When prospecting in the high net worth market, planners often come across situations where a large part of the prospect's estate is held in his or her business. A planner's first instinct may be to ask about the prospect's business succession plan, only to find that the business is owned 100% by the family.
In these situations, typical buy-sell arrangements, such as a cross-purchase or entity purchase, will probably be inappropriate, especially when the intention of the estate/business owner is to pass the business to children.
In cases where not all the children are involved in the family business, estate equalization will usually be another major planning objective of estate owners. The challenge here is to incorporate the succession plan into the estate plan.
Estate owners with this profile may have already begun using their annual exclusion gifts ($12,000 per person in 2008) to pass ownership interests to their children. But when a business is valued in the millions of dollars, the owners can not live long enough to pass the entire value of the business to their children.
Where owners want to maintain control of the business, they may wait until death to pass the firm to the next generation. This tactic can cause problems for the children, as there may be insufficient liquid assets in the estate to cover the estate tax and other settlement costs.
One technique found to be successful in generating sales to clients with this profile is an asset sale to an intentionally defective grantor trust: a vehicle that is "defective" for federal income tax purposes (the grantor continues to be taxed on trust income for federal income tax purposes). But assets transferred by the grantor to the trust also avoid estate and gift tax.
Using this technique, planners can show the estate owner how their business interest can be sold to an intentionally defective grantor trust and how children, being the trust beneficiaries, will receive the business interests at the death of the estate owner without the business being subject to estate taxes.
Let's look at a typical estate owner who holds 100% of the Family S Corp.
Sale to a Defective Grantor Trust
Estate Freeze Benefit
This technique allows the estate owner/grantor to enter into a sale agreement to the trust–in this case, an irrevocable life insurance trust or ILIT that is also an intentionally defective grantor trust–in exchange for a promissory note. The trust will act as a "stockholder" of the company and be responsible for the repayment of the loan to the grantor.
S Corp. distributions will be allocated to the ILIT as if it were an individual stockholder. The trust realizes the growth of the business and excess retained capital. Therefore, this technique will freeze the growth of the asset in the grantor's estate (the note receivable) at the loan interest rate.
Estate Equalization
The trust has an income-generating asset: the stock in the S Corp. Income can be used to pay loan interest back to the grantor and to pay life insurance premiums. The same trust that owns the S Corp stock can apply for and own a policy on the live(s) of the estate owners, with the trust being the beneficiary. The children would be the trust beneficiaries and, at the death of the estate owner/grantor, the S Corp. stock would pass to the named children.
The life insurance proceeds will be used to repay the estate for the loan and any excess death benefit retained can be used to acquire additional estate assets. The estate would now be liquid for the payment of estate taxes and the trust would have additional estate assets that would be distributed to other non-involved children to equalize the inheritance.
Immediate Estate Reduction
Discounted Assets
The business interests sold usually represent a minority or non-voting interest. As a result, the actual proportion of the interest sold can qualify for a discount due to lack of marketability/control. While the amount of the discount can vary and represents only the "opinion" of the parties involved, we restrict for illustrative purposes the amount of the discount to a maximum of 1/3 (33.33%). This is still a significant amount and has a meaningful impact to the grantor's estate.
For example, if a $10 million asset can qualify for a 30% discount, the grantor would take a note back for $7 million. This provides an immediate estate reduction of $3 million and an estate tax savings of about $1.5 million.
Case Study
Let's consider this scenario:
? Mr. Smith is age 72 and in standard health.
? Mrs. Smith is age 71 and in preferred health.
? Their total net worth is about $18 million.
