IntraFamily Business Transfer Techniques Session 8 De Paul

Intra-Family Business Transfer Techniques Session 8 De. Paul University CFP® Program

Business Transfer Issues Because of the illiquidity associated with the transfer of a closely held business, the owner’s estate plan must address the business transfer. n Business owners may face potentially conflicting objectives including the desire to: Gift future appreciation, but retain control n Minimize transfer taxation n Be “fair” to family members n Pass control to only one family member n De. Paul University All rights reserved. 2

Consider Client’s Income Needs In determining the optimal business transfer technique for a specific client, the planner must first understand the extent to which, if at all, the client will need income from the transferred property. De. Paul University All rights reserved. 3

Transfer Techniques Generating Income The following transfer techniques generally provide income to the transferor/seller: Installment sale n Self-cancelling installment note n Private annuity n Sale and leaseback n Grantor retained annuity/unitrust n Buy/Sell agreement n De. Paul University All rights reserved. 4

Question 8 -1 Andrew wants to transfer any future appreciation in his closely held corporation but will need income in the future. Which of the transfer arrangements below is most likely to meet Andrew’s needs? A. A gift-leaseback B. A family limited partnership C. A sale-leaseback D. A qualified personal trust De. Paul University All rights reserved. 5

Installment Sales Installment sales enable the seller to spread gain over a term of years and enable the buyer to spread payments over the same period. n. The value of the business and future appreciation are removed from seller’s estate. n. However, the FMV of the Note (present value of installments unpaid at seller’s death) is included in seller’s gross estate. If seller’s will directs forgiveness of the debt, seller’s estate reports remaining capital gain n Debt is considered “paid” to estate n De. Paul University All rights reserved. 6

Question 8 -2 Marilyn sells her business under an installment note for $100, 000 down and $100, 000 per year for the next 9 years. If Marilyn dies of a heart attack right after receiving the third payment, which of the following would be true? Her gross estate need not include any amount attributable to the installment sale. B. Her gross estate must include $700, 000 attributable to the installment sale. C. Her gross estate must include $300, 000 attributable to the installment sale. D. Her gross estate must include the present value of the unreceived installments A. De. Paul University All rights reserved. 7

Related Party Installment Sales: The Two Year Rule If a seller transfers property in an installment sale to a “related party” and the transferee sells to an unrelated third party within two years of the original transaction, the original seller must recognize all gain in the year of the second disposition whether or not the payments to the original seller are accelerated. n Related parties include: n Spouses, siblings, parents, descendants n Partnership, corporation, estate or trust with which the seller has control or connection n Exception: prove to IRS, that neither disposition tax avoidance as a principal purpose De. Paul University All rights reserved. 8

Related Party Installment Sale Example Patrick Lawson sells his 100% ownership in Patrick’s Posies, a chain of florists, to his daughter Patti. The business is worth $2 MM and Patrick’s adjusted basis is $500 K. Ignoring interest, Patti is obligated to pay her father in 10 annual installments of $200 K each. One year from that sale, Patti sells the business to Fred Blake. n All of the unrecognized gain must be recognized by Patrick as of the date Patti sells the business. n Assuming she has made only one payment, Patrick recognizes $1, 350, 000 De. Paul University All rights reserved. 9

Related Party Installment Sales: Forgiven Payments If the seller of property to a related party forgives installment(s), the seller must recognize gain to the extent that the forgiven payment exceeds the seller’s basis in the property sold. De. Paul University All rights reserved. 10

Related Party Installment Sales: Forgiven Payments Example Monique sells her summer home to her son, Monte, for $400, 000. Monique’s basis in the home is $200, 000 Ignoring interest, Monte agreed to make 10 equal payments of $40, 000 (each). n n If Monique cancels Monte’s entire obligation, before receiving any installments, she has made a $400, 000 gift to Monte and must recognize all gain in the current tax year. If Monique forgives a particular year’s installment payment, she recognizes $20, 000 gain in the year of the forgiveness, and makes a deemed gift of $40, 000 for that tax year De. Paul University All rights reserved. 11

Self-Canceling Installment Note (SCIN) The self-cancelling installment note (SCIN) is an installment sale arrangement whereby payments not yet received at death are canceled. n Thus any unreceived payments are not included in the seller’s gross estate. n Note terms provide for cancelation at seller’s death. n However: buyer must pay a premium price (over FMV) and/or above market interest rate in exchange for the selfcancelling potential n Seller must include full payment(s) in income n Buyer may still claim depreciation deductions on the property. De. Paul University All rights reserved. 12

