– The Current Economic Downturn Is an Opportune Time for Estate Planning and Business Succession Planning
– Acquisition Opportunities – Proceed, But With Caution
During the past year, individuals watched as the values of their assets dramatically declined in an uncertain and tumultuous economic climate. Many business owners have been hit especially hard in the current economic climate, witnessing the businesses they’ve spent years building lose significant value. Economists predict that the economy will recover. Meanwhile, the combination of the precipitous drop in asset values and historically low interest rates is providing an unprecedented opportunity for business owners to transfer the future growth and appreciation of their business interests at significantly reduced (or even eliminated) estate tax and gift tax costs. In other words, as a result of the economy and their individual circumstances, many business owners now have what is probably a once-in-a-lifetime opportunity to maximize the effectiveness of certain estate planning and business succession planning strategies. By way of example (though this is by no means a complete list), we summarized below two such strategies that we regularly design and implement for our closely held business clients.
Intentional Grantor Trust (IGT)
An intentional grantor trust allows the creator, or “settlor,” of the IGT (the business owner) to “freeze” the value of the contributed assets (the company stock) and thereby take advantage of the currently depressed values. By gifting or selling assets to the IGT, the settlor may remove assets from his or her estate for federal estate tax purposes, yet may continue to be treated as the owner of the transferred assets for federal income tax purposes. As a result of this dichotomy, the settlor (rather than the IGT) recognizes all the IGT’s taxable income during the settlor’s life, but at his or her death, the assets in the IGT pass to the IGT beneficiaries, free of any federal estate tax.
To freeze the value of business interests, the settlor sells the business interests to an IGT (which may have been prefunded with a small amount of seed money) in exchange for a promissory note. After the sale, the value of the remaining balance on the promissory note is included in the settlor’s estate, but the value of the business interests transferred to the IGT has been removed. Therefore, upon the settlor’s death, only the value of the note is included in the settlor’s taxable estate. The value of the business interests and, most important, the appreciation in the value of the business interests after the sale to the IGT remain in the IGT and will ultimately pass to the beneficiaries of the IGT, free of any estate tax, at the settlor’s death. By exchanging the business interests for the note, the settlor has “frozen” the value of the asset (i.e., the note) in his or her estate, and thus the growth of the business will not be included in the estate.
In addition to removing the assets from the settlor’s estate, this structure provides significant additional estate planning benefits and works particularly well in the current economic environment. Some of the additional benefits of selling business interests to an IGT in the current economic climate are described below.
- With the recent decline in market values, business owners now have a unique opportunity to maximize their ability to discount the value of their business interests. In addition to the typical discounts for lack of control and lack of marketability, the low value of business interests in the current economic environment serves as an additional “discount” when the owner sells or gifts those interests. Using all these discounts, business owners are able to transfer, by sale or by gift, their business interests at today’s low value. If a business owner sells assets to an IGT, when the value of the business grows, the appreciated business interests may pass to the beneficiaries of the IGT, free of any federal estate or gift tax, because the appreciated business interests are no longer included in the settlor’s estate.
- The current low-interest-rate climate creates the perfect environment for a sale in exchange for a promissory note, as described above. The interest rate on the note is established at the creation of the note. If the business interests in the IGT are able to earn income at a rate in excess of the interest rate of the note, the excess income will remain in the IGT and will pass to the beneficiaries of the IGT, free of federal estate and gift taxes, at the settlor’s death.
- The sale of business interests to an IGT will stop further building of the settlor’s estate with income produced by the business. Ordinarily, income generated by the business would increase the size of the owner’s taxable estate, and roughly half of that income would then be lost in the payment of federal estate tax when the owner dies (after being subject also to income tax when the income was earned). By selling business interests to an IGT, the owner ensures that all future income generated by those interests enhances the value of the IGT and will not be subject to federal estate tax.
In short, the current economic environment provides an excellent opportunity to employ the IGT strategy and thereby help protect closely held business interests from federal estate and gift taxes.
- The IRS treats an IGT as a grantor trust for income tax purposes, which means that the settlor is responsible for all the federal income tax on the income realized by the IGT. By paying the income taxes on the IGT’s income, the settlor effectively is making an additional tax-free gift to the IGT in the amount of the income tax due on the IGT’s income and is further reducing the size of the settlor’s estate for federal estate tax purposes.
