Initial public offerings are lessons in onomatopoeia for a company's founders: “Pop!” goes the stock immediately after the offering; “Hee Hee!” go the founders when they start counting their money.
All too often, though, these sounds are followed by a “Fwooomph!” as 49 percent of the founders' gains are sucked up by taxes.
This last little bit doesn't have to be. With good planning, a founder can move significant value out of his estate with little or no gift- or estate-tax cost. The catch is that the planning must be done well in advance of the IPO transaction. Here are five pre-IPO strategies financial advisors can employ to protect a company founder's future gains.
Gift of Shares to Family Trust. Suppose Joe Founder owns 1,000,000 shares of ABC Corp. stock — private shares currently worth $1 each. If Joe were to make a gift of the shares to a trust for his children, he could use his $1 million gift-tax exemption to avoid any federal gift tax.
This move gets even smarter if ABC later goes public. Let's say the company launched an IPO at $5 per share. This would mean that the shares he put in the trust removed $4,000,000 in appreciation from his taxable estate, saving the family millions in unnecessary taxes.
The family trust can be designed so that Joe's children and his spouse are beneficiaries. This has the obvious benefit of giving Joe indirect access to the benefits of the trust (so long as he remains married, of course).
After Joe's death, the trust can be designed to protect the assets from creditors of Joe's children and even from the claims of divorcing spouses of Joe's children.
However, Joe needs to be sure to make transfers of shares as far in advance of the IPO as possible. The closer the transfer is to the time of the IPO, the more likely it is that the IRS will assert that the real value of the shares for gift-tax purposes is the IPO price or something close to it.
Transfer the Pre-IPO Shares into a Limited Liability Company. This would allow Joe Founder to make a gift of an interest in the LLC, rather than gifting the shares themselves to the family trust. Such a move has three benefits. First, the existence of the LLC should provide a basis for a valuation discount based on lack of control. Thus, instead of the pre-IPO stock being worth $1 per share, an appraiser might value it at only 65 cents to 70 cents per share. Second, Joe Founder could be a manager of the LLC, permitting him to control the transferred stock even after the gift to the family trust. Third, the LLC provides a quick and convenient way to transfer interests in the company with no involvement from the corporation or from its transfer agent.
Transfer the Pre-IPO Shares to a Grantor Retained Annuity Trust (GRAT). The GRAT is probably the single most popular estate-planning tool for pre-IPO stock. With a GRAT, Joe Founder gets to keep the current value of the pre-IPO stock, plus a small fixed return and transfer only the appreciation to a family trust — all at zero gift-tax cost and without using the $1 million gift-tax exemption.
To see how the GRAT works, let's consider the following example: On May 1, 2004, Joe transfers his 1 million shares to a GRAT when they are worth $1 per share. The GRAT agreement states that Joe is entitled to receive a payment of $122,000 per year for the next 10 years. Upon the expiration of the 10-year term of the GRAT, any property remaining in the GRAT would pass to a family trust for Joe's children or his spouse and children.
Under IRS rules, the value of the taxable gift to the GRAT is equal to the value of the property initially transferred to the trust minus the value of Joe's retained stream of annuity payments. In valuing the retained stream of annuity payments, the IRS assumes there will be a certain rate of return earned by the assets inside this trust. This interest rate assumption changes every month. The rate for May 2004 is 3.8 percent. Using that rate assumption, the value of Founder's retained annuity stream would be approximately $1,000,000. Therefore, Founder's taxable gift to the trust would be zero (because the value of his retained annuity stream is exactly equal to the value of the assets transferred to the trust). This is known as a “zeroed out GRAT.”
If the assets in the trust do in fact produce a rate of return equal to (or less than) that 3.8 percent, there will be no benefit to Joe Founder's children, because the assets in the trust will only be sufficient to pay Founder's retained annuity stream, and there will be nothing left in the trust at the end of the two-year period. However, if the assets produce a return greater than the 3.8 percent, there will be property left in the trust to pass to the children. With pre-IPO stock, the degree to which the trust's actual rate of return exceeds the rate of return assumed by the IRS is typically very substantial. The amount of appreciation passing to the children can be even greater if the GRAT is funded with discounted assets, such as an LLC holding pre-IPO stock.
The table below shows how much can be left in the trust, given various rates of return.
Sale to Defective Trust. This technique is a cousin to the GRAT and allows the founder to transfer only the appreciation in the value of the shares to his children, while retaining their current value. The sale to a defective trust does not require quite as great a rate of return as the GRAT in order to be effective. On the other hand, it is a riskier technique than the GRAT from the IRS' point of view.
| Rate of Return | Amount Remaining in GRAT at End of Term | Amount Remaining in GRAT at End of Term Assuming 20% Discount |
|---|---|---|
| 3.80% | $0 | $290,000 |
| 6 | 182,000 | 504,000 |
| 8 | 391,000 | 744,000 |
| 10 | 648,000 | 1,037,000 |
| 15 | 1,567,000 | 2,063,000 |
| 20 | 3,023,000 | 3,657,000 |
Freeze LLC. Under this technique Founder transfers the pre-IPO stock to an LLC, taking back both preferred and common LLC interests. The preferred interests give Founder the right to a guaranteed dividend, plus a set value upon the liquidation of the LLC. Any appreciation in the LLC over and above that necessary to service Founder's guaranteed return is allocated to the common interests. The technique enables Founder to retain income from the pre-IPO stock for life while gifting the common interests to a family trust or other vehicle at reduced gift-tax cost.