SCIN and Families The self-cancelling feature makes the SCIN more popular with intra-family transfers than with unrelated parties. Example: Dwight would have given his son, Durwood, the family business while he lived, except he needed income from the sale. Dwight has no need for income after his death. n Dwight would not likely contract with an unrelated party where total payment might be less than the FMV of his business. n The traditional installment arrangement is preferable with an unrelated party as Dwight’s estate would collect any post-death installments De. Paul University All rights reserved. 13

Tax Consequences of a SCIN n Property sold under a self-cancelling installment note is removed from the seller’s estate for federal estate tax purposes. n For federal income tax purposes, cancellation of payments upon the seller’s death requires the yet unrecognized gain to be reported by the seller’s estate on Form 1041 n Generally estate tax rates exceed long-term capital gains rates, making the SCIN attractive from a tax rate standpoint De. Paul University All rights reserved. 14

SCIN EXAMPLE Bob, age 65, sells the family business (FMV $1 MM, AB $100 K) to his son, Rex, . They agree to a 5% annual interest rate, a 10 -year, self-amortizing promissory note, and $100, 000 down payment. They must implement one of two annual payment arrangements: n Principal premium alternative: Purchase price must be increased from $1 MM to approximately $1, 528, 300 (for the cancellation feature) with annual interest and principal payments of approximately $114, 600 per year. n Interest premium alternative: Annual 5% interest rate must be increased to at least 12. 577% with annual interest and principal payments of approximately $124, 900 per year. n (This concept, rather than numbers tested on CFP® Exam) De. Paul University All rights reserved. 15

Question 8 -3 Which of the following is the least likely result of a SCIN? A. The seller recognizes higher capital gain. B. The seller receives more interest. C. The seller’s gross estate includes unsatisfied payments. D. Installment sale tax treatment is available while the seller is living. De. Paul University All rights reserved. 16

Private Annuities A private annuity provides the seller with a stream of fixed payments for life - typically from a sale of property to a family member. . n The FMV of the property is removed from the seller’s estate n A single life annuity (or joint with spouse) results in no estate tax n Seller incurs no gift tax as property is sold for annuity equal in value to FMV of property De. Paul University All rights reserved. 17

Private Annuities and Life Expectancy IRS may scrutinize annuities where annuitant/seller does not live 18 months beyond date of sale. n Seller’s knowledge of terminal illness on date of sale would result in collapsed transaction De. Paul University All rights reserved. 18

Question 8 -4 Tables show that, based on age, Gene’s life expectancy is 21 years. Which of the following situations would make the use of a private annuity to transfer Gene’s business the most effective? A. Gene lives 25 years B. Gene lives 10 years C. Gene dies 10 from advanced cancer nine months following the sale. D. Gene dies from advanced cancer one month following the sale. De. Paul University All rights reserved. 19

Old Regime Income Taxation of Private Annuity Payments to the Seller Old rules indicated that although payments under a private annuity come from the buyer (rather than from an insurance company) taxation of private annuity payments fell under annuity taxation rules separating each payment into three elements: n n n Basis n Returned tax free Gain n Typically taxed at long-term capital gains rates Interest n Taxed at ordinary income rates De. Paul University All rights reserved. 20

The Buyer under a Private Annuity n Although the unsecured payments to the seller are generally a function of the FMV of the business at sale, the seller’s life expectancy, and an eligible interest rate, the seller’s actual life span is never certain. Thus the buyer may pay: n n More than FMV of property acquired if the seller lives beyond presumed life expectancy, or Les than FMV of property acquired if the seller does not live to the life expectancy age assumed under the private annuity De. Paul University All rights reserved. 21

New Regime Income Taxation of Private Annuity Payments Proposed Treas. Reg. §§ 1. 72 -6(e) requires immediate recognition of all gain in the year of sale for a private annuity transaction n Although not yet final, presumptively the law n Applies to transactions occurring after October 18, 2006 n Estate tax savings may still indicate use but the technique is not as attractive as it once was De. Paul University All rights reserved. 22

Question 8 -5 New tax rules regarding private annuities make them less advantageous from: A. An income tax standpoint B. An estate tax standpoint C. Both an income tax and an estate tax standpoint D. Neither an income tax nor an estate tax standpoint De. Paul University All rights reserved. 23

Sale-Leaseback A sale-leaseback is a transaction where a business asset is sold and the seller leases back the property from the buyer. Seller thus has continued use of the asset but no longer owns it. Future appreciation is removed from seller’s estate. n Provides buyer with income n Provides seller with a tax deduction for reasonable rental expense n De. Paul University All rights reserved. 24

