– 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.

• 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.

• 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.

• 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.