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Estate Planning for the Business Owner

Business owners have several options to consider when planning to transfer their assets. Because estate taxes can be prohibitive, you need to investigate approaches that will maximize the level of value you retain while still providing you with some degree of control over, or continuing cash flow from, the asset being transferred.

By now you're probably well aware of the estate tax repeal under EGTRRA. And your first thought might have been, "Hooray! I don't have to worry about estate planning anymore." But if you read the details, you'll realize the repeal phases in slowly over the next several years. And because of "sunset" provision, in 2011 the estate tax will return unless Congress passes further legislation. (See Chart 7)

In addition, current law includes other provisions that increase the complexity of estate planning, such as gradual repeal of the generation-skipping transfer (GST) tax; reduction in the top gift tax rate but no repeal of the gift tax; increases in gift, GST and estate tax exemptions; and repeal of
the step-up in basis at death.

Finally, you can exclude most gifts of up to $11,000 per recipient each year ($22,000 per recipient if your spouse elects to split the gift with you).

As a result, estate planning is more important than ever — without proper planning, your family could still lose to estate taxes a large share of what you've spent a lifetime building.

Chart 6
Leveraging your gifts with a family limited partnership
Gift of cash Gift of interest in an FLP Difference
One annual gift tax exclusion
Hypothetical minority / marketability discount (e.g., 30%)
Undiscounted value of assets transferred
Appreciation in value at 8% annually for 25 years
Value of gift after 25 years
Eventual estate tax savings at 45%
Source: U.S. Internal Revenue Code


Chart 7
Transfer tax rates, exemptions and credits under EGTRRA
Top Tax Rates Cumulative Tax-free Transfers
Year Gift Estate and GST Gift Estate GST
* If the repeal is not extended.
** Excluding 4% surtax.
Note: Federal gift and estate taxes are unified so that a single progressive tax rate schedule, starting with 37% in 2001 and 41% in 2002, applies to your cumulative lifetime taxable gifts and transfers at death. (The minimum tax rate will increase as the exemption amount increases.) Lifetime taxable gifts are included even if you did not pay a gift tax because of your lifetime exemption. 
Source: U.S. Internal Revenue Code

Family Limited Partnerships

Are you looking for a way to save estate taxes and leverage your use of gift tax exemptions while protecting and maintaining control over the assets you are giving away? If so, a family limited partnership (FLP) may be the perfect estate planning strategy for you.

For decades, taxpayers had fought with the IRS in the courts over the concept of minority and marketability discounts in a family setting. Taxpayers were often successful in these disputes, but generally not without a fight, and a great deal of uncertainty remained about such discounts.

Then, in 1993, the IRS finally conceded the battle and agreed that discounts should apply in family situations. Ever since, the FLP has enjoyed great popularity. The IRS continues to fight FLPs every step of the way, particularly if they're not structured or operated properly. And it’s highly likely that these discounts will eventually be curtailed or even eliminated.

Planning tip 5
Are you ready for a family limited partnership?

Despite all the advantages of a family limited partnership (FLP), the approach is not for everyone. Are you ready to create an FLP? Answering the following questions can help you decide.

Are you concerned about estate taxes and looking for a way to maximize lifetime giving?

Are you willing to reduce the actual value of your estate? (Keep in mind that income and borrowing power may be reduced as well.)

Are you willing to have distributions made pro rata to all the partners, if they are made at all? (Distributions need not be made at all; alternatively, the partnership could distribute only enough for the partners to pay their income taxes. The general partner can also take a reasonable annual management fee from the partnership.)

Are you willing to incur some additional costs for legal fees, appraisal fees and annual partnership tax returns?

The key to enjoying discounts is to use a vehicle, such as an FLP, that does not give the recipients control over the investment they end up owning. Of course, the discount's amount must be determined, ideally by a formal valuation, and will vary depending on the partnership agreement and the nature of the assets transferred to it. Discounts generally range from 20% to 40%.

In the typical FLP, the parents or grandparents making the gift become the general partners, while children and/or grandchildren become limited partners. The latter have neither control over the partnership's management or assets nor any personal liability beyond their interest in the partnership itself. Either all at once (using the gift tax lifetime exemption and perhaps even paying gift tax beyond that point), or over a period of years (using the gift tax annual exclusions), the parents may gift as much as 99% of the partnership to younger generations.

Various assets can be transferred to an FLP, including marketable securities, real estate or interests in closely held businesses. The partnership may become an owner in other partnerships, LLCs or C corporations (but still not S corporations).

