A final piece of Phase I is incapacity planning. If the owner becomes incapacitated and no planning has been done, the family may be forced to ask a court to appoint a guardian or conservator to manage the owner's financial and personal affairs. This result can be avoided in almost all cases through the simple expedient of a properly designed power of attorney and health care proxy naming the appropriate individual to make financial and health care decisions in the event of the owner's incapacity. As a power of attorney can sometimes be an unwieldy document to make decisions regarding a complex business enterprise, we often suggest that the business owner also execute a revocable living trust agreement. The owner's interest in the business can be transferred to the revocable trust during the owner's lifetime and, while the owner has capacity, she can be the trustee. Upon the owner's incapacity, a new trustee would step in to make decisions regarding the business interests held in the trust. This approach can be preferable to a power of attorney because the trust agreement can include detailed instructions for the trustee as to how to make decisions relating to the business. The trust agreement can also provide greater flexibility for appointing additional or successor trustees; this can be more difficult to do with a power of attorney.
Liability Protection Planning
The business activities may give rise to liability risks. A well-constructed estate plan will address these risks and consider methods for insulating the owner's assets from those risks. While it's tempting for clients - and sometimes for their advisors - to think that liability protection mainly involves complex trust or corporate structures to shelter assets, we usually advise clients to first visit with their property and casualty insurance advisor to ensure that their liability insurance is adequate. A properly structured property and casualty insurance program not only can protect the business and the business owner from catastrophic losses, but also often will provide a benefit that's less discussed but perhaps equally important - the payment of legal defense costs in the event of a lawsuit against the business owner or the company. We typically advise a thorough review of the insurance programs for both the business and the business owner, including implementing a healthy amount of umbrella coverage over and above the owner's primary insurance coverage.
For further liability protection, the business owner might consider "insulation" strategies. One insulation strategy involves segregating each of the business's risky activities inside its own liability-shielding structure such as a corporation, limited liability company (LLC) or limited partnership. For example, suppose that the owner's primary business is manufacturing and that the business is operated in a building owned by the business owner individually. Each activity - the manufacturing business and the operation of the real estate in which the business is housed - should be insulated inside its own corporation or other entity. That way, in the event of a lawsuit involving the manufacturing activities, arguably only the assets of the manufacturing business itself, and not the real estate owned in the separate entity or the business owner's other assets, are exposed to the lawsuit. Although a full discussion of choice of entity is beyond the scope of this article, it often will be beneficial for the chosen entity to be a partnership or LLC, rather than a corporation, because the partnership or LLC receives pass-through status for income tax purposes FN9.
Advanced Lifetime Planning
For many advisors, wealth transfer planning is the starting point for planning for the business owner. For us, however, discussions about transferring assets to save estate taxes or to bring the junior generation into the business generally don't begin until after Phase I of the plan has been implemented. We find that this approach produces two benefits. First, it helps ensure that the business owner gets some plan in place instead of engaging in endless and sometimes confusing discussions about lifetime wealth transfer planning, all the while possibly having done nothing to ensure the orderly passage and operation of the business in the event of the owner's death or incapacity. Second, time after time, we find that the very process of going through Phase I planning can help the business owner develop a comfort level with estate planning in general that can make it easier to come to terms with the hard decisions that often need to be made about asset transfers, management succession, loss of control, or loss of access to cash flow, in implementing Phase II of the plan.
As complex as lifetime wealth transfer can be, from the standpoint of taxes alone, it's actually quite simple. If an individual attempts to transfer assets during life to avoid an estate tax, the transfer will generally instead be subject to a federal gift tax. Since the gift tax and the estate tax apply at the same rates and generally have the same exemptions, there should be no incentive for an individual to transfer wealth during life as opposed to waiting to transfer it at death. In effect, by enacting the gift tax as a companion to the estate tax, Congress created an "airtight" transfer-tax system. There are, however, leaks in that system. The three primary examples of those leaks are removing value from the system, freezing value within the system, and discounting values within the system.
