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October 05, 2008 at 04:00 PM
What was once considered a cutting edge type of business organization has now become mainstream: S corporations dominate the choice of tax entities. This is true in spite of the explosion of pass-through entities taxed as partnerships.
One motivation for forming an S corporation is the ability to secure both the limited liability of a C corporation and the conduit tax treatment of a partnership. Also, selling an S corporation is often tax-efficient, and losses from riskier ventures can be passed through to offset income earned outside the business. Thirdly, owners are often motivated to save payroll taxes through corporate distributions rather than take income as wages.
There are, too, estate and business exit planning opportunities for S corporations. It follows advocates of solutions that address S corp owners’ needs will get the “leg-up” on the competition. The proliferation of S corps has brought forth techniques tailored to achieve the owners’ financial goals. The remainder of this article discusses how these stratagems can be leveraged with life insurance.
S Corporation opportunities just below the surface
Two concerns quickly dominate every discussion regarding transferring a family business: taxes and control. Too often, these issues threaten the existence of a business while undermining a successful transition to junior family members. This modern Scylla and Charybdis represent twin challenges that even the best financial professionals may be hard-pressed to successfully navigate.
Financial professionals who capitalize on smart solutions just below the surface will successfully plot a course through these troubled waters. The sale of an S corporation to an intentionally defective irrevocable trust (IDIT) may represent just such an opportunity.
Selling an S Corp to an IDIT: taxes and control
An intentionally defective irrevocable trust may be the perfect device to transfer a family-owned S corporation to the next generation. With a properly drafted trust, considerable tax and control leverage may be achieved. The parents are considered owners of the business for income tax purposes while the trust is treated as a separate entity for transfer taxes. Establishing an accurate initial valuation through a certified business appraiser is vital to prevent unwelcome IRS scrutiny.
Initially, the trust is established and funded with “seed money” to ensure the trust is deemed a bona-fide purchaser of the transferred asset. Typically, 10% of the transferred asset is sufficient for funding; a portion of the parent’s respective $1 million gift tax exemption can be used for this purpose. The parents can then recapitalize the business into voting and nonvoting stock. This does not create a prohibited second class of stock as long as the difference in voting rights does not create unequal distribution and liquidation preferences.
The parents then sell a large portion of the nonvoting shares to the IDIT in return for a promissory note. Because the IDIT is made defective, the parents recognize no gain or loss on the sale. Further, the payment of income taxes attributable to the trust are not considered gifts to the trust beneficiaries.
The parents can spend down the estate without using their annual gift tax exclusion or gift tax exemption. Consequently, the trust can accumulate more wealth for the beneficiaries than would be possible if the trust were responsible for payment of taxes. The result is a highly effective “estate freeze,” as all income and appreciation within the trust enhances the inheritance for the grantors heirs.
Further goals can be accomplished if an interest only note is used to purchase the stock. With interest rates at historic lows–the long-term applicable federal rate is currently 4.6%–the estate freeze can be maximized because the interest obligation can be funded with business profits rather than purchased assets.
