gerald and Eileen will establish. They will then transfer their investment real estate holdings of $455,000 to the FLP. They will then have the LP interests appraised by a qualified appraiser to determine the value of each unit. Because of lack of liquidity and lack of marketability, we presume a downward valuation adjustment of around 35%.
Gerald and Eileen will then establish Grantor Deemed Owner Trusts (GDOTs). These are irrevocable trusts that offer very distinct benefits: assets in the trust are outside of the estate for purposes of estate taxes and assets in the trust are income taxable to the grantor (in this case Gerald and Eileen). This has the added benefit of Gerald and Eileen paying the income taxes on their beneficiaries’ assets; essentially an additional method for making gifts. Gerald and Eileen will gift their LP interests to their individual trusts (in this case $147,000 each). Because this is a relatively small transaction, Gerald and Eileen will simply file gift tax returns and utilize some of their lifetime exemption to report this gift.
Irrevocable Life Insurance Trust
Gerald and Eileen will next establish an irrevocable life insurance trust (ILIT). The ILIT will purchase a $10 million survivorship policy on the lives of Gerald and Eileen. Because of their current cash flow considerations, premium payments are structured to be very low for the first 10 years ($29,100 per year) and then rise after Gerald anticipates the company will be sold ($134,000 per year). This solves an important short-term liquidity problem and allows them to make a decision in ten years about maintaining the policy. As an added safety measure the ILIT will be named as a discretionary beneficiary of the GDOT. This will allow cash flow from the GDOT to pay premiums if necessary.
Charitable Remainder Unitrust
The Fitzsimmons will next establish a Charitable Remainder Unitrust with what is known as a “flip” provision (FlipCRT) and transfer $10 million of Fitzsimmons Company stock to it. The trust will be designed to pay the Fitzsimmons an annual amount equal to 6% of its value determined at the beginning of each year. However, these payments will not commence until the year after the Company stock is sold from the trust. In this case, the Fitzsimmons anticipate a buyer will purchase the stock for cash in five years.
Because CRTs are tax-exempt, there is no capital gains tax due on the sale to either the Fitzsimmons or the trust. Gerald and Eileen will begin receiving an income stream based on the entire $10 million of proceeds from the sale. Utilizing a 6% payout rate, they will receive $400,000 in the first year. If in future years the trust grows in value, the Fitzsimmons will receive 6% of that increasing value. Only the income distributed to the Fitzsimmons will be subject to income tax. Any undistributed income and gains will compound tax-deferred.
In addition to deferring the capital gain on the sale of the stock, the Fitzsimmons will also receive an income tax charitable deduction for a portion of the value transferred to the trust. Because the charity will not receive the proceeds of the trust until after the Fitzsimmons die, the deduction is limited to the present value of their future gift. In this case the deduction is approximately $1.75 million. It can be utilized in the current year and any unused amounts can be carried forward and utilized over the next five succeeding years.
Because they are receiving so much income in excess of their living needs, Gerald and Eileen may choose to fund many of their current charitable interests from their excess cash flow.
Retirement Plan Gifts
Calculations indicate the Fitzsimmons will be able to transfer the current value of their entire estate to their children and grandchildren. Because of this, Gerald is able to name favorite charities as the secondary beneficiary of his retirement plan. If he pre-deceases Eileen she will still have full use of the funds. However whatever is left will go to support and maintain their favorite causes. Retirement plans are excellent charitable giving candidates because not only are they otherwise subject to estate tax, they are also taxable income to those who inherit them. Naming a charity as the beneficiary of a retirement plan eliminates both of these taxes.
Charitable Lead Trusts
Feeling comfortable their heirs will receive ample funds very shortly after their deaths, Gerald and Eileen are able to establish Testamentary Charitable Lead Annuity Trusts (TCLATs) that will “zero out” their estates for estate tax purposes. This special type of trust takes any assets remaining in the estate that would be subject to estate tax and utilizes those assets to give a fixed income stream to the charities of the Fitzsimmons’ choice for a fixed term of years and then gives whatever is left at the end of the term to the heirs. Depending on the term of the trust, the amount it pays, and interest rates at the time the trust is created, the TCLAT can produce an estate tax charitable deduction that equals its value of amounts transferred to it thereby eliminating all estate taxes.
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