Beyond Wills And Trusts: Keeping The Family Business In The Family

Beyond Wills And Trusts: Keeping The Family Business In The Family

Article posted in Privately Held Business Interests on 15 March 2000| comments
audience: National Publication | last updated: 18 May 2011


Passing the family business intact from one generation to the next is one of today's most challenging estate planning problems. And trying to get the company over to one child, who is active in the business, while maintaining proportionate distributions to others who are not is more difficult yet. In this edition of Gift Planner's Digest, Troy, Michigan attorney Salvatore LeMendola demonstrates how the layering of sophisticated charitable and non-charitable planning techniques can help keep the family business in the family.

by Salvatore LeMendola

It is common knowledge that the Federal estate tax is only vulnerable to lifetime gifts. Moreover, there are essentially three general giving strategies for reducing estate taxes. A comprehensive estate plan for individuals with large estates must incorporate one or more of these three strategies. The first strategy is the leveraging of the gift tax annual exclusion and the unified credit by cash gifts to an irrevocable life insurance trust (ILIT). When the ILIT contains generation skipping provisions, it is often referred to as a "Dynasty Trust." The next strategy is to use techniques that reduce or shift the value of assets, such as grantor retained annuity trusts (GRATs), qualified personal residence trusts (QPRTs) and discount family limited liability companies (FLLCs). The final strategy is to implement programs that take advantage of the income and estate tax deductions for gifts to public charities, charitable remainder trusts (CRTs), charitable lead trusts (CLTs), supporting organizations, and private family foundations.

Estate planning specialists will tell you that there are two estate tax systems: one for the informed taxpayer, and one for the uninformed taxpayer. The less you know, the more the IRS takes. The case study that follows is intended to help you put your clients in the informed camp by introducing them to strategies that will allow them to be tax avoiders instead of taxpayers.

The Facts

Assume a married couple with two children, Son and Daughter. Husband is 72-years-old, Wife is 70-years-old, Son is 40-years-old and Daughter is 38-years-old. Son is active in the family business, while Daughter is not. The couple also has six grandchildren, three by each child. Their estate is comprised of the following assets: Widget, Inc., an S corporation worth $5 million, a factory building that is leased to Widget, Inc. worth $1 million, mutual fund investments with a cost basis of $200,000, now worth $2 million, a personal residence (with no mortgage) worth $1 million, and cash of $1 million. It is assumed that the couple will obtain the following rates of return:

Asset Yearly Income Capital Growth
Widget, Inc. 10% 3%
Building 10% 5%
Investments 3% 5%
Residence 0% 5%
Cash 5% 0%

The joint life expectancy of Husband and Wife is 19 years. The projected value of their combined estate at the time of the second death in 2018, using the above rates of return and assuming they consume all of their income, is $18.34 million.

The couple's objectives are to provide for the surviving spouse; to assure that Son receives all of the shares of Widget, Inc. at Husband's death; to treat the children fairly; and to minimize transfer taxes. With a basic estate plan, utilizing both of their estate tax exemptions with an A-B Trust as well as the deduction for qualified family-owned business interests, the couple would have an estate tax liability of approximately $9,019,000 in 2018, netting $9,321,000 to the children. To come up with the tax bill, it is very likely that Widget, Inc., and other non-liquid assets would have to be sold. Therefore, the utilization of more advanced estate tax reduction strategies is necessary in order to achieve the couple's objectives.

Strategy 1: S Corporation GRAT

The first strategy is an S corporation GRAT. In general terms, the owner of S corporation stock (grantor) transfers his/her shares to an irrevocable trust for the benefit of children, while retaining the right to a fixed payment from the GRAT (at least annually) for a set term of years. The annuity or fixed payment would come out of the Subchapter S dividends paid to the GRAT. At the end of the set term, the property remaining in the GRAT passes to the remainder beneficiaries, either outright or in further trust.

