In parts one and two of this series, we laid out a roadmap for preparing a closely-held business for sale, tackling issues ranging from assembling a crack team to the importance of financial planning before sae to the types of buyers you may encounter.
In this final installment, we wrap things up with a discussion of the potential tax value of gifting prior to a sale, as well as the importance of post-sale planning.
First, it's important to know the tools available to you. Federal tax law encourages lifetime gifting by providing several incentives that can be used by a business owner prior to the sale of the business.
Annual exclusion gifts. The tax law allows the business owner to gift $15,000 (in 2019, indexed for inflation) each year to anyone without eating into the $11.4 million gift/estate tax exemption. For a gift to qualify for the annual exclusion, it must be a gift of a present interest; that is, according to the Treasury regulations, the recipient must have an “unrestricted right to the immediate use, possession, or enjoyment of property.” That’s easily satisfied in the context of an outright gift of shares to a family member, but becomes more complicated in the context of gifts to an irrevocable trust. Technically, a gift to an irrevocable trust doesn’t qualify as an annual exclusion gift because it’s considered to be a gift of a future interest. That’s where Mr. Crummey comes in. His lawyer came up with a concept that allows gifts to an irrevocable trust to qualify as an annual exclusion gift. He did this by giving the beneficiaries of the trust the right to withdraw amounts that were contributed to the trust for a specified period of time after the amounts were contributed in a particular calendar year. Fortunately, the court endorsed this strategy and the Internal Revenue Service acquiesced, and thus was born the “Crummey power.”
Gift/estate tax exemption. Any shares gifted to family members that don’t qualify for the annual exclusion will eat into the business owner’s gift/estate tax exemption. The amount of this exemption is $11.4 million (in 2019, indexed for inflation). This is a unified exemption. That means that the business owner can: (1) gift it all away during life, leaving no estate tax exemption, (2) give away a portion during life, leaving the remaining exemption available at death, or (3) give none away dur-ing life, leaving the entire exemption available at death. Any amounts in excess of the exemption are taxed at a flat 40 percent at the federal level (unless they qualify for the marital deduction or the charitable deduction). It should be noted that many states have their own estate taxes that are in addition to the federal tax (but are deductible against the federal taxable estate); one state, Connecticut, actually has a gift tax.
Generation-skipping transfer (GST) tax exemption. While the gift/estate tax exemption applies to the business owner’s assets that are given during lifetime or at death, the GST tax exemption is typically used to avoid tax at the business owner’s children’s or grandchildren’s deaths. To understand the GST tax exemption, it’s important to provide some context. Soon after the federal estate tax was enacted in 1916, attorneys for wealthy families found that there was a gaping loophole. The estate tax applies to everything your client owns at death. What if a wealthy father paid estate tax at his death and left his son’s inheritance in a lifetime trust for the son’s benefit, and when the son died, the assets continued in trust for his children? The trust’s assets weren’t included in the son’s estate because he didn’t own them even though he could benefit from them. The assets were owned by an irrevocable trust that continued at his death for the benefit of his children.
Fast-forward to 1986, when Congress enacted the GST tax to close this and other end-runs around the estate tax. Basically, the GST tax states that the lifetime trust will be subject to a 40 percent tax (same as the estate tax) at the son’s death. But, because Congress gives an exemption from the estate tax, it’s only fair that it give an exemption from the GST tax. The amount of the GST tax exemption is currently $11.4 million (in 2019, indexed for inflation); exactly the same amount as the gift/estate tax exemption. It’s a second exemption that can be layered on top of the gift/estate tax exemption. For example, the business owner could gift shares to an irrevocable lifetime trust for the benefit of her children in the amount of $11.4 million. The taxpayer would file a gift tax return and elect to allocate GST tax exemption to the trust in the same amount. The result would be that the trust would be exempt from the GST tax, no matter how big the trust got, for as long as state law allows the trust to continue—basically 90 to 100 years in most states and for as long as forever in states that have repealed the rule against perpetuities.
The Tax Goals of Gifting to Family
The goals for tax-efficient gifting are threefold: removing value, freezing value and locking in the higher exemption values.
