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.
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.
To leverage the tax benefits of a GRAT, the Burnetts set up an irrevocable trust for a specified number of years, naming their children as trust beneficiaries. They transfer the business interest to the trust, anticipating that the business will continue to appreciate in value.
The business owner retains the right to receive income based on a specified sum or fixed percentage of the value of the business interest transferred to the trust. This strategy works whether the plan is to sell the business or allow it to continue as a going concern. In either event, the grantors will reap the financial benefits of ownership while enjoying the ultimate reward of a reduced estate.
Upon creation of the GRAT, an actuarial calculation is performed to determine the present value of the amount that will pass to the trust beneficiaries. This amount will be deemed a gift from the grantor to the beneficiaries, resulting in a gift tax liability or a reduction of the grantor’s lifetime gift exclusion.
Only the value of the remainder interest paid to the beneficiaries of the trust is subject to gift taxation. This value is determined by subtracting the present value of the income stream retained by the business owner from the fair market value of the business interest being transferred. Gift tax can be avoided using a “zeroed out” GRAT, which occurs when the value paid to the business owner/grantor is equal to the value of the business transferred to the GRAT. Of course, much rides on future appreciation of the business if the zero GRAT is used.
A GRAT can also provide business valuation discounts, which allows the business owner’s privately-held shares to be valued at less than their current book value, since the shares lack liquidity and marketability on the open market. A valuation discount of 30% is common and would enable the small business owner to gift the asset to the trust, minimizing the gift tax liability while leveraging the gift taxes paid.
During the term of the trust, payments to the business owner/grantor must be paid at least annually. These payments are derived from the current income of the business or from the proceeds from the sale of the business and the investments chosen thereafter. Because the GRAT is considered a grantor trust, Ronald and Martha will pay income taxes on all income generated by the trust at his or her individual income tax rate. Should either Ronald or Martha die before the designated term of the trust, the payments would continue to be paid to the estate and the current value of the business interest is still considered part of the estate for estate tax purposes.
If the trust term is outlived, the business interest, including appreciation and earnings, is paid to the trust beneficiaries, and the business interest is removed from the estate. Clearly, the goal is to choose a trust term the grantor is likely to outlive. Also, to plan for the possibility that the grantor will die during the trust term, a term policy could be purchased to cover estate taxes due.
While both the CRUT and GRAT strategies are tax-efficient, the advisor must weigh the client’s actual needs as concerns, as each case is different. Each of the strategies includes an irrevocable trust that deprives the grantor of ownership benefits. Also to be considered are the costs associated with trust creation and ongoing trust maintenance.
Most clients share the common goal of maximizing wealth transfer while minimizing taxation. Both the CRUT and the GRAT offer a client the opportunity to transfer business interests or replacement assets to the next generation while simultaneously removing that interest from the owner’s estate. In an uncertain estate tax environment, both strategies are valuable tools that provide an opportunity to increase the assistance the advisor can bring to their clients.