Compelling reasons for pre-transition planning


Family-business owners often spend a lifetime building their business, and it is typically their single largest financial asset. As the owner contemplates retirement, a common desire is a seamless and successful transfer to the next generation of owners.

While there are many techniques and strategies to assist with this transfer, they can be complicated and time-consuming. So whether an owner plans on selling to an outside party or keeping it in the family, careful planning is critical.

One of the first decisions is determining how the business will be transitioned to the next generation. Should the business be sold outright? Should it be gifted? How should the gift be structured?

While an outright sale will provide the owner with an asset base that can be used to provide a source of retirement income, it presents many challenges. Does the buyer have adequate financial resources? If not, is the owner comfortable with financing the transaction? Is outside financing even available? 

Many family-business owners ultimately decide to employ a combination of sale and gifting strategies when transitioning to the next generation of owners.

The American Taxpayer Relief Act, enacted at the start of 2013, provided for significant changes to the federal tax code, including the largest exemptions in gift and estate tax in history — $5.25 million per individual and $10.5 million per married couple. Business owners may want to consider using these exemptions to gift all or a portion of their business interests to heirs.

Gifting business interests when an owner is still alive can have a dramatic effect on a family’s wealth, as a business is generally an appreciating asset that can grow substantially over an owner’s lifetime. It also allows for the heirs to own a portion of the business and work under the continuing guidance of the more experienced family member, which can eventually lead to a more successful transition.

One compelling structure for pre-transition planning involves transferring assets into a trust. There are a number of trust structures that can achieve different objectives. One such planning technique that may be used by the business owner is a grantor-retained annuity trust. A GRAT is a tax-efficient way to transfer future appreciation of an asset while retaining interest in that asset and ultimately transfering wealth to one’s heirs.

Once the family business interest has been transferred to the trust, any appreciation of the business that remains inside the trust at its termination will pass to the heirs. Plus, asset discounts may apply to gifts of minority interests, which can significantly lower the value of the gift for tax purposes. This can increase the gift’s benefit as the asset appreciates from a discounted level.  

Using a GRAT, a business owner transfers assets “frozen” at today’s fair value, using any applicable valuation discounts, into a trust with a set term. During the term, the business owner pays tax on income and realized gains earned by the trust. However, the trust grantor benefits by receiving an annuity on which no tax is owed.

To comply with the Internal Revenue Service requirements, an interest rate, officially known as the Section 7520 rate but more commonly referred to as the “hurdle” rate, is used to determine the value of the gift. These hurdle rates are near an all-time low, currently 1.4 percent for March 2013. In addition to the annuity payment, all future asset appreciation in the trust occurs outside of the grantor’s estate, meaning it could transfer to heirs free of gift and estate tax while preserving the $5.25 million exclusion.

In a simple example, a business owner could transfer a $5 million asset at today’s valuations into a GRAT with a five-year term. Assuming a 10 percent annual return on that asset, the grantor would take an annuity totaling more than $5.2 million over the trust term. When the term ends, the remaining trust assets pass to the heirs free of gift tax. 

In the absence of planning, that same $5 million — plus all the future appreciation — could be subject to a 40 percent federal estate tax. The difference could be in the millions of dollars.

Executing this type of qualifying transfer that takes full advantage of asset discounts normally requires significant time to plan and involves several experienced professionals, including a qualified appraiser to determine the value of the business and appropriate discounts, an attorney to provide guidance and draft trust documents, and a tax advisor to ensure the proper tax filings are prepared.

Even if your time horizon for a transaction is in the distant future, there are reasons to plan ahead. With current depressed asset prices and high tax exemption levels, planning can make an enormous difference to a business owner’s personal financial well-being and that of his heirs.

Larry Jones is a wealth advisor with J.P. Morgan Private Bank.  Reach him at 248-645-7373.

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