Having worked with owners in the plastics industry for 16 years, I often come across the business owner whose goal is to leave the family business to the child in the business. My question to the owner is “how and when?”
If there is no planning and the business owner passes away, the business usually goes to the surviving spouse. If the business continues to grow from the time of the first death until the death of the surviving spouse, the higher business value will only create a higher estate tax. If the surviving spouse does not work in the business (unless the business is an “S” Corporation) any income he or she receives will be perceived as unreasonable compensation and taxed at both the corporate and individual levels.
Upon the death of the surviving spouse, the business will transfer to the child — but only if there is enough liquid cash to pay estate taxes. If there is enough cash, are the remaining assets sufficient to create fairness among the children not in the business?
If the business goes to the child upon the business owner's death, there are estate taxes payable in nine months. Who is responsible for the taxes? Usually the surviving spouse won't want to pay them; after all, they didn't receive the business. Also, the surviving spouse might need the cash to maintain a certain standard of living. If the child is responsible for the estate taxes, do they have the money to pay them? Even if they do, the child cannot pay the taxes on behalf of the deceased business owner.
The business owner may wish to retire and gift the business to the child, alleviating the estate tax problem. But now gift taxes are due and payable by April 15 of the following year. The business owner could sell the business to the child, but that rarely works. Just to net a dollar, the child must make $1.50, paying 33 percent in taxes. The dollar is paid to the seller, who pays income taxes on the interest portion of the payment and capital gain taxes on the remaining portion. All in all, for every dollar the child makes, the seller nets about 35 cents. That is why 70 percent of all closely held corporations never make it to generation No. 2 and 90 percent never make it to generation No. 3.
Many business owners assume Congress will pass retroactive legislation to restore the exemption on estate taxes to $3.5 million per person. But that's just speculation. For 2010 there are no estate taxes; however, the way the law is written, if the president, the House and the Senate do not address the issue, the exemption will revert to $1 million per person with a top marginal tax bracket of 50 percent in 2011.
Though the government created these financial hurdles, it has also given us the tools to accomplish the goal in question. A single tool will not work best in every situation, but there is a tool that's used more often than not: a grantor retained trust or GRT.
A GRT is a trust created to move wealth to children without gift or estate taxes, while providing a level of protection against future lawsuits, claims and judgments. The grantor (business owner) creates the GRT and transfers the business to the trust.
The trust is set up for a number of years (typically five to eight years) during which time the grantor retains full control of the business and their income. Because the trust is structured so the grantor gets back an amount equal to their salary over the GRT term of years, the payments are calibrated to pay back the grantor's initial contributions.
In addition, factoring in the time value of money from when the transfer is made to when the children actually receive the business, a business owner can expect to transfer the family business for 20 cents on the dollar. In other words, a $1 million business can be compressed to $200,000 in the eyes of the Internal Revenue Service.
When the GRT term is reached, the business passes to the grantor's children or to a trust for their benefit. Should the grantor wish to add the appropriate language to the trust, the business remains in trust for the benefit of the children and passes to the grandchild free of all estate and gift taxes as well.
As with all great tax planning tools there is a catch. If the grantor structures the GRT trust for five years, the grantor must live five years and one day — the grantor must outlive the trust period. A GRT must be structured so there are enough years to obtain a good discount on the asset being transferred, yet short enough to obtain high probability of outliving the trust.
Even if the probability of outliving the trust is high, there is a chance the grantor will die prematurely. With this in mind, the grantor often obtains a life insurance policy owned by the children. In the event the grantor dies, the children receive the death benefit and use the proceeds to buy the business for the surviving spouse, who then will have adequate cash to maintain their standard of living and the children will own the business.
Should the grantor outlive the trust, the grantor has two options, to keep the insurance policy or cancel the policy, but that choice will be made at that time.
Kevin La Mont is president of advance planning and investments for La Mont Group in Irvine, Calif.