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Death and Taxes vs Preserving Wealth
Unless owners plan to protect their wealth before they have it in hand, they cannot take advantage of all of the potential benefits of the tools in the wealth preservation arsenal. A case study illustrates how an owner used one of those tools, a grantor retained annuity trust, to pursueย financial security, provide for his family, and minimize taxes.
Full disclosure: Wealth preservation planning canโt help any of us cheat death, but it can help business owners avoid taxes and pursue financial security.
The ideal Exit Plan (one that provides the business exit you desire) includes a strategy to help you preserve your hard-earned wealth from unnecessary taxation when it is transferred to your family. However, to preserve wealth, business owners must take steps before they actually have wealth. In other words, to realize all of the potential benefits of various wealth preservation techniques, owners must make plans before they convert the value of their businesses to cash.
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The foundation for wealth preservation planning is found in the answers to two of the questions in Step One of The BEI Seven Step Exit Planning Processโข:
- How much wealth do you want when you exit your company? (Additionally, for parents, how much wealth do you want your children to have?)
- How long before you leave your company?
Using your answers as guideposts, you and your advisors can choose the planning technique that will best preserve your wealth, provide for your family, and minimize your tax bill. Letโs look at how one fictional owner used wealth preservation techniques to do exactly that.
George recognized that heโd waited too long to begin gifting part of his company to his kids. A week earlier, Georgeโs CPA told him that, based on the companyโs pre-tax cash flow of $2 million per year, his company could be worth as much as $12 million to a third party.
After recovering from the shock of this realization, George understood that (a) he didnโt need nearly that much cash to retire in style and (b) if he didnโt transfer at least half the value of his business before selling, his family could be looking at millions in gift or estate taxes.
To remedy this situation, George and his Exit Planning Advisor did the following:
- Hired a certified business appraiser to assign a conservative but supportable value to the company.
Result: Based on tax case law and valuation principles applicable to Georgeโs situation, the appraiser valued the transfer of a 49% minority interest (i.e., less than controlling) at $4 million. In her opinion, the appropriate minority discount was 35% of the full fair market value (assumed to be $12 million) of the stock. Using the 35% discount, George could give away nearly half of the company to his children (a gift valued at approximately $4 million) and would pay no gift tax (based on a law that provided for a $5 million lifetime gift-tax exemption). While George was happy with the idea of not paying a tax, he didnโt relish using most of his lifetime gift- and estate-tax exemption, and wanted a better answer. So, he took another step to avoid needlessly wasting this valuable exemption.
- Created a grantor-retained annuity trust (GRAT). (See โGRAT Noteโ at the end of this article for more-detailed information.)
Result: By using a GRATโperhaps the most useful piece of the wealth preservation puzzleโGeorge would avoid using a significant part of his $5 million lifetime gift tax exclusion and would still give almost 50% of the company to his children.
Through wealth preservation planning performed well in advance of his exit, George was able to:
- Transfer nearly one-half of his business, with a fair market value of $9โ12 million, to his children over four years (a time frame George chose) using little or none of his lifetime exemption.
- Receive all of the cash flow from the company during that four-year period, because the annuity payment to George was designed to equal the amount of cash flow expected from the stock transferred into the GRAT (George needed this income to achieve his financial security Exit Objective).
- Transfer the trust asset, nearly one-half of the company, to trusts for his children, completely free of any gift tax.
George established these trusts when he created the GRAT to carry out his wishes regarding when (and whether) his children would receive money from those trusts.
Techniques such as GRATs and the careful use of minority discounts (as well as many other estate taxโavoidance techniques) only work as intended if they are put in place well before you exit your business. These techniques also work well when two objectivesโin this case, Georgeโs financial security and his desire to provide for his familyโmust be achieved in tandem.
We can provide you with additional information about transferring wealth to children and/or protecting as much wealth as legally permissible from unnecessary taxation. Contact us today.
GRAT Note
In this note, we provide additional details about how and why a GRAT can help pursue an ownerโs twin objectives: financial security and providing for oneโs family.
A GRAT is an irrevocable trust into which the business owner (and the trustee of the GRAT) transfers some of his or her stock. The GRAT must make a fixed payment (i.e., annuity) to the owner each year for a predetermined number of years. At the end of that period, any stock remaining is transferred to the ownerโs children. It is important to note that the business owner must be alive at the end of the GRATโs term for the asset in the GRAT (in Georgeโs case, the business) to be distributed to the beneficiary.
Stock transferred into a GRAT is treated as a gift. The amount of that gift is the value of the asset transferred minus the present value of the annuity that the owner will continue to receive. (Georgeโs advisors made sure that the present value of the annuity paid out over four years almost equaled the value of the stock transferred into the GRAT. In doing so, George gave only a nominal and non-taxable gift.)
The key to a GRATโs success is to transfer an asset that appreciates in value and/or produces income in excess of 120% of the federal midterm interest rate, which fluctuates monthly.
Brett Andrews
Exit planning expert
Tara Groody
Operations Expert
Rebecca Andrews
Insurance expert
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