If the grantor dies before the term of the GRAT, the assets in the GRAT are included in his/her estate (with any used gift tax exemption being restored). In such case, the grantor is in no worse a position for having tried a GRAT. However, if the grantor survives the term, the S corporation stock, plus the appreciation in the value of the stock, plus those Subchapter S dividends in excess of the required annuity payments, pass tax free to the remainder beneficiaries. The value of the gift to the GRAT is based on the grantor's age, the length of the set term, the amount of the annuity, and the IRC §7520 rate. The lower the grantor's age and/or the lower the §7520 rate, the smaller the gift. Likewise, the longer the term of the trust and/or the larger the annuity, the smaller the gift. Of course, the grantor will want to set a term he/she is likely to survive.

Assume Husband transfers 50% of his stock in Widget, Inc., to a GRAT. However, to maintain control over Widget, Inc., Husband will first recapitalize Widget, Inc. into one share of voting stock and 99 shares of nonvoting stock. He will then transfer 50 shares of his nonvoting stock to the GRAT, which will have a 10-year-term and will name Son as the sole remainder beneficiary.

The key to the transaction is valuing the gift to the GRAT. Since the shares transferred to the GRAT lack marketability and lack control, a "valuation discount" is appropriate. Let's assume a discount of 30% is available for the nonvoting stock in Widget, Inc., as determined by an independent appraiser. Therefore, the initial fair market value of the stock transferred to the GRAT will be $1,750,000 (50% x $5 million x 70%). Since Widget generates 10% of ordinary income in the form of dividends, the income flowing to the GRAT will be $250,000 (i.e., $2,500,000 x 10%). This allows the GRAT to pay an annuity of 14.29% (i.e., $250,000/$1,750,000). The value of a 10-year-retained 14.29% annuity using IRS tables (assuming an IRC §7520 rate of 6%) is $1,480,000. The value of the gift is, therefore, the value transferred less the value retained, or $270,000 (i.e., $1,750,000 - $1,480,000). Assuming Husband lives to his life expectancy and that Widget shares continue to appreciate at 3% per year, the value of the shares in 19 years will be $4,385,000. The net result is that Husband will have transferred over $4 million of Widget stock to Son, while using only $270,000 of his estate/gift tax exemption.

Strategy 2: Family Limited Liability Company

The second strategy is a replay of the first, but using a family limited liability company (FLLC) to give the factory building to Daughter via a GRAT. An FLLC is the entity of choice to hold the real property because the FLLC allows the parents to control the FLLC's assets as the managers of the FLLC; the FLLC's operating agreement is amendable; the giving of fractional interests is simplified; restrictions can be placed on the transfer of membership interests; and the FLLC interests are less attractive to the donees' creditors.

The couple will form a new FLLC. Husband and Wife will be 1% member-managers, and Wife will be a 98% non-managing member. Husband will transfer the building to the FLLC. Wife will then transfer 50 of her 98 non-managing membership units in the FLLC to a 10-year GRAT for the benefit of Daughter only. Since the couple is relying on Husband's life expectancy for the success of the S Corporation GRAT, by putting most of the FLLC interests in Wife's name and then in Wife's GRAT, the couple is hedging their bet that at least one of them will survive the set term. Moreover, having Daughter as the remainderman of the FLLC/GRAT provides an opportunity for some estate equalization between Son and Daughter. To avoid any potential disputes in the future between Son and Daughter, Widget, Inc. and the FLLC should enter into a long-term lease with rent escalators, as well as an option to purchase by the tenant at fair market value.

Assuming a 40% discount for lack of marketability and lack of control is available, the initial fair market value of the FLLC/GRAT is $300,000 (i.e., $1,000,000 x 50% x 60%). The income being generated by the FLLC/GRAT is $50,000 per year (i.e., $500,000 x 10%). Thus, the GRAT's rate of return is 16.66% (i.e., $50,000/$300,000). The value of a 10-year-retained 16.66% annuity using IRS tables (assuming an IRC §7520 rate of 6%) is $270,000. The value of the gift is, therefore, the value transferred less the value retained, or $30,000 (i.e., $300,000 - $270,000). Assuming Wife lives to her life expectancy and the building continues to appreciate at 5% per year, the value of 50% of the FLLC will be $1,265,000. The net result is that Wife will have transferred over $1.2 million of FLLC interests to Daughter, while using only $30,000 of her estate/gift tax exemption.