Grantor Retained Annuity Trust
Another very effective estate planning and business succession planning strategy that is ideal for the current economic climate is the Grantor Retained Annuity Trust (GRAT). When creating a GRAT, the creator, or “settlor,” makes a gift to the trust in exchange for an annuity for a set term of years. The value of the settlor’s gift is equal to the value of the remainder interest in the GRAT. Ideally, the gift of the remainder interest should be as small as possible so that the settlor uses the smallest amount of his or her lifetime gift-tax credit. At the conclusion of the GRAT’s term, the balance of the assets remaining in the GRAT, including the growth or appreciation of the assets, will pass to the beneficiaries, free of any additional estate or gift tax.
The value of the remainder interest is based upon several factors, which will impact the size of the settlor’s gift to the GRAT. Some of these factors are described below.
- Length of the GRAT. The longer the term of a GRAT, the smaller the gift that passes to the remainder beneficiaries. However, in order for the GRAT to be effective, the settlor must survive the term of the GRAT.
- Value of the Assets Transferred. The smaller the value of the assets transferred to a GRAT, the smaller the gift to the remainder beneficiaries. Thus, in the current economic environment where assets have significantly declined in value, business interests that are expected to appreciate in value are ideal to fund a GRAT.
- Interest Rate. The lower the interest rate, the smaller the gift to the remainder beneficiaries. Thus, in the current economic environment where interest rates are at historically low levels, the GRAT strategy is particularly attractive.
Like an IGT, a GRAT is also a grantor trust for income tax purposes. The settlor, not the GRAT, is responsible for the payment of all the federal income taxes realized by the GRAT. Thus, the assets in the GRAT are not depleted by the payment of income taxes, and the settlor’s payment of the income taxes has the effect of an additional tax-free gift to the GRAT beneficiaries in the amount of the income tax paid. Again, this is a very effective estate planning and business succession planning strategy that reduces the size of the settlor’s taxable estate from a federal estate tax perspective while preserving the assets in the GRAT for the beneficiaries.
- Size of Gift. If individuals are hesitant to use any portion of their lifetime gift-tax credit when making a gift to a GRAT, a “zeroed-out” GRAT may be an especially effective option in the current economic environment. Just as in the case of a typical GRAT, the settlor receives an annuity during the term of the GRAT. However, with a zeroed-out GRAT, the annuity is equal to the value of the assets transferred into the GRAT. In effect, the gift to the remainder beneficiaries is “zeroed out” because the settlor will retain the entire gift in the form of annuity payments. Since the settlor will receive exactly what was transferred to the GRAT, no gift is made to the remainder beneficiaries, and the settlor has not used any of his or her lifetime gift-tax credit. However, any appreciation in the assets transferred in excess of the annuity payments will remain in the GRAT and will be transferred to the remainder beneficiaries, free of both federal gift and estate taxes, without ever reducing the settlor’s lifetime gift-tax credit.
While asset values and interest rates are low, GRATs have very little downside as a business succession and estate planning tool. If the assets appreciate in value, any growth in excess of the annuity payments passes to the GRAT remainder beneficiaries. If the assets do not appreciate sufficiently, they are returned to the settlor in the form of the annuity payments. In order for the GRAT to be effective from an estate planning perspective, as mentioned above, the settlor must survive the term of the GRAT. If the settlor dies during the term, the assets in the GRAT are includable in the settlor’s taxable estate.
The current economic climate is providing unprecedented opportunities for business owners to revise their estate and business succession plans. The combination of the dramatic decline in business values and the low-interest-rate environment is affording business owners who use certain strategies a very unique opportunity to transfer the appreciation and growth of business interests with little to no federal gift or estate tax consequences. We summarized just a couple of such strategies above.
If you would like to discuss effective strategies or any other aspect of your estate or business succession planning, please contact Dave Winkowski at 484.323.1347, Justin Brown at 215.564.8764 or any other member of our Closely Held Business Practice Group.