Removing value. Removing value from the transfer tax system is difficult to do in the context of gifting shares of a closely held business. In most cases, if an individual makes a lifetime gift, that gift (valued as of the date of the gift) is brought back into the donor’s taxable estate at death for purposes of calculating the estate tax. However, there are three exceptions to the general rule. First, if the business owner makes a gift using his $15,000 annual gift tax exclusion, the gifted property is completely removed from the taxable estate. Second, if the business owner gifts shares representing a minority interest in the business, she would be entitled to valuation discounts based on a qualified appraisal for lack of control and lack of marketability. These discounts can sometimes exceed 30 percent, effectively removing that amount from the taxable estate if the IRS respects the discount. Third, if the shares are transferred to an irrevocable trust that won’t be included in the business owner’s estate, the trust can be drafted so that she can continue to pay the trust’s income taxes during her lifetime, thereby effectively reducing her taxable estate by the taxes paid on behalf of the trust without being considered to have made a gift. This is known as a “grantor trust,” and this technique is highly effective in removing value from the business owner’s taxable estate.
Freezing value. Freezing value involves the business owner making a gift (outright or in trust) using some or all of her gift tax exemption. On the owner’s death, the amount of exemption used to make the gift is brought back into the estate for purposes of calculating her estate tax. Any appreciation on the gift from the date of the gift until the business owner’s death is excluded from the taxable estate. That is to say that the business owner succeeds in “freezing” the value of the gifted property for estate tax purposes at its date-of-gift value rather than at its date-of-death value.
Locking in the higher exemptions. On Jan. 1, 2018, the gift/estate and GST tax exemptions doubled as part of the new tax law. Unfortunately, because of certain Senate procedural rules, the higher exemptions will sunset without additional Congressional action at the end of 2025. This means that the exemptions will return to where they were prior to the new law (indexed for inflation). If, however, the business owner uses a portion or all of the higher exemption amounts by making gifts prior to the sunset date, those amounts gifted in excess of the exemption amount at sunset will be locked in and exempt from transfer tax going forward.
When a business owner considers making gifts to family in advance of the sale of the business, there’s an alphabet soup of gifting techniques that can be considered.
Outright gifts. Outright gifts of shares or interests in a limited liability company (LLC) or partnership are quite easy. Like any other gifts of illiquid assets valued at more than $5,000, such gifts require a qualified appraisal and, if they’re gifts of minority interests, can result in valuation discounts. The risks of outright gifts occur after the sale, when the recipient receives cash for the shares. Is the recipient mature enough to handle the money responsibility? Will having the cash outright act as a disincentive to leading a productive life? Will the assets be available to a divorcing spouse? If these and other issues related to an outright gift are a concern and the values are large enough, it might make more sense to have the assets held in an irrevocable trust for the beneficiary.
Gifts to irrevocable trusts. These gifts have many advantages. They can be set up to protect the trust assets from the beneficiary herself, from divorcing spouses and from the beneficiary’s creditors. If GST tax exemption is allocated to the trust, the assets won’t be includible in the beneficiary’s taxable estate. Finally, if the trust is drafted to be a grantor trust for income tax purposes, the grantor can continue to pay the income taxes on behalf of the trust (effectively, a free gift).
We particularly like the spousal lifetime access trusts (SLAT) approach, which involves creating an irrevocable trust for the benefit of the business owner’s spouse and descendants. Typically, the spouse is the primary beneficiary, and the descendants are secondary. To avoid an argument that the trust should be included in the grantor’s estate under Internal Revenue Code Section 2036, the grantor mustn’t have any legal right to the assets held in the trust, nor can there be any prearrangement or understanding between the grantor and her spouse that the grantor might use the assets in the trust. Nonetheless, if the grantor is in a happy marriage, it can be comforting to know that her spouse will have access to the property in the trust (unless they get divorced or the beneficiary spouse predeceases the grantor). It should be noted that each spouse can establish a SLAT for the benefit of the other spouse, but the terms of the two trusts can’t be identical. If they are, the IRS can disregard the trusts and bring the assets back into each grantor’s taxable estate under the “reciprocal trust doctrine.”
The alternative to the SLAT is a descendant’s trust. Such a trust merely excludes the spouse as a beneficiary. One downside of a descendant’s trust versus a SLAT is that the children are the primary beneficiaries and, in most states, have a right to know about the trust at a certain age and, depending on distribution standards in the trust, can make demands on the trustee for distributions. This may fly in the face of the business owner’s intention to not have young adult beneficiaries know that they have money before they’ve established themselves as responsible adults.
