Scott Goldberger, Estate and Trust Director at Kaufman, Rossin & Co. and John R. Anzivino, Estate & Trust Principal at Kaufman, Rossin & Co., contributed this article to BusinessNewsDaily’s Expert Voices: Op-Ed & Insights.
Do you have a succession plan for your business? Most business owners would like their families to benefit from their business and wealth, but they may also have other concerns, such as maintaining their lifestyle, keeping control of the company, minimizing gift or estate taxes and safeguarding against financial predators.
Now is an opportune time to start or update your plan because some of the most powerful estate planning techniques are likely to be reduced or eliminated in the near future. Earlier this year, the Obama Administration released its Fiscal Year 2014 Revenue Proposals, highlighting certain tax law changes that are under consideration – including several in the estate, gift and generation-skipping transfer tax arenas.
Back in 2009
Under current law, the maximum tax rate for estate, gift and GST tax purposes is 40 percent and, for each of those taxes, the exclusion is $5 million (indexed for inflation to $5.25 million in 2013). Under the Proposal, beginning in 2018, we would revert back to 2009 law, when the top rate was 45 percent and the exclusion amount was $3.5 million for estate and GST tax, but only $1 million for gift tax. Also, there would be no indexing for inflation.
GST tax exclusion is not forever
The GST tax is a 40 percent tax imposed on gifts and bequests to transferees two or more generations younger than the transferor (e.g., a gift to your grandchildren). As noted above, the GST tax exclusion is $5.25 million in 2013. If the GST tax exclusion is allocated to a trust, no GST tax is imposed on the trust assets or on distributions to the beneficiaries. Moreover, as long as the assets remain in trust, they are not subject to estate tax when the beneficiaries die.
Historically, state laws restricted the number of years that a trust could last. Today, many states permit trusts to continue in perpetuity or for an extended term, such as 500 years or 1000 years. If the GST tax exclusion is allocated to these so-called “dynasty trusts,” the trust assets may compound over several generations free of transfer tax.
In an attempt to curb this practice, the Proposal specifies that on the 90th anniversary of the trust’s creation, the allocation of the GST tax exclusion would terminate. The rule would apply only to trusts created after the enactment of the new law and to post-enactment contributions to a preexisting trust.
With a “grantor trust,” the grantor (i.e., creator) is treated as the owner and reports the trust’s income and deductions on his personal income tax return. Transactions between the trust and grantor are ignored. If the trust is irrevocable, transfers to it generally are not included in the grantor’s estate upon his death.
Grantor trusts are often used to shift wealth from the grantor to the trust’s beneficiaries without the imposition of gift or estate tax. For example, a business owner (the grantor) could sell an interest in his business to a grantor trust in exchange for a promissory note. He does not recognize any gain (or loss) on the sale and does not pay income taxes on the note interest. Any income or appreciation on the trust assets after the sale inures to the benefit of the trust outside of the business owner’s estate. Moreover, when he pays income tax on the trust’s earnings, it functions like an additional tax-free gift to the trust.
The Proposal seeks to reduce the benefits of this technique by requiring the post-sale income and appreciation to be included in the grantor’s estate upon his death. The income and appreciation is treated as a gift if, during the grantor’s lifetime, it is distributed to the beneficiaries or grantor trust status ceases. This rule would not apply to sales consummated prior to the enactment of the new law.
Minimum term for GRATs
A grantor retained annuity trust is an irrevocable trust funded with assets expected to appreciate in value. The GRAT pays the grantor an annuity for a term of years. At the end of the term, the intended beneficiaries receive the balance of the GRAT assets. The interest rate used to compute the annuity is the IRS’s 7520 rate or “hurdle rate,” which for July 2013 is 1.4 percent, close to an all-time low. Any income or appreciation in excess of the hurdle rate passes to the beneficiaries free of transfer tax.
The main risk with a GRAT is that if the grantor dies during the term, the trust assets (or at least the portion needed to produce the annuity) are included in the grantor’s estate for estate tax purposes. For that reason, and to minimize the chance that years of good investment performance are offset by bad years, short-term GRATs have been the most popular. Under current law, a term of as little as two years is permitted.
The Proposal would require that a GRAT have a minimum term of 10 years, thereby increasing the risk that the grantor fails to outlive the term, which would eliminate any anticipated transfer tax benefit.
Valuation discounts in jeopardy
Surprisingly, the Proposal does not address valuation discounts for transfers of interests in family-controlled entities. However, such discounts have been in jeopardy for several years, and it is expected that the Treasury Department will soon issue regulations to restrict or eliminate such discounts.
Based on generally accepted valuation principals and case law, non-controlling interests in LLCs, partnerships or corporations typically may be discounted for estate and gift tax purposes, often by as much as 30-40 percent, to reflect lack of control and lack of marketability. The discounts allow the taxpayer to transfer additional wealth to beneficiaries free of estate and gift tax. It is expected that the new regulations will make discounts unavailable for interests in family-controlled entities that are transferred to family members or to trusts for their benefit.
These regulations could be issued by the Treasury without Congressional consent. Therefore, the elimination of valuation discounts is perhaps even more imminent that those in the Proposal.
If you haven't started or updated your business succession and personal estate plans, talk to your attorney and your accountant; it’s important to make sure everything is in order long before the plan will be executed — especially given the potential tax changes that are on the horizon.
The views expressed are those of the author and do not necessarily reflect the views of the publisher.