Acquisition Opportunities – Proceed, But With Caution
The worldwide economic recession has, to varying degrees, affected businesses of all sizes, in all industries and in all regions. In some cases, the recession has caused previously profitable businesses to become distressed. In other cases, it has created opportunities for businesses with strong balance sheets to grow strategically through acquisitions that complement their existing products or services or that expand their footprint into new markets. Seizing such opportunities through a carefully structured asset acquisition can yield significant benefits. Additional care must be taken by the purchaser, however, if the company selling assets is distressed or potentially insolvent.
In situations where the seller of assets might be distressed, there is the risk that after the asset acquisition is complete, the seller will have insufficient assets to pay all its creditors. In an effort to obtain payment, the unpaid creditors of the seller might then threaten or seek to have a court determine that the asset acquisition was a fraudulent transfer of the seller’s assets. If a court were to find that the transfer of assets was fraudulent, the entire transaction could be at risk and the implications to the purchaser could be significant. In particular, the court could set aside the entire transaction, causing the purchaser to lose some or all of the purchase price paid for the assets.
The outcome of a court’s review of a transaction to determine whether it was fraudulent will depend on the particular facts and circumstances surrounding the asset acquisition. Accordingly, when acquiring the assets of a distressed business, the purchaser should consider not only the structure of a transaction but also the actions of the parties involved, both before and after the transaction. In particular, the purchaser should strive to act – and should encourage the seller to act – as follows:
At Stradley Ronon, our attorneys have assisted several clients in structuring, negotiating and completing a number of transactions to take advantage of the opportunities created by the current economic environment, while also providing the guidance necessary to help protect such transactions from the claims of the seller’s creditors. For more information regarding this article, please contact Karen McWilliams at 610.640.7970.
- Avoid Conversations Regarding Specific Creditors. While it is important to ask the seller if it will be able to pay all its creditors in full, if the answer is “no,” you want to be sure that both you and your representatives avoid any conversation with the seller and its representatives regarding which creditors will be paid or how much they will be paid, either before or after the asset acquisition. If the seller is honest and is unable to pay all creditors in full, then you might want the seller to consider either a bankruptcy or an escrow of the purchase price and disbursements to its creditors pro rata.
- Pay the Reasonably Equivalent Value. While you will always want to pay the least amount necessary to complete the deal, driving too hard of a bargain on price can put the transaction at risk in bankruptcy proceedings or upon other court challenge. The purchase price you pay for the assets should be sufficient to be considered objectively as the reasonably equivalent value of the assets purchased.
- Keep Payments Separate. If you will be providing goods (for example, inventory) to the seller prior to the closing of the asset acquisition, keep the seller’s payment for such goods separate from your payment of the purchase price. If you are an unsecured creditor of the seller, consider filing a Uniform Commercial Code financing statement to perfect a purchase money security interest against the seller in connection with all goods sold to the seller prior to closing. In the event that the seller files for or is forced into bankruptcy shortly after the closing of the asset acquisition, a UCC financing statement will help reduce the risk of a claim that the seller’s payment for such goods was a preference.
- Pay Reasonable Salaries. If you hire any of the seller’s shareholders in connection with the asset acquisition, the salary, bonuses and benefits paid by you to such shareholder should be within both (i) the market salary range for the position and (ii) the range you typically pay for the position to be held by the shareholder. Salary, bonuses or benefits that exceed such ranges may be considered additional purchase price for the assets acquired, which additional purchase price was improperly paid to the shareholder rather than to the seller and therefore is available to creditors.
- Avoid Using the Name of the Seller. After the closing of the asset acquisition, ensure that all documents and correspondence sent by you in connection with the acquired business – for example, to former suppliers or customers of the seller – use only your legal name or “doing business as” name, and not the name of the seller, unless you acquired the seller’s name as part of the asset acquisition.
- Full Payment Disclosure to Creditors. Respond promptly to any fraudulent transfer or similar claim made or threatened against you by any creditor of the seller. Provided there is no confidentiality restriction prohibiting disclosure, the response should clearly state that you did not assume any of the seller’s liabilities related to the creditor (if accurate) and should include general information regarding any future payments that you may be obligated to pay the seller – for example, the timing of any future payments or the existence of any escrows for the benefit of the creditors.
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