For those fortunate entrepreneurs who are looking to exit successful businesses for a life of leisure using their value to generate additional retirement income, several tax-efficient options are available. Among the most attractive of these are the charitable remainder trust and the grantor retained annuity trust.
The charitable remainder trust lets the business owner avoid capital gains tax liability, create a charitable legacy, supplement retirement income, receive a significant income tax deduction, and reduce estate taxes. The transfer of business interests into a CRT enables the owner to sell the business without having to pay capital gains taxes, thereby leveraging the full value of the sale proceeds.
Let’s look at an example. Ronald and Martha Burnett, both aged 60, have a $4 million estate, including ownership of a $3 million business they own together, which they established 15 years ago with a $50,000 investment. The business has become successful and several competitors have approached them about purchasing it.
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While a sale looks attractive, they are concerned about the money they will lose to capital gains taxes. Though the Burnetts’ children have never been interested in the family business, they want the children to receive as much of the value of the estate as possible.
After speaking with their tax advisor, the Burnetts establish a charitable remainder uni-trust and make a gift of the business interests to the CRUT, naming their favorite charity as the remainder beneficiary. The trustee sells the business for $3 million and invests those proceeds into a portfolio (potentially that of an annuity) from which the trustee will pay 7% of the CRUT’s year-end value to Ronald and Martha annually, as required by the terms of the CRUT.
Because of the avoidance of capital gains taxes, the Burnetts can leverage the full sale proceeds, allowing them to receive more money annually than they would otherwise if they only had the post-capital gains tax value working for them.
To replace the asset transferred to the CRUT and, thereby, avoid reducing the estate their children will receive, Ronald and Martha can establish a wealth replacement trust. The WRT would purchase a second-to-die life insurance policy and, once Ronald and Martha have died, the trust would receive the death benefit from the life policy free of both income and estate taxes, with the trustee distributing the proceeds to the trust beneficiaries. Moreover, the Burnetts can make the premium payments to the WRT from the CRUT payments they receive.
In addition to an income stream for life, Ronald and Martha also would receive an immediate income tax deduction equal to the present value of the interest that will ultimately pass to charity. In this case the deduction could be near $500,000. Subject to income limitations, the deduction can be taken in the current year with the remainder carried forward for up to five years.
Another exit strategy available to the Burnetts is a grantor retained annuity trust. A GRAT can transfer future appreciation of the business to family members free of gift and estate taxes, provided the small business owner, the grantor of the trust, survives the trust term.