Jaconetta, Burnham & Wimer, LLC

This document was last revised on July 1, 2002 and does not reflect changes in the law that have occurred since that date. The purpose of this outline is to provide an overview of concepts germane to the subject. None of the information contained herein should be relied upon without careful analysis of the changes to the applicable laws and regulations since the revision date.

I. Outright Gifts of Business Interests.

A. The annual gift exclusions of the business owner and his or her spouse can be utilized to gift closely held business interests to children and other descendants each year.

1. With a married business owner, $22,000.00 worth of stock or ownership interests can be gifted to each child each year free of gift tax.

2. Several court cases have permitted use of combined lack of control and lack of marketability discounts in the range of 30-50% of the value of the closely held business enterprise. Courts have looked to the following factors in deciding the appropriate size of valuation discounts:

(a) Does the company have a history of paying no or low dividends;

(b) Is the company managed and controlled by a small group of individuals;

(d) Is the company likely to be sold or to go public;

(e) Is there a history or practice of the company redeeming stock or of shares being sold to family members or third parties;

(f) If non-voting shares are transferred, do the non-voting stock shareholders have the right to participate in company decisions; and

(g) If voting shares are transferred, is the block of shares being transferred enough to control corporate affairs.

3. Care must be exercised to structure the closely held business enterprise in a way that allows the owner to control the business following the transfer of interests to the next generation.

• Corporations can recapitalize by authorizing the issuance of non-voting stock;

• Partnership agreements and limited liability company operating agreements can specify that the business owner retains control of management following a transfer of a majority interest in the business enterprise.

B. A more aggressive approach would be to use the business owner’s entire gift tax exemption to gift interests in a closely held business to children and other descendants.

1. If both the business owner and spouse use their entire gift tax exemption, $2 million worth of business interests can be transferred in the year 20004 without producing a federal gift tax liability.

2. Connecticut gift tax would have to be paid to the extent the amount of the gift exceeds the applicable exclusion amount.

3. Gifting larger amounts may eliminate the need to reappraise the value of the business each year (as with annual exclusion gifts).

4. The use of the business owner’s entire gift tax exemption is most advantageous with businesses which have highly appreciating values.

NOTE: As an alternative to outright gifts of business interests to children, a business owner can gift business interests to an irrevocable trust which benefits the business owner’s spouse for life and passes to a trust for the children at the spouse’s death.

II. Grantor Retained Annuity Trust (GRAT). A GRAT allows the grantor to transfer assets, i.e., interests in closely held businesses, into an irrevocable trust and retain the right to receive fixed payments for a certain number of years, while paying reduced gift taxes on the transfer and removing the assets from the grantor’s estate. A GRAT is a qualified interest under Chapter 14 of the Internal Revenue Code and therefore the zero value (of retained interests) rule is not applicable.

A. The Mechanics

1. An individual, i.e. the grantor, transfers ownership of S corporation stock, partnership interests or limited liability company interests into an irrevocable trust.

(a) A GRAT usually makes sense when highly appreciating assets are transferred into the GRAT.

(b) Using stock of a corporation to fund a GRAT has become popular, where discounts can be used to determine the value of the stock transferred into the GRAT, and the amount of the taxable gift can be zeroed out (reduced to zero) by increasing the amount of the retained annuity payments and therefore the value of the retained interest in the GRAT.

2. The grantor retains the right to payment of a fixed amount each year for a period of time (the “Term”) as defined in the GRAT.

(a) The Term is usually between 5 and 20 years, but must be

a minimum of 2 years.

(b) The payments are usually made in monthly, quarterly or annual installments.

(i) A specific dollar amount payable periodically but not less frequently than annually.

(ii) A stated percentage of the fair market value of the property transferred into the GRAT determined on the date of transfer into trust.

Note: The annuity amount can increase each year by up to 120% of the annuity amount paid for the preceding year.

3. At the end of the Term, the trust assets pass to the beneficiaries of the trust (usually children or grandchildren of the grantor).

4. If the grantor dies before the end of the Term, the trust assets pass to the grantor’s estate or according to a power of appointment exercised by the grantor.

B. Tax Consequences

1. Gift Tax. The amount subject to gift tax is less than the entire value of the property transferred into the GRAT, since the grantor is retaining the right to payments of the fixed amount each year during the Term. The fair market value of the assets at the time of the gift is reduced by the actuarial value of the retained interest to determine the amount of the gift. Thus, a grantor can reduce the size of the gift (potentially to zero) by increasing the length of the Term or the amount of each annuity payment. Additionally, any appreciation in the value of the assets during the Term passes to the beneficiaries gift tax free.

(a) Federal Gift Taxes. Grantor can use his or her federal gift tax exemption to avoid federal gift taxes on the transfer but decreasing the amount of the credit available at death.

(b) State of Connecticut Gift Taxes. The State of Connecticut gift tax structure does not recognize the federal gift tax exemption. Therefore, Connecticut gift tax is due on the total value of the gift.

NOTE: Since the transfer of property to a GRAT is not a gift of a present interest in property to the beneficiaries, the transfer does not qualify for the annual gift tax exclusions of the grantor.

