Some taxplanning strategies for family businesses

March 5, 2011
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While President Barack Obama and Congress provided some much-needed clarity to estate planning and gifting at the close of 2010, their “fix” stands for only two years — and that has created perhaps even more questions for family businesses.

As we all know by now, the new law — the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 — sets out a maximum estate tax rate of 35 percent for 2011 and 2012. It also established a unified estate and gift exclusion amount of $5 million, or $10 million for married couples. For the first time in nearly a decade, this means that taxpayers can transfer gift tax-free during their lifetime, the same amount they can transfer estate tax-free upon death.

Beginning in 2013, the estate tax exemption is set to go back to $1 million per taxpayer with a 55 percent maximum estate tax rate. While it’s too soon to predict what is likely to happen two years from now, the current climate affords a variety of planning opportunities for businesses interested in succession planning, or simply transferring some wealth and reducing their tax exposure now.

Given the continued low-interest environment, family businesses should carefully review their estate plans now. They may want to take advantage of three planning vehicles that seem perfect for right where we are in 2011.

Grantor Retained Annuity Trusts

Grantor Retained Annuity Trusts, or GRATS, have been a favorite planning vehicle of family businesses for many years. These irrevocable trusts have a number of benefits, including providing:

  • A revenue stream back to the grantor for a designated period of time, creating fixed annuity payments.

  • An excellent way to pass marketable securities and other easily valued assets.

  • Tax benefits that can result in a “zeroed out” gift for the grantor.

GRATS work this way: A grantor establishes a trust using cash, securities or a business interest. The trust returns to the grantor a fixed annuity over a certain period of time. At the end of that period, what remains in the GRAT is passed on to the beneficiary.

We have seen a virtual “gold rush” of GRATs in the last 18 months, which is quite understandable. Continued uncertainty in the economy makes them highly desirable as vehicles to transfer the appreciation of assets, but not the assets themselves. If the assets depreciate, though, the GRAT dissolves automatically, leaving the grantor out the set-up fees.

Intentionally Defective Irrevocable Trusts

Intentionally Defective Irrevocable Trusts sound like something that should be avoided at all costs. But IDITs, as they are known, are actually sophisticated installment sales that can benefit family businesses by reducing estate, gift and generation-skipping transfer taxes. The “defective” part comes into play in relation to income taxes.

IDITs work this way: A grantor sells appreciating assets to the trust, removing them from an estate while retaining responsibility for income taxes. This is often done at a discounted value. The IDIT, which is created to intentionally violate one or more of the grantor trust rules, then makes regular payments back to the grantor. Instead of company distributions building up the value of the grantor’s estate, they accumulate in the trust. When the note is paid off, the remaining assets in the IDIT transfer to the beneficiaries’ estate — all tax-free.

Before selling the assets, the general rule of them is to ensure the trust has enough equity to enter into a sale transaction — or typically about 10 percent of the value of the full transaction. IDITs remain a popular transfer technique, especially for those who are ready to transfer a full or partial interest in a closely held business to family members.

Intra-family loans

Perhaps the easiest — and the most overlooked — vehicle is the intra-family loan. These loans permit family members to transfer funds between one another without the time, expense or complexity of establishing a trust.

Intra-family loans work this way: One family member makes a loan to another family member, charging the applicable federal rate of interest. This rate, which is published monthly by the federal government, is required by the IRS to reflect a “real” transaction, not a gift — thereby avoiding the need to pay gift taxes.

The recipient, in turn, can put the funds into an investment instrument that may have a higher return rate. A payment schedule is established and, when the loan is repaid, the recipient keeps the margin, less the costs of managing the investment.

Relatively simple in their approach, intra-family loans are an excellent method to transfer assets, particularly when the markets remain unsettled.

Review your plan now

Despite the fledgling recovery both nationally and closer to home in West Michigan, we still struggle with “low”: low valuations for property, low valuations for closely held businesses and low interest rates. Family businesses that are considering succession planning may find this an optimal time to take assets out of their estate while the $5 million exemption (or $10 million for married couples) is available.

In light of the December 2010 change in the law, now is an excellent time to review an estate plan. GRATs, IDITs and intra-family loans are three great planning techniques that family businesses can utilize now to transfer wealth and avoid tax exposure.

Mandy Chardoul, MST, CFP, is a senior consultant at Plante Moran Financial Advisors, one of the nation’s largest independent registered investment advisory firms. Her practice focuses on advanced estate and tax planning.

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