The best approach to selling one’s business depends on the particular circumstances. For those whose net worth is well within the estate tax exemption, for example, it might be best to focus on reducing income taxes. But those who expect their estate to be significantly larger than the exemption amount may be more concerned with estate tax reduction. This article offers four estate-tax-wise techniques to transfer a family business — all of them involving “defective” trusts.
For many people, a family-owned business is their primary source of wealth, so it’s critical to plan carefully for the transition of ownership from one generation to the next.
The best approach depends on your particular circumstances. If your net worth is well within the estate tax exemption, for example, you might focus on reducing income taxes. But if you expect your estate to be significantly larger than the exemption amount, estate tax reduction may be a bigger concern.
1.IDGT. An intentionally defective grantor trust (IDGT) is an income defective trust. As such, it can be a highly effective tool for transferring business interests to the younger generation at a minimal gift and estate tax cost.
An IDGT is designed so that contributions are completed gifts, removing the trust assets and all future appreciation in their value from your taxable estate. At the same time, it’s “defective” for income tax purposes; that is, it’s treated as a “grantor trust” whose income is taxable to you. This allows trust assets to grow without being eroded by income taxes, thus leaving a greater amount of wealth for your children or other beneficiaries.
The downside of an IDGT is that, when your beneficiaries inherit the business, they’ll also inherit your tax basis, which may trigger a substantial capital gains tax liability if they sell the business. This result may be acceptable if the estate tax savings outweigh the income tax cost. But what if the value of your business and other assets is less than the current estate tax exemption amount, so that estate taxes aren’t an issue? In this case, you might consider an estate defective trust.
2. Estate defective trust. Essentially the opposite of an IDGT, an estate defective trust is designed so that beneficiaries are the owners for income tax purposes, while the assets remain in the estate for estate tax purposes. This technique provides two significant income tax benefits. First, assuming your beneficiaries are in a lower tax bracket, this strategy will result in lower “familywide” taxes. Second, because the trust assets remain in your estate, the beneficiaries’ basis in the assets is “stepped up” to fair market value, reducing or eliminating their potential capital gains tax liability.
This strategy assumes you’ll have little or no estate tax liability. If your estate increases unexpectedly or Congress decides to reduce the exemption, the benefits may be lost.
3. Sale to an IDGT. If you prefer to sell the business to your children, consider an installment sale to an IDGT (with the payments funded by the business’s cash flow). Selling to a trust allows you to retain some control over the business while removing it from your taxable estate. And by structuring the transfer as a sale, you’ll avoid gift taxes. Also, when you sell assets to a grantor trust you’re essentially selling them to yourself, so there are no capital gains taxes on the transaction.
4. BIDIT. One drawback to selling to an IDGT is that, if you die before the sale is complete, the IDGT will be converted to a non-grantor trust and your estate will be hit with a capital gains tax liability (usually based on the present value of all unpaid installments). To avoid this risk, some taxpayers have started using business intentionally defective irrevocable trusts (BIDITs). A BIDIT works like an IDGT, except it’s established by the business itself rather than the owner. Because the grantor is an entity rather than a person, this technique eliminates the income tax risk associated with the grantor’s death.
Be aware that the BIDIT is relatively new and untested, but its proponents believe that it can provide a variety of estate tax, income tax and asset protection advantages over an IDGT.
If you own a family business, be sure to review your ownership succession plan in light of recent tax developments. Determining the right strategy to implement when transferring ownership of the business to heirs depends on the value of your business and other assets and the relative impact of estate and income taxes.