Strategy 3: Charitable Remainder Trust

The third strategy involves charitable giving. Husband and Wife will ultimately need income when the annuities from the 10-year GRATs expire. To diversify their mutual fund portfolio, they will establish a charitable remainder unitrust (CRUT) that will pay them 10% of the CRUT's fair market value, re-valued annually, during their joint lifetimes. At the death of the surviving spouse, the remainder of the CRUT's assets will pass to the couple's private family foundation. The value of their income tax deduction is based on their ages, the percentage payout, the frequency of payment, and the IRC §7520 rate. The older their ages and/or the higher the IRC §7520 rate, the larger the deduction. Likewise, the lower the frequency of payments and/or the lower the percentage payout, the larger the deduction.

For their $2 million gift (with a cost basis of $200,000), the couple will be entitled to a $460,000 income tax charitable deduction (assuming an IRC §7520 rate of 6%), saving them $182,000 in income taxes (i.e., $460,000 x 39.6%). Assuming the underlying assets return 10% per year, the CRUT will generate $3.8 million in gross income during their lifetime ($2,000,000 x 10% x 19 years). Out of that amount, $760,000 will be used to purchase, over a 10-year-period, a $2 million second-to-die life insurance policy inside a Dynasty Trust for "wealth replacement." The Dynasty Trust will be for the sole benefit of Daughter and her descendants as a method of estate equalization. The couple will net, after insurance premiums, but before income taxes, $3,222,000 ($3,800,000 + $182,000 - $760,000). At the second death, $2 million will pass from the CRUT to the family foundation, to be managed by the couple's heirs for eternity.

Compared to selling the assets outright and reinvesting the after-tax proceeds, the CRUT wins at every level. It provides greater income, even after the payment of the insurance premiums. After paying 20% (or $360,000) in capital gains taxes, the couple would have $1,640,000 to reinvest, which would provide $3,116,000 of gross income ($1,640,000 x 10% x 19 years) over their joint lifetimes. The CRUT provides $3,040,000 of gross income, net of insurance premiums, plus $182,000 in tax savings, or $3,222,000 in total gross income. This is $106,000 more than compared to an outright sale. There is no estate or capital gains tax on the assets in the CRUT, as compared to $360,000 in capital gains taxes and $902,000 in estate taxes (i.e., $2,000,000 - $360,000 = $1,640,000 x 55%). Without the CRUT, the children would have inherited $738,000 (i.e., $1,640,000 - $902,000). With the CRUT and wealth replacement trust, charity will receive $2,000,000 from the CRUT and Daughter will receive $2,000,000 from the Dynasty Trust. With the CRUT, charity goes from receiving nothing to receiving at least $100,000 (i.e., $2,000,000 x 5%) per year from the foundation, ad infinitum.

Strategy 4: Qualified Personal Residence Trust

The fourth strategy involves the use of a qualified personal residence trust. The typical QPRT transaction involves a transfer of a residence to an irrevocable trust in which the grantor retains the right to live in the residence, rent free, for a set term of years. At the end of the term, the residence, plus all appreciation, will pass to the designated heirs, outright or in further trust. The value of the gift is based on the grantor's age, the length of the term, and the IRC §7520 rate. The higher any or all of these three variables are, the smaller the gift. If death occurs before the trust term ends, the residence will be included in the grantor's estate. However, any gift tax exemption used would be restored. Therefore, the grantor is in no worse a position for having tried a QPRT. If the residence is sold during the trust term, any cash not reinvested in another residence must be "GRATed" back out to the grantor. At the end of the trust term, the grantor can rent the house at fair market value. Moreover, if the QPRT is designed as a "grantor trust," no income tax on the rent will be payable by the heirs, and the rent payment itself is not considered an additional gift.