The additional leverage that results from a gift's discount is demonstrated in Chart 6 on page 20. This scenario is based on the use of one annual gift tax exclusion of $11,000. Of course, these tax savings can be multiplied if you make many $11,000 gifts each year for a number of years.

FLPs at least partially protect assets from outsiders. A limited partner's creditor or a divorcing spouse may be able to become a limited partner, but he or she may not be thrilled with an investment that an adverse party controls, that may not generate any cash flow, that can't be sold or borrowed against, and that may create substantial income tax responsibilities.

Grantor Retained Annuity Trusts

It is safe to say that many of those who have not done so already would be happy to give away substantial assets to their children if not for three critical concerns:

  • They do not yet feel comfortable parting with the income stream an asset generates.
  • They are not sure whether their children can handle full control of, or full income from, an asset.
  • They do not want to pay a large gift tax or perhaps even use up a big chunk of their lifetime exemption.

Interestingly, a grantor retained annuity trust (GRAT) can go a long way toward addressing all these issues. With a GRAT, you can make a substantial gift today while retaining an income stream for some period of time. You may also be able to keep control within a trust that may not pay out income to beneficiaries for even longer. And yet, a gift today that is relatively small for tax purposes can turn into a substantial transfer.

Planning tip 6
Defective grantor trusts can be effective

One popular planning strategy is the use of a "defective" trust. A defective trust purposefully contains one or more provisions that results in its being treated as a grantor trust for income tax purposes. This means that all the trust's income is taxed to the grantor on his or her individual return. It also means, for example, that you can sell an asset to the trust at a substantial gain but incur no income tax on the gain because, for tax purposes, the transaction is treated as a sale to yourself.

Meanwhile, this same trust, if properly drafted, will qualify as a separate entity for estate tax purposes. Therefore, the transfer to the trust will remove the asset from your estate. Although this may sound like an unintended quirk in the law — and perhaps it is — it has been recognized by the courts and has become an accepted estate planning technique.

What this means is that selling to a defective trust can accomplish similar results as gifting to a grantor retained annuity trust (GRAT). Payments are made back to the seller (grantor), typically over a period of years as an installment sale with interest.

A GRAT pays a predetermined amount, which may vary in size or duration, back to the grantor. It may be a fixed percentage of the original value or a percentage based on the trust's annually recalculated value. The annuity's term must be fixed at no less than two years.

The amount of the taxable gift is determined upon the initial transfer based on a government derived interest rate factor. But the transferred asset must first be valued and, just as with an FLP, a minority or marketability discount may affect the asset's value.

The real impact, of course, is that you're making a gift with a built in delay mechanism because of the annuity coming back to you. In the meantime, if the asset increases in value more than the government tables assume it will, you can get substantial gifting leverage.

For example, let's say you have a closely held business that you believe will grow 20% annually for the next five years. The business is worth $2 million and you want to transfer 25% of it to a GRAT, taking an annuity for five years that is large enough to make the gift's value close to zero.

First, you would need to value the asset being placed in the GRAT. For instance, though 25% of a $2 million business equals $500,000, a discount may be taken because the GRAT is receiving a minority interest. If this discount is 40%, the value of the asset itself would be $300,000.

The amount of the annuity necessary to reduce the gift to near zero will depend on government interest rates, which are adjusted monthly. Let's say, in round numbers, that the annuity to be paid back to you might be $75,000 annually (totaling $375,000, or 125% of the discounted value, over the five year period).

Indeed, the business might earn enough in net income each year (in this example, exactly 15% of its nondiscounted value) so that the trust could pay the annuity every year out of its cash flow from the business.

Thus, the results might be as follows:

  • 25% of a $2 million company is eventually transferred without any gift tax or use of the lifetime exemption.
  • 25% of future appreciation in the business also will escape gift tax because the gift is being made now.
  • The actual financial impact of the gift is delayed for five years because the trust has little or no cash flow during the annuity period, beyond what it needs to pay the annuity.
  • What could go wrong?

