One concern of many business owners is how to transfer their business to the next generation of family members in the most tax-efficient manner. For some owners, use of a charitable remainder trust (CRT), in tandem with an irrevocable life insurance trust (ILIT), will provide the perfect business transfer approach.

To begin, the successor owner(s) must own a small percent of stock in the business before the CRT transaction occurs. The business owner transfers his or her stock to a CRT in return for a lifetime income. The business owner determines income paid by the trust when the trust is created.

The business then buys back, or redeems, the stock from the CRT with cash or, in some states, with a note. After the redemption, the former minority owners are now 100% owners of the business.

An ILIT, sometimes referred to as a “wealth replacement trust,” is created and funded with a life insurance policy to replace the value of the parents business interest gifted to the CRT. Using Crummey gifting procedures, payments from the CRT to the parents may be used as a source of funding for premiums for the ILIT. The death benefit in the ILIT replaces the value of the business interest in the parents estate and passes to the children whenever the trust terminates.

When the stock is gifted to the CRT, the business owner gets an immediate income tax deduction for a charitable contribution on his or her personal tax return. This deduction is equal to the value of the remainder interest in the CRT.

This deduction is subject to the appropriate annual limitation for charitable contributions, typically 30% of adjusted gross income for capital gain property. Any unused charitable deduction can be carried forward for five years.

When the CRT sells the stock back to the business, it pays no taxes on the transaction because it is a tax-exempt entity. Portions of each payment from the CRT to the former business owner may be taxed as: (1) ordinary income; (2) capital gains (at 15% through 2008); (3) tax-exempt income; or (4) tax-free return of basis.

With proper planning, the largest portion of the payment could be taxed as a capital gain. Using a CRT in this manner will spread capital gain taxation over the payment period, similar to an installment sale.

Transfer of the business interest to the CRT reduces the value of the business owners and spouses taxable estate, thereby producing estate tax savings. Life insurance proceeds in the ILIT will also be kept out of parents taxable estates, passing tax-free to children as pre-determined by terms of the trust.

Assuming gifts to the ILIT for life insurance premiums stay within the gift tax annual exclusion, the transaction also takes place free of gift tax implications.

Without adequate planning, business owners often struggle to find a business transfer solution which provides them with full, fair market value for their business. By using the CRT strategy, business owners benefit by being able to transfer their business at fair market value to the CRT. Life insurance inside the ILIT may be used for estate tax liquidity.

In addition, the charity benefits through access to the remainder interest in the CRT. The idea of lifetime recognition by a favorite charitable cause may also be attractive to some business owners.

While the CRTs benefits are many, there are some practical limitations to consider. The vehicle is not appropriate for S corporations because a CRT may not own S corporation stock. S corporation owners could, however, terminate the S election prior to the CRT transaction.

Until the 2003 tax act, business owners needed to be careful in constructing the transaction to avoid dividend treatment of the redemption through application of the dreaded attribution rules. However, since dividends are now taxed at the capital gain rate of 15%, at least through 2008 under current law, this is less of an issue.

It is also important to avoid the appearance that redemption of the stock is a binding legal obligation of the CRT or that the CRT is otherwise compelled to redeem the stock.

The entire capital gain will likely be taxed in the current year if the IRS believes such binding obligation existed.

Although some caution is in order, as is always the case with advanced planning techniques, for many business owners the far-reaching tax benefits of this approach will be hard to beat.

Pete Leo, J.D., CLU, ChFC, LLIF, is associate director-advanced solutions at Principal Life Insurance Company. You can e-mail him at Leo.Pete@principal.com


Reproduced from National Underwriter Life & Health/Financial Services Edition, February 11, 2005. Copyright 2005 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.