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February 02, 2005 at 07:00 PM
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.
