Corporate & Finance Alert
(Rita M. Danylchuk, Cathleen T. Butler)
May 5, 2009
Believe it or not, there is a silver lining in today's economy when it
comes to estate planning and particularly passing the family business
to the next generation. Statistics show that many family businesses do
not survive the transition of management from the original founder to
subsequent generations. The current economy notwithstanding, two
primary reasons for business succession failure are lack of proper
estate planning and that many business owners wait until death to
transfer ownership of the family business to the younger generation at
significant estate tax cost. The current economic climate is favorable
for transferring business interests to younger generations. As
discussed below, the current environment of low interest rates,
depressed asset values and valuation discounts make it an opportune
time for senior owners of closely-held businesses to pass the torch to
the younger generation at minimal transfer tax cost.
What Can You Do?
Interest rates are at historical lows. This offers the owner of a
closely-held business an opportunity to make loans to a child or
grandchild purchasing the business under terms the descendant may be
able to afford. Typically, to structure a loan to a family member that
meets IRS guidelines, the loan must bear interest at a rate which at
least equals the monthly rate issued by the Internal Revenue Service,
referred to as the Applicable Federal Rate or "AFR." The AFR for May
2009 for a note with a term of 3 years or less is a whopping 0.76%! If
the loan is for a term of 3-9 years, the AFR increases to 2.05% and
for a loan of 9 years or more, the AFR is 3.58% Given these low AFR
rates, family loans or sale of business interests pursuant to
installment sales are ideal ways to transfer wealth and assets to the
younger generation.
In the current distressed economic climate, it is possible to transfer
assets, such as closely-held stock and real estate, to your children
and grandchildren at the currently depressed values of the business
assets . By transferring a business interest now to a child or
grandchild at a depressed value, the future appreciation on the
business interest can inure to the benefit of the younger generation
with minimal or no gift or estate tax consequences.
Under current law, valuation discounts can be applied to the transfer
of certain business interests. Generally, two types of discounts apply
- a marketability discount because the business interest is not a
publicly-traded asset; and a discount for minority interest or lack of
control if the interest being gifted represents the non-voting or
non-controlling interest in a company. Let's take an example: assume
Dad and Mom own a printing business appraised at $3 million (including
real estate and other business assets). Mom owns a 49% non-voting
interest in the business and Dad owns a 1% voting interest and a 49%
non-voting interest. Mom can gift her 49% non-voting interest to her
children at a discounted value because the interest is a minority
interest in a closely-held company that is not readily marketable when
compared to assets that are publicly-traded. Discounts vary but
generally range from 20% to 40% of the gross value of the asset. In
the above example, if Mom gifts a 49% non-voting interest to her
children, the value of the gift without any discounting will be
approximately $1,470,000 ($3,000,000 x 49%). Now assume a 35% discount
applies because the interest being gifted represents a non-controlling
interest in a closely-held business. The value of the gift for gift
tax purposes will be reduced to approximately $955,000 ($3,000,000 x
49% x 65%), a difference of approximately $515,000. With the current
Federal estate tax rate at 45% on estates exceeding $3,500,000, the
use of a valuation discount can result in substantial estate tax
savings.
While valuation discounts are currently utilized in the estate
planning arena, their existence may be fleeting. On January 9, 2009,
the "Certain Estate Tax Relief Act of 2009" (HR 436) was introduced in
the House of Representatives. This proposed legislation seeks to
eliminate the use of valuation discounts in a closely-held company
which holds non-business assets (assets not used in active trade or
business). For example, any transfer of non-business assets (stocks,
bonds, real estate, etc.) would be valued without any valuation
discounts. The proposed legislation also seeks to eliminate minority
discounts that currently apply for transfers by a donor whose family
members have control over the business even if the donor does not.
How Can You Do It?
1. Gifting
In 2009, the annual amount that each individual can gift to a donee,
without incurring a gift tax, increased from $12,000 to $13,000. A
husband and wife can make a joint gift of $26,000 without incurring a
gift tax. For gifts exceeding the annual exclusion amount, an
individual can gift up to $1,000,000 during life without paying any
Federal gift tax (herein, the "Lifetime Gift Exemption"). The use of
annual exclusion gifts and the Lifetime Gift Exemption, combined with
valuation discounts, may allow an individual to transfer a substantial
portion of his business interest to family members at minimal gift tax
cost. Gifts of business interests can be made to children directly or
to trusts established for the benefit of children and/or
grandchildren.