2 Estate Tax. The irrevocable nature of the GRAT removes the value of the assets from the grantor’s estate, if the grantor survives the Term of the trust. If the grantor dies during the Term, the value of the assets is included in the grantor’s estate and a credit in the amount of the gift taxes paid on the transfer into the GRAT is applied to the estate taxes due. As a result, no estate tax savings are achieved unless the grantor survives the Term.

C. Specific Requirements Applicable to GRATs. A GRAT must comply with the following requirements of Code Sections 25.2702-3(b) and (d):

1. Exclusive Distributions to Grantor. The trust must provide that

distributions can not be made to anyone other than the grantor during the Term.

2. Establishment of Fixed Term. The trust must establish a fixed Term of years for the payment of the annuity amount. The grantor can not change the Term after it has been established.

3. Prohibition on Commutation. The trust must prohibit the acceleration or prepayment of the annuity amount to the grantor.

4. Mandatory Payment of Annuity Amount. The annuity amount must be paid to the grantor each year during the Term, even where trust income or cash on hand is not sufficient.

(a) Where cash is not available for distributions, trust assets can be

distributed in kind.

(b) The annuity amount can be paid after the close of the taxable year, provided that it is made no later than the date that the trust’s tax returns are due (without regard to extensions).

5. Additional Contributions Not Allowed. Once the GRAT is established, the grantor can not add additional property to the trust.

D. Advantages

1. Estate and Gift Tax Savings. Reduction or elimination of gift taxes paid on transfer of assets into the GRAT and elimination of estate taxes if the grantor survives the Term of the trust.

(a) Post transfer appreciation in value of assets passes to trust beneficiaries estate tax free.

(b) Lack of marketability and control discounts can be used to determine value of closely held business interests transferred into the GRAT.

2. Avoid Probate. Transfer of assets to the trust removes it from your probate estate.

3. Succession. The grantor can ensure that the trust assets pass to his or her desired beneficiaries.

4. Grantor Trust Status. Since the grantor retains an annuity interest in the GRAT and the trust provides that the trust assets revert to the grantor’s estate if the grantor dies during the Term, the GRAT is usually treated as a grantor trust for income tax purposes. Grantor trust status offers the following advantages:

(a) No gain or loss is recognized on the transfer of assets to and from the trust.

(b) The grantor is taxed on all trust income during the Term allowing trust assets to appreciate tax free for the beneficiaries.

E. Disadvantages

1. Estate Tax Savings Not Guaranteed. If the grantor dies during the Term of the trust, the assets are included in the grantor’s estate and there is no estate tax savings realized.

2. Risk of Lack of Future Appreciation. If the assets in the GRAT appreciate at a rate which is less than the applicable federal discount rate under Code Section 7520, estate tax savings will not be realized.

3. Irrevocable Nature of Trust. The transfer of assets to a GRAT is irrevocable; that is, the grantor has no right to revoke the trust or withdraw trust assets from the trust once it is funded.

4. Loss of Control. Since title to the assets pass to the trust and then the beneficiaries, the grantor loses control of decisions concerning the assets.

5. Loss of Step-up in Basis. Since the GRAT removes the trust assets from the grantors estate if the grantor survives the Term, a step-up in basis in the trust assets upon the death of the grantor is lost and the beneficiaries’ basis in the trust assets equals the basis of the assets in the hands of the grantor prior to the date of transfer into the GRAT.

6. Annual Gift Exclusions Not Available. Since the transfer of assets to a GRAT is a gift of a future interest in property to the trust beneficiaries, the transfer does not qualify for the grantor’s annual gift exclusions.

7. Connecticut Gift Tax. The transfer of assets into the GRAT is subject to Connecticut gift tax.

III. Installment Sale of Business To Family Members. An installment sale of a business to family members allows the business owner to freeze the value of the business in his or her estate while providing the business owner with a stream of income that can be used in retirement.

A. Business is sold to family members at its appraised value.

1. All post-sale appreciation in the value of the business passes to family estate tax free.

2. Since the business is sold at its fair market value no gift tax is owed on the transfer.

B. Family members sign a secured promissory note which requires them to pay for the business in periodic installments over a number of years.

1. The duration of payments under the promissory is usually a period of time necessary to allow the business owner to bridge the gap in income prior to receiving social security or beginning distributions from qualified retirement plans.

2. The promissory note must bear interest at a rate equal to or greater than the applicable federal rate in order to avoid gift taxes.

3. Installment sale reporting allows the business to defer payment of income taxes on the sale until note payments are actually received.

4. A sale of business interests to family members (rather than a sale of assets of the business) can produce capital gain treatment on the sale to the business owner (subject to certain limitations).

C. In certain situations, non-qualified deferred compensation agreements can be used to minimize the double taxation of dollars used to fund the purchase of the owners business interests.

D. Deferral of the payment of the purchase price allows the family members to use the post sale earnings of the business to fund the purchase of the owners’ business interests.

PLANNING NOTE: An installment sale of a business to family members is an excellent planning tool for owners who are no longer actively involved with the business on a full-time basis, but still draw large salaries from the business. The concept involves using the dollars generated from the business to provide the same income to the business owner following the sale while removing a valuable illiquid asset from the estate of the business owner.