Intra-Family Loans The advantages of an intra-family loan (versus a commercial loan) include speed, ability to borrow, and elimination of lending points (mortgage loans). n n If borrowing family member pays market interest rates, no gift is made Unpaid loan balance at death is included in lender’s estate Lender reports interest in gross income Borrower deducts if: n Home mortgage interest (if itemizing) n Business interest if the loan is for a legitimate business purpose De. Paul University All rights reserved. 25

Intentionally Defective Grantor Trusts An IDGT uses the disconnect between the income tax and transfer tax rules to allow a grantor to make a completed gift but retain income tax ownership. n Gifted asset is out of donor’s estate n Donor pays tax on the income, reducing his estate while allowing the trust to grow. n Tax paid can be less as trust brackets are more compressed than individual brackets De. Paul University All rights reserved. 26

IDGTs – Endangered Species? President Obama’s fiscal 2013 revenue proposals include a new plan that could eliminate the benefits associated with IDGTs. n Under the proposal, when a transfer is made to a grantor trust, the gift tax would be applicable when: n there is a distribution from the grantor trust or n when the trust ceases to be a grantor trust. n To the extent not yet distributed, any amount in the grantor trust at the date of the grantor’s death would be subject to estate tax. De. Paul University All rights reserved. 27

Making a Trust “Defective” for Income Tax Purposes When a trust is “defective” for income tax purposes, the grantor holds one or more of the following controls over trust income and/or principal: n Trust income is (or may be) distributed or accumulated for grantor and/or spouse n Trust income is used (or may be used) to discharge a legal obligation of the grantor n Example: Court-ordered child support n Grantor (or spouse) may control beneficial enjoyment of trust income or principal n Which beneficiaries receive distributions, and when § Continued………. . De. Paul University All rights reserved. 28

Making a Trust “Defective” for Income Tax Purposes (cont’d) n Trust income is used or may be used to pay insurance premiums on grantor or spouse n Funded life insurance trusts must be grantor trusts because trust income is used to pay life insurance premiums n Grantor holds >5% reversionary interest in trust property n Reversion occurs if upon beneficiary’s death, assets pass back to grantor n Exception for beneficiary < age 21 predeceasing grantor n Grantor (or spouse) holds certain administrative power(s) n Ability to gift trust property, vote shares held by trust, or borrow (unsecured) from the trust De. Paul University All rights reserved. 29

Making a Trust “Defective” for Estate Tax Purposes The following grantor-retained conditions make a trust “defective” for estate tax purposes meaning the trust property must be included in the grantor’s gross estate: n. Grantor retains right to income or beneficial enjoyment from trust property n Life interest n. Grantor retains the right to designate beneficiaries n. Grantor retains the right to change trustee n Unless new and old trustees are independent of grantor n. Grantor holds > 5% reversionary interest at death De. Paul University All rights reserved. 30

Question 8 -6 Which of the following powers is least likely to make a trust defective for tax purposes? A. The grantor receives trust income. B. Trust income is used to pay life insurance premiums on the grantor’s life. C. The grantor retains the right to change trustees. D. The grantor holds a reversionary interest over the trust principal. De. Paul University All rights reserved. 31

Grantor Retained Annuity Trusts (GRATS) Grantor contributes assets to a term trust and agrees to receive a fixed dollar amount from the trust each year (the annuity payment) for the term. n When the GRAT is established , the grantor incurs a gift tax on the present value of the remainder interest n The gift is the difference between the amount contributed and the present value of the annuity payments that the grantor will receive. n Amounts remaining in the trust when its term expires pass to the grantor’s heirs tax-free. n Fixed annual payment amount provides certainty, but no inflation protection. De. Paul University All rights reserved. 32

GRAT Example In November 2012, Scott, age 60, transfers $1 MM to a ten-year GRAT retaining a 6. 5% annuity interest ($65, 000 per year) for the term of the trust. n Taxable gift = $382, 090 (NPV of remainder) n Assuming a 3. 5% return, the remaindermen will receive $638, 050 in 2022 n Scott receives a total of $650, 000 over the term n Assuming a 33% tax bracket he nets $435, 500 De. Paul University All rights reserved. 33

Grantor Retained Unit Trusts (GRUTs) The grantor contributes assets to a term GRUT and agrees to receive annual distributions computed as a fixed percentage of the annually revalued trust assets. n Taxable gift = NPV of remainder n. Amounts remaining in the trust when its term expires pass to the beneficiaries tax-free. n. Unitrust payments may provide inflation protection, but will rise or fall annually with the value of the trust. De. Paul University All rights reserved. 34

