Advisers to family businesses in times of low interest rates are using a not-so-new way of transferring wealth and providing for retirement cash flow. It is called “sale to a grantor trust,” and it takes advantage of a limited time offer: under current IRS rules, the federal exemption for gift tax is $5 million through 2012, at which time it reverts to $1 million. This strategy is not really new, however, with the elevated gift tax exemption and low interest rates, it makes it really attractive to consider now.
This maneuver can make sense for the owner(s) of a stable business who want to pass along their interests to their children and also can’t afford to forego the cash flow that would be the outcome of an outright gift of the business interest.
Here is how this might be structured:
- The grantor creates an irrevocable trust for the benefit of his/her descendants. The trust is specifically designed so that the grantor is taxed on the trust’s income, but the trust assets are not taxed in the grantor’s estate.
- The grantor makes a gift to the trust. For estate tax purposes, this gift (or so called “seed” money) should be equal to at least 10 percent of the value of the assets to be sold to the trust. This gift will use up a portion of the grantor’s $5 million ($10 million for married couples) gift tax exemption. The gift can be made in cash or with the same assets to be sold to the grantor trust.
- The grantor then sells assets to the trust that are expected to outperform the interest rate on the note. Typically, there is no down payment, and principal and interest are payable over an amortization period of nine to thirty years. Ideally, the assets sold to the trust would generate income (to make the principal and interest payments), and would also qualify for valuation discounts for lack of control and lack of marketability. For example, non-voting interests in an LLC or a Subchapter S corporation are often good assets to sell to a grantor trust. A grantor trust is also an eligible Subchapter S stockholder.
- The interest rate on the note is fixed for the entire note term at the lowest rate allowed under the tax law. This rate is known as the applicable federal rate (AFR) and is published monthly by the Department of the Treasury.
Why does this make sense in today’s environment?
- The grantor recognizes no gain or loss on the sale. The reason is that the grantor and the trust are considered one and the same person for income tax purposes.
- The grantor is not taxed separately on the principal or interest payments the grantor receives. Instead, the grantor is taxed on all of the trust’s income. In essence, the grantor is making a tax-free gift to the trust’s beneficiaries by paying the trust’s income taxes.
- The future growth (equity) in the trust provides additional equity with which to support future installment sales within the 10-percent test referred to above.
- In today’s environment of low interest rates, owners of small businesses can transfer to descendents a high-appreciating asset minimizing estate taxes issues and receive tax-free cash flow to boot.
Selling assets to beneficiaries using the installment method has long been a popular estate freezing strategy–particularly in times of low interest rates. The sale works even better if it is made to a grantor trust rather than to the beneficiaries directly. There are some enhancements that can be done to make this strategy even better that have not been presented here.
