As a result of the increase in the federal gift tax exemption in 2018, now is an ideal time to utilize gift tax planning where an older generation wishes to transfer ownership of a closely held family business to a younger generation. The federal gift, estate and generation-skipping transfer tax exemptions are currently $11,400,000 and indexed for inflation. In 2026, however, the federal gift, estate and generation-skipping transfer tax exemptions are scheduled to reduce to $5,000,000 as indexed for inflation.
Overall considerations in transferring a closely held family business
There are many options to consider in transferring a closely held family business and each family must determine what methods are best for their situation. These methods include grants of stock ownership as compensation, sale of stock, either outright or in trust, to a younger generation and gifts of stock, either outright or in trust, to a younger generation. In many cases the gift tax value of the business interest is discounted for minority interest and lack of control.
Why do many families prefer gifts to trusts?
There are also significant non-tax advantages of a sale or gift of stock using a trust. First, the older generation can control the ultimate ownership of the stock for the younger generation. Second, a trust can provide asset protection for the younger generation from creditors, including divorcing spouses. Third, a trust can establish very specific terms under which the income or eventual sales proceeds are held for the benefit of a child and future grandchildren.
There are significant tax advantages, including leveraging gift and generation-skipping transfer tax exemptions, as well as income tax benefits of using a trust. The grantor (donor) of the trust can allocate generation-skipping transfer tax exemption to the trust so that the trust will not be taxed in a child’s estate and can pass free of estate tax to grandchildren or remote descendants. This will provide the ability for the family business to continue through the generations, assuming that is the goal of the family. Income tax advantages include the ability for the grantor to minimize use of the gift tax exemption, defer or eliminate gain on a sale of the business and continue to pay income taxes on the transferred business interests using the GRAT or IDGT techniques described below.
Structuring a gift of business interests using a Grantor Retained Annuity Trust (GRAT)
A GRAT is a gift tax technique that is ideal for business owners who have already used or do not wish to use their gift tax exemption. Using a GRAT, a donor can transfer future appreciation of gifted business interests for a very small gift tax cost.
Sale to an Intentionally Defective Grantor Trust (IDGT)
An alternative to an outright sale or gift is a sale of business interests to an irrevocable trust established by the grantor (donor) for the younger generation. It is possible to draft this trust as an intentionally defective trust, so that for income tax purposes the trust will be treated as a grantor trust as to the grantor. This means that the sale to the trust will not trigger capital gains to the grantor. Further, the grantor will continue to report all of the income generated by the business interests even though that income is received by the trust. This is a way to leverage the original gift as the grantor’s payment of income taxes is not treated as an additional gift to the trust.
Other significant advantages are the flexibility afforded by drafting the trust to include a provision allowing the trust to reimburse the grantor for income taxes if the grantor does not have sufficient funds to pay the income taxes. Further, in the unlikely event that the succession plan for the family business changes, the grantor has the ability to substitute assets of the trust, which means that the grantor can transfer cash to the trust equal in value to the business interest and take back the business interest.