Grantor Retained Income Trusts (GRITs) A GRIT is a term trust where the grantor retains the right to receive trust income for its term. n Grantor’s interest is neither an annuity or a unitrust payment n Chapter 14 Rules (IRC) value the retained income interest at zero. n Since the taxable gift equals the amount transferred minus the interest retained there is no transfer tax benefit to a GRIT De. Paul University All rights reserved. 35

Question 8 -7 Under a GRIT, the interest retained by the grantor is most likely to be valued at: A. FMV B. FMV less liquidity discounts C. Basis D. Zero De. Paul University All rights reserved. 36

Intra Family Transfers Not Providing Seller Income Certain intra-family transfer techniques remove an asset and its future appreciation from the transferor’s estate but do not provide that transferor with cash payments. n Examples: n Gifts of S corporation shares n Family limited partnerships n Gift leasebacks n Stock recapitalizations n Qualified personal residence trusts (QPRTs) De. Paul University All rights reserved. 37

S Corporations In Estate Planning A closely held business owned in an S corporation can be used to transfer appreciation to family members. n Stock gifts can be spread over years and among donees to maximize the annual gift tax exclusion n If S Corp is profitable, income may be shifted to lower -bracket family members n Be wary of kiddie tax for donee < age 24 n If S Corp is a service business, IRS can shift dividend income to properly reflect the value of services rendered De. Paul University All rights reserved. 38

Family Limited Partnerships (FLPs) The FLP typically is formed to hold the family business or active investments with the anticipation that the parents will make gifts of their FLP interests to their children. n FLP interests are illiquid and thus should be eligible for substantial discounts for transfer tax purposes. n Income and appreciation may be shifted to lowerbracket family members n Older generation may retain as little as 1 -2% equity in the business, but retains full management control as general partner. n Can decide all distributions of equity and income De. Paul University All rights reserved. 39

FLP Lack of Control Valuation Discount The recipients FLP interests become limited partners with virtually no management control. n Management control remains with the transferor as general partner n Thus, a lack of control discount from FMV is generally allowed on the transferred limited partnership interests for gift tax purposes De. Paul University All rights reserved. 40

FLP Lack of Marketability Discount A limited partner can not sell his/her interest freely. Generally the limited partner must receive permission from the general partner to sell. n n n Permission may not be forthcoming if the GP wishes to preserve ownership by the family exclusively). Thus, a lack of marketability discount is generally allowed on the transferred limited partnership interests for gift tax purposes IRC recognizes lack of marketability for closely held business interests generally De. Paul University All rights reserved. 41

Question 8 -8 Which of the following types of valuation discounts is least likely to be available in conjunction with a family limited partnership? A. The blockage discount B. The minority discount C. The lack of control discount D. The lack of marketability discount De. Paul University All rights reserved. 42

FLP Leveraged Gift Example Arch Caldwell owns a business now organized as an FLP having a book value of $1 MM. Due to various valuation discounts, the gift is valued at $500 K for gift tax purposes. If Arch and his wife utilize the annual exclusion and gift splitting to their 3 children and 7 grandchildren (10 in all) they can transfer all of the value of their business within 2 years. n 10 donees x $26, 000 = $260, 000 per year n x 2 years = $520, 000 De. Paul University All rights reserved. 43

FLP Disadvantages n Because the transfer of limited partnership interests (representing up to 98 -99%% of the equity in the business) is a lifetime gift, the step up in basis available with a death-time transfer is lost. n The transferor - general partner has unlimited liability for claims against the business. n But the FLP does not assume liability for GP’s personal obligations. De. Paul University All rights reserved. 44

Question 8 -7 Which of the following best describes an advantage of the family limited partnership (FLP)? A. Although the transferor surrenders control, s/he transfers future appreciation while minimizing gift tax. B. The transferor retains control but transfers future appreciation while minimizing gift tax. C. The transfer enjoys the limited liability generally associated with incorporating. D. The transferor values the gift at today’s FMV rather than tomorrow’s De. Paul University All rights reserved. 45

Gift Leaseback Under a gift-leaseback, a parent (typically) gifts business assets to a lower-bracket and younger family member (or a trust). The parent’s business then leases the assets from donee. n Gifted assets should be fully depreciated. n Lease payments to donee are deductible by parent’s business n Assuming a real business purpose and reasonable rental cost n Rental income is included in the donee’s gross income (presumably in lower bracket than donor) De. Paul University All rights reserved. 46