IV. Installment Sales to Intentionally Defective Irrevocable Trusts. Intentionally defective irrevocable trusts (IDITs) are trusts designed to afford their creators the best of both worlds from an estate and income taxation point of view. From an estate tax perspective, the IDIT is an irrevocable trust, and therefore, the assets of the IDIT, if properly structured, are excluded from the estate of the grantor at death. From an income tax perspective, the IDIT is a grantor trust. Thus, otherwise taxable sale transactions between the grantor and the IDIT are ignored for income tax purposes, and the income of the IDIT is taxed to the grantor.

A. The Mechanics

1. The grantor creates the IDIT.

(a) The IDIT is an irrevocable trust that is designed (very similar to the irrevocable life insurance trust) to exclude any assets transferred to it from the grantor’s gross taxable estate for estate tax purposes.

(b) The IDIT can benefit the grantor’s spouse during his or her lifetime and then pass to the grantor’s children without being included in either of the grantor’s or the grantor’s spouse’s estate. The IDIT can be structured with generation skipping provisions so that the assets stay in trust for the entire lives of the grantor’s children and then pass to the grandchildren without ever being subject to estate taxes in the children’s’ estates.

(c) The IDIT will contain one or more “defective” provisions which will cause the trust to be treated as a grantor trust for income tax purposes only.

2. Grantor transfers seed money to the IDIT, usually an amount equal to 10% of the value of the assets being sold to IDIT.

3. The grantor sells closely held business interests to the IDIT for an amount equal to the fair market value of the interests being sold.

(a) The Trustee of the IDIT executes and delivers to the grantor a promissory note with a face amount equal to the value of the business interests being purchased.

(b) The promissory note bears interest at the applicable Section 1274 rate. With a note over nine years, the federal long-term rate applies.

B. Tax Consequences

1. Estate Taxes.

(a) The value of the closely held business interest owned by the IDIT is excluded from the grantor’s estate even if the grantor dies before the promissory note is paid off.

(b) The appreciation in value of the closely held business interest following the sale to the IDIT escapes estate tax. As long as the business interest appreciates at a rate which is higher than the applicable Section 1274 rate, the IDIT is a successful estate planning tool.

(c) If the grantor dies before the promissory note is paid in full, the value of the promissory note is included in the grantor’s estate for estate tax purposes.

2. Gift Taxes.

(a) The transfer of the seed money to the IDIT is a transfer subject to gift taxes. If the IDIT contains Crummey powers and the grantor is married, $22,000.00 per beneficiary can be transferred to the IDIT gift tax free. Beyond that, up to the grantor’s (and grantor’s spouse’s) gift tax exemption can be transferred to the IDIT as seed money federal estate tax free.

(b) The sale of the business interests in return for a promissory note with the same value is not treated as a taxable gift.

• care must be taken to determine the value of the business interest by certified appraiser.

• most tax practitioners agree that Chapter 14 of the Code applicable to transfers of retained interests does not apply to IDITs.

3. Income Taxes. For income tax purposes, the IDIT is treated as a grantor trust.

(a) IRS rulings have held that a sale of assets between a grantor and a grantor trust is not treated as taxable event. Thus, no gain or loss is recognized to the grantor on a sale of the business interest to the IDIT.

(b) The grantor is not taxed on the interest payments on the note.

(c) All income of the IDIT is treated as income of the grantor and therefore is taxed to the grantor at the grantor’s personal income tax rates.

• Most practitioners agree that payment of the income taxes by the grantor on the income of the IDIT is not a taxable gift by the grantor to the IDIT.

• If the closely held business interests are subsequently sold by the IDIT, the gain or loss is recognized by the grantor.

C. Powers Which Cause a Trust to be Treated as a Grantor Trust. The following is a list of powers which can be included in an irrevocable trust in order to render the trust a defective grantor trust for income tax purposes.

1. Premium Payment Power. Under Code Section 677(a)(3), the grantor is taxable as the owner of any trust or trust portion as to which any nonadverse trustee may apply trust income to the payment of premiums on policies of insurance on the life of the grantor or the grantor’s spouse.

2. Spouse as Beneficiary. The grantor’s spouse’s status as a beneficiary eligible to receive distributions of income in the discretion of a nonadverse trustee causes the trust to be a grantor trust under Code Section 677(a).

3. Power to Borrow. The power of the grantor or the grantor’s spouse to borrow income or principal of the trust without regard to adequate interest or security will cause the trust to be a grantor trust under Code Section 675(3)

4. Power to Add Beneficiaries. A grantor is treated as the owner of the entire trust if a nonadverse person has the power to add persons (other than after-born or after-adopted children) to the class of trust beneficiaries, in addition to having discretion to distribute trust income and principal.

5. Right to Substitute Assets. The grantor’s retention or grant to another person (such as a spouse) of the right, exercisable in a nonfiduciary capacity, to reacquire trust assets by substituting assets of equivalent value, will create a grantor trust under Code Section 675(4).