Editor: Michael D. Koppel, CPA, PFS
Those who make a living providing tax planning services to clients are painfully aware of how difficult their jobs become in tough economic times. When times are good and profits are high, clients are (mostly) happy to pay for help in minimizing their tax liabilities. However, when profits are low or nonexistent, clients can be reluctant to focus on tax planning, let alone pay a professional to provide those services.
Understandable as this attitude may be, it is a mistaken and dangerous one. Conditions that typically exist during economically depressed times present opportunities for business owners to do things that may not work under more favorable economic conditions. The planning ideas presented in this item focus mainly on ownership interests in closely held businesses, although some of the techniques could work with publicly traded securities as well.
For a significant portion of the past year, the United States has experienced a low interest rate environment. This began with the Federal Reserve taking action to resolve the financial institution crisis and now looks as though it could last for a while longer. Such an environment has a direct affect on tax planning because lower interest rates make various planning strategies more attractive.
Grantor retained annuity trust (GRAT) planning is one such strategy. Taxpayers normally use GRATs to transfer to others property that they expect to appreciate in value. Essentially, the grantor funds a trust with this property, and the trust is required to pay an annuity back to the grantor during the trust’s term.
The annuity that the trust pays back to the grantor is determined by reference to the Sec. 7520 rate, which the IRS publishes each month along with the applicable federal rates (AFR). This interest rate, the term of the trust (as decided by the grantor), and the value of the property at the time it is contributed to the trust are used to determine the amount of the annuity that must be paid. At the end of the GRAT’s term, whatever is left in the trust is distributed to the trust’s beneficiaries. The GRAT is then terminated.
The end result is that the grantor has transferred to the GRAT’s beneficiaries any growth in the value of the trust’s property that exceeds the Sec. 7520 rate. More often than not, these beneficiaries are family members of the grantor. If the maximum calculated annuity is paid, the transfer of this growth is done free of any gift tax implications. A major disadvantage of this technique is that the grantor must survive the trust term for the trust property to be excluded from the grantor’s estate. Therefore, planners often create multiple GRATs and vary the terms of the trusts to balance the risk of the grantor’s untimely demise with the potential benefits that GRAT planning provides.
Clearly, a GRAT is worth considering today because lower interest rates reduce the amount of the annuity that the GRAT must pay. This makes it easier for the growth in the value of the trust property to exceed the Sec. 7520 rate, thereby increasing the amount left in the trust to be transferred to the beneficiaries when the GRAT is terminated. In addition, the use of ownership interests in a closely held business to fund the GRAT can improve the possible savings even more.
Transfers to Family Members
The current economic downturn has had a negative effect on businesses in just about every industry and profession. As a result, it is not unusual for a business to experience a reduction in value as compared with previous years. The silver lining in this dark cloud is that the reduced value can make it more cost effective to transfer a significant portion of the business to family members using a GRAT.
For example, when a business owner contributes nonvoting units of a closely held business to a GRAT, the annuity is based on the value of the units discounted for lack of marketability and control. Limited liability company units and/or S corporation stock also can be used. S corporation eligibility is not endangered as long as the grantor is an eligible S corporation shareholder because of the grantor trust status of the GRAT. And the trust can pay the annuity in cash or ownership units, which eliminates cashflow issues. The more the value of the ownership interests increases after the initial contribution, the better the plan works, because lower valuations at the time of the GRAT make it more likely that subsequent value increases will exceed the Sec. 7520 rate (perhaps by a large margin).
The planning associated with GRATs is complex and should be undertaken only with the assistance of competent legal counsel. This complexity also results in significant fees charged by all the advisers involved, so the technique is appropriate only for the transfer of business interests of significant value. However, under the right circumstances, the potential benefit can be enormous, especially in those situations where the value of the business is expected to skyrocket once economic conditions improve. Therefore, there is no time like the present to explore this opportunity with appropriate clients.
Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.
For additional information about these items, contact Mr. Koppel at (781) 407-0300, or firstname.lastname@example.org.