In late 2010, Congress moved to temporarily increase the lifetime federal gift exemption from $1 million to $5 million, applicable to the 2011 and 2012 tax years only (the CT gift exemption is $2 million).
The larger gift exemption provides an opportunity to shift business ownership to the next generation without payment of gift tax. The lifetime exemption is used when gifts exceed the annual exclusion of $13,000 per person.
Business succession entails more than transitioning ownership, and as such, business management and control must also be considered. Transfer plans can have a great deal of flexibility built into them so having a comprehensive succession plan is not necessary to start the process.
Voting and non-voting Ownership
Critical to any business succession plan is the use of both voting and non-voting stock or LLC units. The voting units can be retained by the parental generation while transferring ownership via the non-voting shares to the next generation. Any business can be readily recapitalized into voting and non-voting shares or units. Even an S corporation can have voting and non-voting shares, if all shares are common stock.
Later planning can involve the transfer of voting shares to those family members with capacity to manage the business. Importantly, if different classes of units with preferred returns or special economic advantages are created when recapitalizing an LLC or other partnership form, they will be ignored for gift tax purposes.
Outright gifts or gifts in trust
Shares or units can be given directly to children or grandchildren; however, such transfers may complicate personal income tax returns and will be available to creditors, including spouses. An alternative is to use trusts; either in the form of a single trust for the family group or individual trusts. A single trust centralizes income tax filing and payment requirements, and keeps information about the business’ income and profits from being exposed on individuals’ income tax return. A trust may also provide some measure of protection against creditors.
The most streamlined income tax arrangement involves a “Grantor Trust,” which does not pay taxes and is not required to file an income tax return. Instead, all items of income or expense are reported on the grantor’s (or creator’s) personal tax return. The ability to pay income taxes associated with shares no longer owned (increasing the asset shift), increases the attractiveness of the technique.
Growth control trusts (asset shifting trusts)
Two techniques involving grantor trusts (a permitted S corporation shareholder) — a “Sale to Grantor Trust” and a “Grantor Retained Annuity Trust (GRAT)” — both return the original asset plus a set rate of return to the creator, while transferring any value increase to the next generation. Today’s historically low interest rates make these trusts very attractive. The rate of return retained by the creator is based on the applicable federal rate, which changes each month.
The Sale to Grantor Trust involves an initial gift (seed money) followed by a sale of assets to the trust in exchange for a note that bears interest at the appropriate federal rate. With a grantor trust, the sale transaction is ignored for income tax purposes (no capital gain is triggered and no tax is triggered on the interest payments). This technique may benefit multiple generations, and enables the parties to lock in their interest rate. Interest and principal can be paid each year or in irregular amounts, with payments in cash or in the form of the asset sold to the trust. The increased gift exemption permits larger seed money gifts, which in turn permits bigger sale transactions.
The Grantor Retained Annuity Trust (GRAT) involves a transfer to the trust with a series of retained annuity payments. The annuity payments resemble installment payments on a sale transaction, and can be made in cash or in the form of the asset given to the trust. The annuity payment amounts are set at the beginning of the trust, and calculated based on the applicable federal rate and the number of years the trust will last in order to produce the desired gift tax result. An annual valuation is required to make the annual payments. This technique is not appropriate for multiple transfers.
With the exemption slated to sunset with the end of the 2012 tax year, business owners still have time to modify their business succession plans to reap its benefits.
Bill Fleming is managing director of PwC. The accounting and consulting firm formally known as PricewaterhouseCoopers LLP serves Central Connecticut from offices in Hartford.
Bill Fleming
