Help Business Owners Play Beat the Clock
Alarm clocks kill dreams. And they strike without warning. Alarm clocks are ticking for millions of family-owned businesses in the United Statesmany of them S Corporationswhose owners plan to pass their companies to their children. If these business owners fail to take the right planning steps, die prematurely or both, the alarm will sound on their dreams of transferring their business to the next generation.
You can help your clients who own small businesses to silence these alarms before they ever sound. You can do so in part by employing an increasingly popular planning technique, the Grantor Retained Annuity Trust. A GRAT can reduce capital-depleting gift and transfer taxes that can make it financially prohibitive to pass a business to the next generation.
A GRAT can also generate a steady stream of income for the business owner. Your client can accomplish these objectives by establishing a GRAT with help from a qualified attorney.
GRATs are especially popular with S Corps, limited liability corps and other closely held businesses with steady profits, particularly those with large real estate holdings. Because IRS regulations clearly define the tax treatment of GRATs, advisors increasingly see the vehicle as an alternative to Family Limited Partnerships (FLPs) for passing assets to future generations.
To illustrate the GRATs value, consider the example of Fred, president of Rent Properties, a $5 million, closely held real estate business that owns and manages apartment buildings. Fred, 55, and his wife, Ethel, want to transfer the business, established as an S Corp, to their daughters, Kelly and Melanie, in 15 years.
Fred places $4 million of RPs stock, which amounts to 80% of his business, in a GRAT. During the next 15 years, the GRAT will generate $300,000 a year (at a hypothetical 7.5% annually).
Using the applicable federal rate or AFR (determined by consulting an IRS table) of 4.6%, Freds gift to his children is approximately $1 million, which uses his applicable gift tax exclusion amount. After 15 years, the GRAT dissolves and 80% of Rent Properties passes free of gift taxes to both Kelly and Melanie.
How so? The longer Fred holds the GRAT and the more income he receives from it, the smaller the value of the business for gift tax purposes.
One problem remains: If Fred expires before the GRAT, the entire value of his business could be subject to estate taxes. This could create financial headaches for his daughters. Since estate taxes in 2005 start at 45% for assets valued at more than $1.5 million, Freds premature death could even force his daughters to sell the business.
One solution is to create as much liquidity as possible to cover estate tax that Kelly and Melanie may owe on Freds business should he die prematurely. Because the business is worth $5 million and the estate tax exemption is $1.5 million, Freds daughters potentially have an estate tax liability of $1.6 million, or 45% of the remaining $3.5 million.
Freds financial advisor recommends the purchase of a permanent life insurance policy with a $2 million death benefit to create liquidity for his estate. An irrevocable life insurance trust (ILIT) is created for the policy to protect the death benefit proceeds from the federal estate tax.
The cost of insuring Fred is $35,200 in annual premium for 15 years. If he chooses, Freds company can use company dollars to buy the policy and allow him and his wife to further leverage their annual gift tax exclusions.
Fred could consider buying a term policy instead of a permanent policy for the 15-year term of the GRAT. However, a permanent policy has several advantages over a term policy. The death benefit from a permanent policy provides liquidity for Freds estate beyond the 15-year term of the GRAT. Fred has other assets that could potentially be subject to federal estate and state death taxes.
The permanent policy can also provide Kelly and Melanie with death benefit proceeds to help settle Freds estate, help them expand the business, or meet other personal financial objectives. In addition, the permanent life insurance can be used to equalize the value of Freds estate for other heirs not active in the business.
The alarm clock can toll for the owners of small businesses at any moment. With your help, they can help ensure the proper plans are in place to “beat the clock” and keep their businesses ticking for the next generation.
Dick Plesha is a senior account executive for Hartford Life Insurance Company, a subsidiary of Hartford Financial Services Corp. He can be reached at [email protected].
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.