In the example described above, Mom's gift of her 49% interest would
not be subject to any out of pocket gift tax. If Mom gifted her 49%
interest, valued at $955,000 for gift tax purposes, to her three
children and split the gift with her husband, $78,000 of the gift
would be covered by the annual gift exclusion and the remainder of the
gift would be covered by a portion of Mom's $1 million Lifetime Gift
Exemption. Mom would not be required to pay out-of-pocket gift tax to
the IRS. Further, through gifting, Mom will remove approximately $1
million from her taxable estate, resulting in estate tax savings of
approximately $450,000. Dad can also do similar gifting with his
interests in the business.
If parents are concerned about outright gifts to children, a trust can
be established to own the business interest. From a creditor
perspective, any assets in the trust also will be protected from
creditor claims of trust beneficiaries (i.e., the children) to the
extent the assets in the trust are not distributed out to the
beneficiaries. Further, if properly created, a trust can exist for
multiple generations.
2. Sales to Family Members
As an alternative to a gift of the business interest, the business
owner may consider the sale of the business interest to the junior
generation with a promissory note. Unlike a commercial loan, the terms
of an intra-family promissory note can be structured to meet the
specific needs and circumstances of a child or grandchild. For
instance, the promissory note can provide for interest-only payments
for the term of the note with a balloon principal payment paid at
maturity. The sale of a parent's business interest to a child will
provide a stream of income for the parent and enable the child to
obtain an interest in the family business at a lower cost due to the
current depressed value of assets and low interest rates. While the
parent may realize capital gain on the sale of the business interest,
the capital gains rate of 15% minimizes the tax hit when weighed
against the value of the business interest that is removed from the
donor's estate.
3. Sales to Intentionally Defective Grantor Trusts
In the current economic climate, selling a business interest to an
intentionally defective grantor trust ("IDGT") is another attractive
transfer technique. An IDGT is a trust under which the grantor is
treated as the owner of trust assets for income tax purposes, but not
for gift or estate tax purposes. Any transactions such as sales
between a grantor and an IDGT are ignored for income tax purposes.
Accordingly, the grantor parent will not recognize a capital gain on
the sale of a business interest to an IDGT and any interest income
paid on a promissory note will not produce taxable income to the
grantor. The beneficiaries of an IDGT can be the grantor's children
and grandchildren or even individuals who are not the grantor's lineal
descendants but to whom the grantor wishes to leave the business. The
business interest sold to the IDGT, together with all future
appreciation in the value of the business, will be removed from the
grantor's taxable estate and inure to the benefit of the IDGT
beneficiaries.
Going back to the prior example, let's assume that Dad sells his 49%
non-voting interest in the family printing business, valued at $3
million, to an IDGT in exchange for a promissory note with a face
value of $955,000, bearing interest at the appropriate AFR. The face
value of the promissory note is based upon the appraised value of the
49% non-voting interest utilizing a minority interest and lack of
marketability discount of approximately 35% ($3,000,000 x 49% x 65%).
Assuming this discount is accepted by the IRS, Dad will have
transferred $1,470,000 worth of property (undiscounted) to his IDGT
without utilizing any of his Lifetime Gift Exemption. Since the IDGT
is treated as a grantor trust for income tax purposes, no gain or loss
will be recognized on the sale of Dad's 49% non-voting interest in
exchange for the promissory note. Further, no interest will be treated
as paid on the promissory note during the term of the note and all
items of income and deductions will flow through and be taxed to Dad
as grantor, rather than the IDGT, for income tax purposes. With a sale
to an IDGT, it is recommended that the IDGT should have sufficient
assets of its own to make a down payment on the purchase of Dad's
non-voting interest. If the IDGT does not have sufficient assets, then
prior to the sale, Dad should make a gift to the IDGT of assets that
can be used to make the subsequent purchase of assets. Typically, a
gift equal to at least 10% of the value of the assets transferred to
the IDGT should be sufficient.
To conclude, the current availability of valuation discounts,
historically low interest rates and depressed asset values all are
clear indicators that now is the time for business owners to seriously
consider passing the torch to the next generation - do it now before
the flame goes out.
Should you have any questions regarding your own situation, please
contact Rita M. Danylchuk or Cathleen T. Butler of our Trusts and
Estates Group.
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