Interest rates remain low, which makes it an ideal time for business succession planning.
One compelling business succession plan involves selling an interest in a family business to a trust for the benefit of children and/or other family members in exchange for a promissory note. Because the interest rate on the note will be relatively low – August rates set by the IRS are 4.58% for notes greater than nine years – less cash is needed from the business to service the note, and the business is ultimately removed from the client’s taxable estate for less.
As an example, assume that Dad owns a manufacturing business appraised at $10 million. Dad owns a 1% voting interest and a 99% non-voting interest, and would like to transfer the business to his two children, who also work in the business. How can Dad go about transferring the business?
One possibility is for Dad to create a new trust for the benefit of his children and their families. The children could be co-trustees, and would have fairly broad discretion to make distributions from the trust to themselves or their families. The trust could be structured as a “grantor trust” for income tax purposes, which means that Dad would remain liable for income taxes on trust income, a further advantage from an estate planning perspective.
Dad would then make two gifts. First, he would make a gift of his 1% voting interest (valued at $100,000), distributed to the children equally. Second, he would fund the trust with a gift of a 9% non-voting interest in the business ($900,000). He would apply a portion of his $1 million gift tax exemption amount so that no gift tax is due on this gift. He would also apply a portion of his generation-skipping transfer (“GST”) tax exemption to the gift to the trust so that the trust is exempt from the GST tax as well. Because the gift to the trust is of non-voting shares, it is valued at a discount because it is a non-marketable, non-controlling interest. Such discounts typically range from 20% to 45%. Assuming that a 30% discount applied, the gift would be valued at $630,000 ($900,000 x 0.7).
Dad would then sell a 90% non-voting interest in the business to the trust in exchange for a note. Because the sale is to a grantor trust, it is not recognized for income tax purposes and no capital gains tax is triggered on the sale. In addition, due to the discounts, the interest sold would be valued at $6.36 million ($9 million x 0.7), which would be the principal amount of the note. Interest on the note would be set at the lowest rate necessary to avoid imputed interest under the tax laws – currently 4.58%. If the note were structured as a 10-year balloon note, the interest payments would be $291,288 per year, which should be manageable in terms of cash flow from a business this size. The principal repayment would be due in 10 years.
Following this transaction, Dad has removed the business and all future appreciation in the business from his taxable estate. His children own the 1% voting interest and the trust owns the 99% non-voting interest. In place of the business, Dad now owns a promissory note with a fixed value of $6.36 million, and has effectively removed over $3 million from his taxable estate.
Dad will receive interest payments of $291,288 per year on the note. If rates were, say, 3% higher, the required payments would be $482,088 per year over the note’s 10- year term, and would require that much more cash flow from the business. Thus, the low interest rate is quite an advantage.
In the current environment of low interest rates, using a sale to a grantor trust as part of a business succession plan can produce very positive results. This type of business succession planning is complicated, however, and you should always consult with an attorney for specific advice.
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