The economic decline doesn’t have many positive effects, but it can increase the benefits of estate planning strategies, especially for business owners. The current environment allows you to transfer business interests to your loved ones at a low estate and gift tax cost. Business owners should meet with estate planners and consider accelerating plans to transfer ownership.
Two factors make this an optimum time for transfers of family businesses.
Most businesses are at their lowest valuations in some time. The sharp drop in the economy has reduced revenues and profits almost across the board. Future growth prospects are lower than a few years ago. The valuations of public stocks also are down. Since estate and gift taxes are based on the values of assets, low valuations mean low transfer taxes. Low values also mean you can give away more assets (such as shares of stock) tax free through the annual gift tax exclusion and the lifetime gift tax credit than you could at higher valuations.
Taxes are not the only reason to plan a transfer now. Most family businesses fail or are sold to new owners outside the family because transfers are not planned. A transfer of family business ownership involves more than taxes and needs time to be successful.
You need to set a plan for changing both ownership and management. You might decide each of your children should have an ownership share, but not all of the children are able or willing to help manage the business. Or the children might not be able to work together, or they might have different philosophies of how to run the business.
For these reasons you need to determine who will have decision making power in the business. Control of business operations can be separated from sharing in the income and appreciation. You can set things up so all the children receive income from the business while only those involved in managing the business make decisions about running the business. Non-management owners would be able to make decisions only about major issues, such as selling the business or increasing debt.
About three-quarters of family businesses owners expect to transfer their businesses to the next generation, according to PricewaterhouseCoopers. But only about one third of owners will accomplish that goal. A major reason is they do not plan for management succession. They either pick the wrong person to run things or assume the kids will work it out.
Transfers also fail and are not planned because the founding owners did not do enough personal retirement planning. They drew money out of the business as needed and did not set aside personal funds or streams of income outside of the business. The result as they reach their senior years is they have to continue owning and managing the business. They can’t afford to ease the transition to the next generation, because even a sale of part ownership won’t generate enough cash flow to match what they are taking out of the business. That’s why the owners’ financial and retirement planning is a key element of the business transfer strategy.
Of course, another reason family business transfers fail is the lack of tax planning.
There are many tax-wise ways to transfer ownership of the family business to the next generation. One particularly useful strategy in this economic environment is the grantor retained annuity trust, or GRAT.
In a GRAT, you transfer assets to a trust. The trust term can be any length of time two years or longer, but most estate planners believe two years is the ideal time. The trust pays you an annuity over its life that is designed to empty the trust at the end of the term. The payouts are based on the assumption the trust earns a return on its investments equal to the current IRS-established interest rate.
This is where the tax benefits come in. The IRS establishes the rates monthly based on market rates for treasury bonds. The current rate for two-year treasury bonds is less than 1% annually. Suppose you put $100 in the trust. The trust will pay you about $51 each year.
Now, suppose the trust’s assets earn more than the treasury rate each year. There will be excess assets in the trust at the end of its term, and those assets will be transferred to your children or other beneficiaries of the trust. There will be no estate or gift taxes on the amount transferred to the children. The higher the return on the assets in the trust, the greater the amount transferred tax-free to the next generation.
When the return on the assets does not exceed the IRS rate or you pass away before the trust term is over, no harm is done. The assets are back in your estate as though you hadn’t taken any action.
Another benefit is you can substitute other assets for assets in the trust. Suppose it becomes apparent the assets you placed in the trust won’t exceed the IRS interest rate. You can buy those assets from the trust with other assets. If these assets exceed the IRS interest rate in the remaining trust term, you children receive the excess.
Most estate planners recommend setting up multiple or rolling two-year GRATs with different assets in them. This is better than creating one GRAT with multiple assets or a major part of your estate in it. Some assets might not have a return exceeding the IRS rate during the two years, but others will. With one trust, the two groups might offset each other. But with multiple trusts, the low returning or losing assets don’t offset those with big gains. Setting up rolling trusts each year is a long-term strategy that is likely to reduce your taxable estate over time.
The IRS interest rates are known as the adjusted federal rates or the 7520 rates. They are set each month, and you can find them on the IRS web site at www.irs.gov.
GRATs must meet technical requirements of the tax code, so you’ll need to work with an estate planning attorney to make them effective.
There is talk in Washington of curtailing the use of GRATs by requiring them to last at least 10 years. A 10-year GRAT still can be a good deal, but two-year GRATs are safer. Look into GRATs soon, and set them up if they are appropriate for your estate.
There are strategies for transferring the family business in addition to GRATs, such as family limited partnerships, straight gifts of stock, and others. This is a great time to begin transferring ownership of the family business to the next generation. Meet with your estate planning to discover the strategies that work best for you.
January 2010. RW