Combined trusts smooth successions

April 5, 2009
| By Pete Daly |
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Thanks to some creative estate-planning tools, parents can leave a business valued at $1 million or more to their children while avoiding the impact of gift and estate taxes. According to tax experts at the law firm of Miller Canfield, the tactics involve combining the characteristics of two types of trusts: irrevocable and grantor.

Due to the laws and intricacies of the federal tax code pertaining to gift and estate taxes, combining the two "isn't quite so simple. But it's all there and it's certainly valid — there is nothing 'scheme' about it. It's acceptable practice," said attorney David Thoms of the Personal Services Group at Miller Canfield.

The point of the strategies involving the combined aspects of irrevocable and grantor trusts is to give value away while minimizing use of unified credit and staying within the rules, according to Thoms.

Everyone is entitled to a unified credit that reduces or eliminates taxes under the gift and estate taxes code. Currently, an individual can give away up to one million dollars of value during his or her lifetime before being subject to gift tax. That does not count payments made on behalf of someone else for direct medical care and for college tuition, or gifts of up to $13,000 in 2009 to any individual.

The estate tax is another matter and is in flux right now, with the Obama Administration proposing to increase it. However, the estate tax exemption amount is currently set at $3.5 million ($7 million for a couple), which includes the value of gifts made during the individual(s) lifetime.

According to Dawn M. Schluter of Miller Canfield, an irrevocable trust is designed to escape future taxation on an estate. A grantor trust is protected from income tax, with all items of the trust income, deduction and credits reported on the individual's (the "grantor") tax return. Transactions between the grantor and grantee are not reportable as taxable events.

Put the two together in an irrevocable grantor trust and the result is what Schluter describes as a kind of "tax nirvana" where both income and estate taxes are minimized.

In a recent Miller Canfield newsletter, Schluter gave an example of an individual who owns a business and wants to transfer it to her son, who is running the company. At the same time, she wants to retain cash flow from the business to fund her retirement. But she would incur a large capital gain tax liability by selling the business directly to her son.

The value of the business is too high for her to be able to gift it to her son without paying gift tax, and she wants to be fair to all of her children, anyway. The solution is to sell the business to an irrevocable grantor trust in exchange for a promissory note that will be paid to her in installments over a given time frame. No taxable gain results from the sale, nor is there a tax impact on interest payments on the promissory note.

Being a grantor trust, it involves income tax on the payments to the owner — but there are special rules that allow the value of the transaction to be determined by tables in the tax code. Because the beneficiary of the trust will not own the company for years to come, its value over time is calculated as less than it would be if the owner sold the company outright.

Eventually, the note is paid off as the owner receives retirement income, and her son will control the business, even if the trust retains the business stock while the owner is alive. Once the owner is dead, of course, the trust turns the assets over to the named beneficiary.

A GRAT, or Grantor Retained Annuity Trust, is another solution involving the establishment of a trust. It can occur with a family business but is more frequently involved with situations where an individual owns a concentration of stock that would be part of the estate upon the death of that individual.

Schluter used the example of an individual who expects the value of his or her stock to appreciate rapidly. The individual wants to transfer that short-term appreciation to his children, so he transfers the stock to a GRAT that will last three years. The GRAT pays the owner a set annuity during the specified time frame. The owner pays no gift tax but at the end of the time frame, the trust appreciation is distributed to the children.

Thoms said the IRS has a defined interest rate for GRATs, for valuation purposes, and "right now, it's very advantageously low."

A third scenario involves an individual who wants to fund a charitable bequest over a period of years. The individual owns an income-generating business — an S corporation — which he hopes to leave to his grandchildren someday.

The solution is a Charitable Lead Trust, into which the individual puts non-voting shares of his company stock. The trust then supports the charity over a term of years, using cash flow from the business. The individual has managed to retain control of his company during the trust term, but at the end of that time, the trust assets are transferred to the grandchildren.

The individual may be entitled to an income tax charitable deduction for the full value of the gift to the charity during the term of the trust. Thoms said in some cases there may be a gift tax consequence if payments to the charity don't "zero out" the assets of the trust by the end of the set life of the trust.

The result of the Charitable Lead Trust has been to reduce the individual's income tax while alive, while at the same time transferring ownership of the business to the grandchildren at less value over time than if the business had been sold outright.

"They are getting it years later but we are using the present value now," to benefit a charity, noted Thoms.

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