Are you looking for a way to transfer your business or real estate investments to your children or grandchildren without the imposition of estate or gift taxes? If so, and your business or real estate investments generate cash flow, then you should consider the following technique to accomplish your goal. An installment sale of an interest in a business to a so-called "defective grantor trust" can be used to transfer the value of a business to children and grandchildren at a substantially-reduced transfer tax cost. This technique is commonly used with S corporations, limited liability companies and partnerships.
It is important at the outset to note that this technique is not without risk. It could be subject to future challenges by the IRS under current law or as a result of future changes in the law. It is also important to note that this is only one of many tax planning techniques in your arsenal -- depending on the circumstances, other planning devices may be more advisable.
This tool is suitable in the following circumstance:
- A high net worth individual who owns an interest in an S corporation, limited liability company or partnership and desires to transfer his or her interest in the business to children and/or grandchildren.
- The business is expected to appreciate in value.
- The business has a history of generating cash flow.
- The client is neither risk averse nor averse to the administrative complexities that accompany the use of this technique.
- The client is willing to assume the risk that there could be unfavorable tax consequences.
The owner of an interest in a business that is organized as an S corporation, limited liability company or partnership sells part or all of the interest to a specially-designed trust in return for a down payment and an installment promissory note for the balance of the purchase price. By reason of special provisions in the trust, the sale should not be subject to income tax and payments on the promissory note also should not be subject to tax. Nevertheless, the value of the business interest would not be subject to estate tax upon the owner's death. Furthermore, the trust's share of the income generated by the business will be taxed to the owner while he or she is alive, thereby causing the business interest to be even more valuable to the beneficiaries of the trust since the owner is paying the income tax.
Steps To Selling To A Defective Grantor Trust
First, the business owner creates an irrevocable trust. Under the terms of the trust, certain powers are retained by the business owner which should result in he or she being considered to be the owner of the trust for income (but not estate) tax purposes. As a result of these retained powers, income that would normally be taxed to the trust should instead be taxed to the business owner and transactions between the owner and the trust should be ignored for income tax purposes. This type of trust is called a "defective grantor trust."
When the business owner creates the trust he or she would make a cash gift to the trust (the "seed money"), enough to allow the trust to make a down payment of at least 10% of the purchase price of the business interest being sold to the trust. A gift tax return will be required and, depending on the particular facts, gift taxes may need to be paid by reason of this gift.
Secondly, after the trust is created and funded, the business owner sells a portion or all of his or her interest in the business to the trust in return for the seed money and an installment promissory note for the balance of the purchase price. The purchase price would be established by an appraisal of the interest in the business being sold to the trust. Depending on the particular facts, this appraisal may reflect a discount for lack of marketability as well as a minority discount.
Because the trust is a defective grantor trust, there should be no capital gain realized on the sale. (However, because the business owner no longer owns the interest sold to the trust, there will be no step-up in the tax basis for the interest upon the business owner's death.)
Third, after the sale is completed, the trust will repay the promissory note using cash distributions received by reason of its interest in the business. (A portion, perhaps all, of these cash distributions will consist of the annual distributions regularly made by the business to enable its owners to pay income taxes on their respective shares of the income generated by the business.)
As noted previously, the trust's share of the income generated by the business should be taxed to the business owner, who will use the note repayments made by the trust to pay the applicable income taxes. In effect, the trust should be ignored for income (but not estate) tax purposes and will not even have to file income tax returns while the business owner is alive. Since these income taxes have to be paid by someone it is almost as if the business interest were sold to the trust essentially for pennies on the dollar.
Fourth, because the trust is recognized as a separate legal entity for estate tax purposes, appreciation in the value of the business interest sold to the trust will escape estate taxation on the business owner's death. However, if the business owner dies prior to the complete repayment of the promissory note, the unpaid balance will be included in the business owner's estate (thereby causing it to be subject to estate tax unless protected from tax through other planning techniques such as the marital deduction) and, although the matter is not entirely clear, may also be subject to income tax to the extent that the unpaid balance of the note is in excess of the business owner's basis in the note immediately prior to death. Fortunately, however, it appears that any estate taxes attributable to the note will be treated as a deduction when computing the income tax on note payments made after the business owner's death.
Lastly, the trust can be terminated after the business owner's death, thereby permitting the business interest to pass to his children. Alternatively, the business interest may continue to be held in trust for the benefit of the business owner's children and grandchildren. Furthermore, if the trust continues and is designed to benefit grandchildren, substantial leveraging of the $1 million generation skipping tax exemption is possible; thus, for example, a $100,000 taxable gift to the trust for which $100,000 of the generation skipping tax exemption would be allocated would enable the trust to purchase $1 million in business interests.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.