Grantor retained annuity trusts (GRATs) and sales to intentionally defective irrevocable trusts (IDITs). The basic concept behind a GRAT is to allow the business owner to give stock in the business to a trust and retain a set annual payment (an annuity) from that property for a set period of years. At the end of that period, ownership of whatever property that’s left in the GRAT passes to the business owner’s children or to trusts for their benefit. The value of the owner’s taxable gift is the value of the property contributed to the trust, less the value of her right to receive the annuity for the set period of years, which is valued using interest rate assumptions provided by the IRS each month pursuant to IRC Section 7520. If the GRAT is structured properly, the value of the business owner’s retained annuity interest will be equal or nearly equal to the value of the property contributed to the trust, with the result that her taxable gift to the trust is zero or near zero.
How does this benefit the business owner’s children? If the stock contributed to the GRAT appreciates and/or produces income at exactly the same rate as that assumed by the IRS in valuing the owner’s retained annuity payment, the children don’t benefit because the property contributed to the trust will be just enough to pay the owner her annuity for the set period of years. However, if the stock contributed to the trust appreciates and/or produces income at a greater rate than that assumed by the IRS, there will be property left over in the trust at the end of the set period of years, and the children will receive that property—yet the business owner would have paid no gift tax on it. The GRAT is particularly popular for gifts of hard-to-value assets like closely held business interests because the risk of an additional taxable gift on an audit of the gift can be minimized. If the value of the transferred stock is increased on audit, the GRAT can be drafted to provide that the size of the business owner’s retained annuity payment is correspondingly increased, with the result that the taxable gift always stays near zero. One downside of a GRAT funded with closely held business interests is that if the business isn’t sold, a qualified appraisal needs to be obtained not only in the year of the gift but also in any year that the GRAT continues to own shares, to determine the number of shares needed to make the GRAT payment in a particular year.
When we suggest a GRAT to a business owner, we nearly always invite her to compare the GRAT with its somewhat riskier cousin, the IDIT sale. The general IDIT sale concept is fairly simple. The business owner makes a gift to an irrevocable trust of, say, $100,000. Sometime later, the business owner sells, say, $1 million worth of stock to the trust in return for the trust’s promissory note. The note provides for interest only to be paid for a period of, say, nine years. At the end of the ninth year, a balloon payment of principal is due. The interest rate on the note is set at the lowest rate permitted by the IRS regulations. There’s no gift because the transaction is a sale of assets for fair market value (FMV). There’s no capital gains tax, either, because the sale is between a grantor and her own grantor trust, which is an ignored transaction under Revenue Ruling 85-13.
How does this benefit the business owner’s children? If the property sold to the trust appreciates and/or produces income at exactly the same rate as the interest rate on the note, the children don’t benefit, because the property contributed to the trust will be just sufficient to service the interest and principal payments on the note. However, if the property contributed to the trust appreciates and/or produces income at a greater rate than the interest rate on the note, there will be property left over in the trust at the end of the note, and the children will receive that property, gift tax-free. Economically, the GRAT and IDIT sale are very similar techniques. In both instances, the owner transfers assets to a trust in return for a stream of payments, hoping that the income and/or appreciation on the transferred property will outpace the rate of return needed to service the payments returned to the owner. Why, then, do some clients choose GRATs and others choose IDIT sales?
The GRAT is generally regarded as a more conservative technique than the IDIT sale. It doesn’t present a risk of a taxable gift in the event the property is revalued on audit. In addition, it’s a technique that’s specifically sanctioned by IRC Section 2702. The IDIT sale, on the other hand, has no specific statute warranting the safety of the technique. The IDIT sale presents a risk of a taxable gift if the property is revalued on audit and there’s even a small chance the IRS could successfully apply Section 2702 to assert that the taxable gift is the entire value of the property sold rather than merely the difference between the reported value and the audited value of the transferred stock. Moreover, if the trust to which assets are sold in the IDIT sale doesn’t have sufficient assets of its own, the IRS could argue that the trust assets should be brought back into the grantor’s estate at death under IRC
Section 2036. Also, with a GRAT, if the transferred assets don’t perform well, the GRAT simply returns all of its assets to the grantor, and nothing has been lost other than the professional fees expended on the transaction. With the IDIT sale, on the other hand, if the transferred assets decline in value, the trust will need to use some of its other assets to repay the note, thereby returning assets to the grantor that she had previously gifted to the trust—a waste of gift tax exemption.