Not much, other than the fact that the GRAT may not work:

  • The IRS can adjust any gift's value, but with a properly drafted GRAT this won't necessarily cause a taxable gift. The trust can provide that such an IRS adjustment is "corrected" by giving back a portion of the transfer originally made to the trust.
  • You always have the risk that, when a taxable gift is made, you will have wasted the exemption or annual exclusions if the asset's value declines. But in a GRAT similar to the above example, that risk is small because the taxable gift is minimal.
  • You (or you and your spouse) could die before the annuity term's end. The transfer to the trust will not be effective for estate tax purposes unless you outlive the annuity term. This is an issue that certainly can be addressed with life insurance.
Chart 8
Amount of insurance needed at 48% to provide children with $1 million after estate taxes
In irrevocable life insurance trust Owned by insured
2005 2006
Insurance proceeds
Estate tax (47% in 2005, 46% in 2006)
After-tax proceeds

Irrevocable Life Insurance Trusts

Buying life insurance via an ILIT will typically allow for a tax-free death benefit. Life insurance in an ILIT will normally remain outside the insured’s estate. However, the purchase and/or transfer of the policy should be handled with care to avoid incidents of ownership. You will need a lot more insurance — almost twice as much, in fact — to provide the same benefit to your family if the proceeds must first be used to pay an estate tax of as much as 47% in 2005, or 46% in 2006 — see Chart 8

If you own life insurance policies when you die, the proceeds are includable in your taxable estate. Ownership is determined not only by whose name is on the policy, but also by who controls certain rights, such as the right to change the beneficiary. The solution? Be sure you are not considered the owner of insurance on your life.

Instead, create an ILIT. The trust owns the policies and pays the premiums. You can make a gift to the trust every year so that it has the funds to pay premiums. And, if properly structured, these gifts can qualify for the $11,000 gift tax annual exclusion. When you die, the proceeds pass into the trust and are not included in your estate, nor will they be included in your spouse's estate (although the trust can be — and generally is — structured to provide benefits to a surviving spouse as well as other beneficiaries).

Is there any reason not to use a trust to hold insurance on your life? Generally no, but certain situations may preclude this approach. Insurance that provides funding for a buy-sell agreement will be held by another individual or entity. Policies can be owned by the insured's adult children rather than a trust. And if your estate, including insurance, is small enough that you don't need to be concerned about estate taxes, you can be spared the complication. Finally, if you believe you will need to access the policy's cash value, ownership in a trust can complicate the situation. In general, ILITs have quite understandably become an integral part of many people's overall estate plan.

Planning tip 7
Getting an existing insurance policy into the trust

What if you want to move an existing insurance policy to an irrevocable life insurance trust (ILIT)? This may not be easy if the policy isn't a term policy. If it has been around for a while, the policy's cash surrender value may be high enough that the transfer would create a large gift, using up not only your annual gift tax exclusions but a portion of your lifetime exemption as well. You must also survive the gift of the insurance policy to the trust for three years to keep the proceeds out of your estate.

If the trust buys the policy, you may run afoul of the transfer-for-value rule and subject the eventual proceeds to income tax. One exception to this rule allows a transfer to a partner of the insured. Interestingly, that partner can own a very small interest (there is no minimum percentage) and there need not be a connection between the insurance and the partnership. As a result, one strategy is to make the insurance trust a partner to an FLP, thereby qualifying for this exception.

Charitable Remainder Trusts

A properly structured charitable remainder trust (CRT) provides you with several benefits:

  • You can avoid paying capital gains tax on the sale of an appreciated asset. When the trust sells an asset, it pays no tax on the gain.
  • You get a partial charitable income tax deduction when you fund the CRT. The amount of that deduction is based on interest-rate-sensitive government tables. The present value of the interest eventually going to charity must be at least 10% of the total.
  • The CRT pays you income during its term (which can be for the remainder of your life). You will pay income tax as you receive funds from the trust. Your investment yield may actually go up because the CRT can sell a highly appreciated — but low yielding — asset without paying tax and replace it with another, more suitable investment.

Planning tip 8
Charitable trusts and S corporations: A good match?*

Charitable trusts and foundations can now be shareholders in S corporations. Thus, you can now get an income tax deduction for contributing S corporation stock.

Doing this, however, can be quite complicated and may not work favorably. Someone, either the trust or a beneficiary, will have to pay tax on the trust's share of S corporation income and gains. As long as the trust gets enough cash flow to pay its share of the tax, though, the charitable organization should still be very happy to receive the gift.

Although not immediately, a CRT also provides a substantial benefit to the charity, because it will someday end up with the remaining balance in the trust. Yet you may still retain almost as much (possibly even more) for yourself and your heirs as if you had kept the asset, because of increased cash flow during the trust's term and an immediate tax deduction.

The risks? Your death at an early age (if income was being paid for your lifetime) could trigger an earlier transfer to the charity and many years' less income for your family. Or, you may enjoy a long life, but suffer a financial downturn. The solution may be to use some of the income stream from the CRT to buy life insurance. It will provide you or your heirs with an additional source of funds.

This is an example of how life insurance can round out a great strategy. Adding the life insurance policy can help you turn your CRT into a "win win" situation.

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