Gift-Leaseback Requirements n Transaction needs to be structured and documented very n n carefully to minimize IRS scrutiny The terms of transaction must be negotiated at arm’s length Lease terms are very important Leaseback should involve the necessary business operation If trust is used: n n Trustee should be completely independent from grantor Grantor should retain no reversion De. Paul University All rights reserved. 47

Gift-Leaseback Example Dr. Bob owns a downtown medical building in which his practice is the sole tenant. Downtown real estate is appreciating. Dr. Bob has two young children. He has many other assets and would like to remove the medical building and its future appreciation from his estate. n Dr. Bob transfers ownership of the medical building to a trust for his two children, naming an independent trustee. n He then enters into a lease agreement to rent the building from the trust. His practice deducts the payments. His children or the trust keep the payments. n Future appreciation on the building is removed from Dr. Bob’s gross estate. n Gift to trust is a taxable transfer n Use of Crummey powers would qualify gift for annual exclusion De. Paul University All rights reserved. 48

Question 8 -9 A disadvantage to the gift-leaseback arrangement is that it: A. Can only be done with minor children. B. Removes future appreciation from the transferor’s gross estate. C. Creates income-taxable payments to the transferor. D. Is likely to generate a taxable gift. De. Paul University All rights reserved. 49

Bargain Sale A bargain sale is a sale of property (typically to family member or charity) for less than full FMV. The consideration received by the seller represents the sale, and the excess (to FMV) represents the gift. To the extent the consideration received exceeds the seller’s basis, capital gain is realized. n Treatment depends on seller’s holding period n De. Paul University All rights reserved. 50

Bargain Sale Example Harry owns land with a basis of $200, 000 and a current FMV of $613, 000. He would like to gift the property to his grandniece, Mary, but needs income to support his retirement. Harry sells the land to Mary for $400, 000. n Harry’s capital gain is $200, 000 n n ($400, 000 proceeds less $200, 000 basis) Harry’s taxable gift is $200, 000 n ($600, 000 -$400, 000 -$13, 000 annual exclusion) De. Paul University All rights reserved. 51

Question 8 -10 The reason why capital gains occur in conjunction with a bargain sale is that: A. a gift is made. B. the sales proceeds exceed basis. C. the property is removed from the seller’s estate. D. the transfer is complete. De. Paul University All rights reserved. 52

Qualified Personal Residence Trust (QPRT) In a QPRT, the grantor transfers title to his primary residence or vacation home to the trust, retaining the continued use of the residence for a term of years. n Assuming the grantor survives the term, the right to use the residence ends when the QPRT term expires. n The residence is removed from the donor’s gross estate At the termination of the QPRT term, the trust continues or terminates according to its terms. n Subject to the trustee’s (or beneficiary-owner’s) agreement the grantor may continue to use the residence but must pay fair market rent. De. Paul University All rights reserved. 53

QPRT Gift Taxation A QPRT is irrevocable, so a gift occurs at creation of the trust. The amount of the gift is the NPV of the remainder interest following the term of the grantor’s use. n Depending on the QPRT term selected and prevailing interest rates, the value of the gift (remainder) can be reduced, typically by 25 – 50 percent of the residence’s value. n If the grantor survives the term, the property (including any appreciation) escapes estate tax. De. Paul University All rights reserved. 54

QPRT Example Lisa transfers her $1 MM residence to a QPRT, retaining the right to use the residence for a seven-year term. The value of the present gift to her children, the remainder beneficiaries, may be only 50 percent, or $500, 000. If Lisa survives the seven-year term, the residence will not be included in the her gross estate (nor will any of the appreciation in value of the residence occurring after the initial transfer). n After seven years, if Lisa’s home has appreciated in value to $1. 4 million, she has transferred the home to her children for transfer tax purposes at a value of only $500, 000. n If Lisa dies during the QPRT term, the residence will be brought back into her gross estate for estate tax purposes. n Lisa’s estate will receive full credit for any tax consequences of the initial gift to the QPRT, so she is no worse off (except attorney fees and transfer costs) than if no QPRT had been created. De. Paul University All rights reserved. 55

Question 8 -11 Which of the following objectives can a qualified personal residence trust generally accomplish? A. Ensure that the residence is removed from the transferor’s estate. B. Ensure that the transfer will pay no federal estate tax. C. Maximize the marital deduction. D. Reduce federal gift tax. De. Paul University All rights reserved. 56