Although the IDIT sale is generally regarded as posing more valuation and tax risk than the GRAT, the GRAT presents more risk in at least one area, in that the grantor must survive the term of the GRAT for the GRAT to be successful. This isn’t true of the IDIT sale. In addition, the IDIT sale is a far better technique for clients interested in GST planning. The IDIT trust can be established as a dynasty trust that escapes estate and gift tax forever. Although somewhat of an oversimplification, the GRAT generally isn’t a good vehicle through which to do GST planning.
As important as it may be for the business owner to understand the risks and benefits of a GRAT versus an IDIT sale, we’ve found that the primary driver of which technique to choose is cash flow. With an IDIT sale, the note can be structured such that the business owner receives only interest for a period of years, with a balloon payment of principal and no penalty for prepayment. This structure provides maximum flexibility for the business to make minimal distributions to the IDIT to satisfy note repayments when the business is having a difficult year and for the business to make larger distributions in better years. With the GRAT, on the other hand, the annuity payments to the owner must be structured so that the owner’s principal is returned over the term of the GRAT, and only minimal back-loading of payments is permitted. Accordingly, the GRAT may be the technique of choice when the business produces fairly predictable cash flow, while the IDIT sale is chosen more often when cash flow is more erratic.
Planning After the Sale
The planning shouldn't stop once the sale goes through. There are still many opportunities to efficiently manage tax liability in the aftermath of the sale, not to mention the simple value of asking the client: What next?
Creating a pooled investment vehicle or family office. Preserving and growing family wealth after a sale isn’t as easy as it may seem. Many times, each shareholder goes off in her own direction, spending and/or investing the proceeds as she sees fit. This independence can either work out well or fail miserably, depending on the quality of financial advice received. An alternative is for the family to pool the proceeds from the sale and invest them together using professional investment managers and possibly even a family office.6
Charitable planning. Charitable planning after a liquidity event can be a tax-efficient way to be philanthropic while offsetting some of the taxes in the year of the liquidity event. Unlike pre-liquidity charitable planning, post-liquidity charitable planning is fairly straightforward if the business owner receives cash in the transaction. Cash gifts to a public charity are deductible up to 60 percent of adjusted gross income in the year of the gift (with a 5-year carryforward for any excess contributions). All charitable vehicles are available post-sale, including outright gifts to public charities (including donor-advised funds), gifts to PFs and gifts to charitable remainder and charitable lead trusts.
Investment/financial planning. Once the liquidity event has occurred, the business owner, working with a financial advisor, should update the financial plan with the actual dollar amounts (taking into consideration taxes that may be owed on the liquidity event).
Qualified small business stock. Post-liquidity, there are some attractive income tax savings and deferral opportunities if the stock is considered qualified small business stock (QSBS). QSBS is stock in a domestic C corp formed after 1993 that operates an active business. To qualify, the corporation must use at least 80 percent of its asset value in the active conduct of one or more qualified trades or businesses (certain industries are excluded), and the gross assets of the corporation, as of the date the stock was originally issued, can’t exceed $50 million.
On the sale of QSBS, the seller may exclude between 50 percent and 100 percent of the gain (depending on when acquired), up to the greater of: (1) $10 million, or (2) 10 times the basis in the QSBS. To qualify, the QSBS must be held for at least five years prior to the sale, and the shareholders must have acquired the stock at its original issue, in exchange for cash or property, or as compensation for services rendered. It’s important to note that some of the benefits of the QSBS exclusion may be diminished by the rules
related to the alternative minimum tax.
In addition, on the sale of QSBS (held more than six months), the seller may elect to defer realized gain by reinvesting the sale proceeds into a new QSBS investment within 60 days of the sale. The seller’s basis in the replacement stock is reduced by the amount of the gain deferred. This ensures that gain continues to exist, but is merely deferred.
Second acts. Many times, the business owner is so focused on getting the business sold that she fails to think about her life after the sale (other than vague references of exotic vacations and more free time). All we’re saying here is that before the business owner gives up her current work, she needs to think about how her time will be occupied productively after the deal is completed. Will it be a new business, a focus on philanthropy or getting an additional degree? We don’t want the business owner to have seller’s remorse.
—This article is provided for informational and educational purposes only. The views and the opinions expressed in this article are those of the authors and do not necessarily represent or reflect the views of UBS Financial Services Inc. or its affiliates.
This is an adapted version of the authors' original article in the March 2019 issue of Trusts & Estates.