Wife will establish a 15-year QPRT for the benefit of Daughter only. Once again, the QPRT is being used as an estate equalizer for Daughter. The value of the 15-year-retained interest using IRS tables (assuming an IRC §7520 rate of 6%) is $810,000. The value of the gift is, therefore, the fair market value of the residence, less the value retained, or $190,000 (i.e., $1,000,000 - $810,000). Assuming Wife lives to her life expectancy and that the residence continues to appreciate at 5% per year, the value of the residence in 19 years will be $2,530,000. The net result is that Wife will have transferred over $2.5 million in realty to Daughter, while using only $190,000 of her estate/gift tax exemption.

Strategy Five: Buy-Sell Agreement

The fifth and final strategy is a buy-sell agreement for Widget, Inc., which will provide that upon the death, disability, or retirement of a shareholder, the remaining shareholder will purchase that shareholder's stock at a predetermined price and terms. To fund the obligation, each shareholder will own a life insurance policy on the lives of the other shareholder. The IRS requirements to fix the estate tax value of the shares are three-fold: 1) the agreement must be a bona fide business arrangement; 2) the agreement must not be a device to transfer the business to family members for less than full and adequate consideration; and 3) the agreement must have arms-length terms.

Husband and Son will enter into a buy-sell agreement. Son will own a life insurance policy on his father for the discounted value of his father's shares not given to the GRAT. The premiums can be bonused to Son, or can be split dollared with Son through Widget, Inc. The buy-sell agreement will, therefore, deliver the remainder of Husband's stock to Son at Husband's death, yet allow Wife (and eventually Daughter) to receive equivalent value. In addition, the buy-sell agreement will keep the stock given to Son via the GRAT out of the reach of creditors, including a divorced spouse.


To recapitulate, Husband and Wife have made the following lifetime gifts: Husband made a $270,000 gift of 50% of his Widget stock to a 10-year S corporation GRAT; Wife made a $30,000 gift to a 10-year FLLC/GRAT; Husband and Wife made a $2 million gift to a 10% CRUT; Wife made a $190,000 gift of their personal residence to a 15-year QPRT; and they funded a $2,000,000 wealth replacement trust with the tax savings from establishing the CRUT. Therefore, Husband has $730,000 (i.e., $1,000,000 - $270,000) of his estate/gift tax exemption remaining, and Wife has $780,000 (i.e., $1,000,000 - $220,000) of her estate/gift tax exemption remaining. In 2018, their projected estate will now be $6 million, comprised of the following assets: 50% of Widget, Inc. (valued at $3.73 million), 50% of the FLLC (valued at $1.27 million), and cash (valued at $1 million). At the second death, in 2018, the IRS will still collect $2,150,000 in taxes, but the children will now net $9,845,000 each from the estate and from the lifetime gifts, as shown below:

Son Asset Daughter
$4,385,000 Widget, Inc. (GRAT) N/A
$4,385,000 Widget, Inc. (BUY-SELL) N/A
N/A LLC (GRAT) $1,270,000
N/A LLC (ESTATE) $1,270,000
N/A QPRT $2,530,000
N/A ILIT $2,000,000
$1,075,000 Estate $2,775,000

The children will thus net $10,369,000 more dollars, the IRS will not get $6,869,000 in taxes, and charity will receive $2,000,000 more than it otherwise would have, as shown below:

Old Plan New Plan
Family $9,321,000 $19,690,000
Estate Taxes $9,019,000 $2,150,000
Charity $ -0- $2,000,000
Controlled Wealth $9,321,000 $21,690,000

It should be noted that if Husband had transferred all 99 nonvoting shares of Widget, Inc., to the S Corporation/GRAT, and if Wife had transferred all of her FLLC interests to the FLLC/GRAT, then no estate taxes would be due at the death of the surviving spouse-assuming they consumed or given all of the annuity payments. Thus, it should be clear that the estate tax is not a tax at all. Rather, it is a penalty that is imposed on those who fail to plan ahead, or who hire the wrong planners!

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