Removing value from the system is hard to do. In most cases, if an individual makes a gift during lifetime, that gift is brought back into the taxable estate at death for purposes of calculating the estate tax on the individual's estate. However, there are two exceptions to this general rule, which are the annual gift tax exclusion and the "med/ed" exclusion. If an individual makes a gift using his $13,000 annual gift tax exclusion, the gifted property is entirely removed from the taxable estate. Individuals are also permitted to make gifts of unlimited amounts for tuition and certain medical expenses, as long as the payment is made directly to the provider of services. Such med/ed gifts are entirely excluded from the taxable estate.
Freezing value within the system usually connotes the individual making a gift using some or all of his lifetime exemption from federal gift tax. For example, a business owner might make a gift of $5 million worth of stock in the business to a child. Upon the owner's death, the $5 million gift is brought back into the estate for purposes of calculating the owner's estate tax. However, it's only brought back into the estate at its value at the time the gift was made and should be sheltered from tax at that time via the use of the owner's $5 million estate tax exemption FN10. Accordingly, if the value of the gifted property increases between the date of the gift and the date of the owner's death, the appreciation avoids transfer tax. That is to say, the owner succeeds in "freezing" the value of the gifted property at its date-of-gift value.
A holy grail of estate planners has been to find a way of freezing the value of an asset at some number lower than what it is actually "worth" to the owner's family, also known as discounting values. Suppose a business owner owns all of the stock in business with an enterprise value of $5 million. If the business owner gives all of the stock to her child, she will have made a taxable gift of $5 million. On the other hand, suppose that the business owner gives half the stock to one child and half to the other child. An appraiser is likely to opine that the interests received by the children are subject to lack of control discounts, since either child could deadlock the other in a vote involving the stock. If the appraiser applies, say, a 20 percent lack of control discount, the value of the gift would be reduced to $4 million. Accordingly, the business owner succeeds in freezing values at something less than the full value of the business in the eyes of the family as a whole FN11.
One of our favorite examples of a technique that can remove, freeze, and discount values all in one fell swoop is the spousal estate reduction trust (SERT). In a typical SERT, the owner creates an irrevocable trust, naming her husband or some other trusted individual or institution as trustee. During the life of the owner and her spouse, the trustee is authorized to sprinkle income and principal among a class consisting of the owner's husband and descendants. Upon the death of the husband, the remaining trust assets are divided into shares for descendants and held in further trust. The owner's gifts to the SERT can qualify for the gift tax annual exclusion because the trust would include Crummey withdrawal powers for each of the owner's descendants. This removes value from the owner's estate. If desired, the owner could use the trust as a repository for a larger gift using her lifetime gift tax exemption, thereby freezing values for transfer-tax purposes. Moreover, the asset to be gifted to the trust can be interests in the closely held business, which a qualified appraiser may value by applying discounts for lack of control and lack of marketability, thereby achieving a discounting of asset values for transfer tax purposes.
Beyond being a good vehicle through which to achieve the wealth transfer trifecta of removing, freezing, and discounting values, the SERT provides a number of other benefits. The trust includes the grantor's spouse as a beneficiary. 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 SERT, nor can there be any prearrangement or understanding between the grantor and her spouse that the grantor might use 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 even after the gift. As an additional benefit, the SERT would be established as a grantor trust for income tax purposes. As a result, the business owner would pay income tax on the income and gains earned by the trust. This depletes the owner's estate and enhances the value of the trust, but isn't treated as a taxable gift, in effect providing a very powerful additional means of removing value from the transfer tax system. Finally, the business owner could allocate her GST tax exemption to the SERT, thereby removing the gifted assets from the transfer tax system for multiple generations.
Additional popular wealth transfer strategies for business interests include the grantor retained annuity trust (GRAT) and the sale to an intentionally defective irrevocable trust (IDIT). 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 of years, ownership of the property passes to the business owner's children or to trusts for their benefit. The value of 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 sufficient 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 upon 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.
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. Some time 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, 9 years. At the end of the 9th 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. 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 generation skipping 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 generation skipping planning FN12.
As important as it may be for the business owner to understand the risks and benefits of a GRAT versus an IDIT sale, in our practice 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 backloading of payments is permitted. Accordingly, the GRAT tends to be the technique of choice where the business produces fairly predictable cash flow while the IDIT sale is chosen more often when cash flow is more erratic.