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Business Owner's Guide: Wealth Planning Techniques

National Wealth Planning Strategies Group, Chief Investment Office

For many business owners, the day-to-day demands of running a successful business take precedence over long-term considerations like succession planning and personal financial management. But addressing these long-term issues is simply good business. Taking proactive steps in anticipation of a liquidity event long before it happens can help business owners accomplish long-term goals like transferring wealth to loved ones in a tax-efficient manner and reducing future estate taxes.

Your Merrill Private Wealth Advisor can help you think through important business planning questions when considering a business sale or transition:

  • The type of transaction: Is it an outright sale to a third party or a transfer to family through gift or sale?
  • Timing: What is the time frame for the business transaction? Will it happen in the near- or long-term?
  • Control: How much control of the business does the owner wish to retain?
  • Wealth transfer choices: Would you like to transfer equity interests to family or charities? If so, when and how much? Will they be voting or non‑voting interests?
  • Taxes: How much will taxes reduce the proceeds from a sale or transfer? How can the liquidity event be managed more tax-efficiently?

we can work with you and your other advisors to help design and execute individualized strategies that balance business, family and personal needs, while striving to reduce the impact of income taxes on sales proceeds and transfer taxes on business values.

Frequently used strategies include:

Direct Gifts to Individuals or Trusts Grantor Retained Annuity Trust (GRAT)
Sale to an Intentionally Defective Grantor Trust (SIDGT) Charitable Remainder Trust


The following pages offers an introduction to these common wealth planning techniques and their value to business owners. There are other techniques available that may be appropriate depending on your circumstances. Talk to your advisor to determine which approach makes the most sense.

Direct Gifts to Individuals or Trusts

A direct gift of an ownership interest in a business removes the asset, and any potential appreciation on the asset after the date of the gift, from your balance sheet.

Who is it for?
Business owners who wish to reduce their taxable estate by transferring wealth to family members, non‑family members or trusts for their benefit.

What is it?
While there are many sophisticated estate planning strategies available to business owners, a direct gift of a business interest to an individual or a trust is simply a transfer of that interest to an individual or trust.

How does it work?
Direct gifts of business interests primarily occur in two ways:

Annual Exclusion Gift: Annual exclusion gifts can offer significant tax savings if made on a continual basis. You can give away up to $15,000 in 2019 (this amount is adjusted for inflation in subsequent years) to as many recipients as desired without being subject to federal gift tax and without utilizing any of your lifetime exemption amount. Once given, the value of these gifts would no longer be part of your estate and, therefore, would not be subject to estate tax. To the extent the annual exclusion is not used in a particular year, it is lost and does not carry over to the next year. However, a new annual exclusion will be available for that subsequent year.

Lifetime Exemption Amount: Every individual possesses an exemption from federal gift and estate taxes in the amount of $11,400,000 in 2019. This amount is indexed for inflation for subsequent years. The exemption can be used during life, upon death, or partly for each. Due to the sizable amount of the exemption, you can make significant gifts of a family business without using more complicated estate planning strategies. The exemption can be used in addition to annual exclusion gifts.

There are, however, possible drawbacks of lifetime gifts. The gift recipient generally receives the same tax basis the property had while in your hands. In other words, in the event that the recipient sells the property, they are responsible for capital gains tax on the full appreciation. Therefore, lifetime gifts need to balance the estate tax benefits with the potential income tax costs. There are certain planning techniques involving trusts that can shift that gain back to you.

Why use it?
An annual exclusion gift removes the gifted assets, and all future appreciation on those assets, from your taxable estate. A lifetime exemption gift removes from your taxable estate only the future appreciation on the gifted assets.

Valuation Discounts on Interests in Family Businesses

When a gift or sale of a portion of a closely held business is made, a valuation discount for lack of control (also referred to as minority interest) and lack of marketability can provide significant additional gift tax benefits.

The use of discounts has resulted in IRS scrutiny and challenges, particularly when the gift is an ownership interest in an entity other than an active trade or business. In an attempt to curtail discounts for family-controlled entities, the IRS issued long-awaited proposed regulations on Aug. 2, 2016, that could limit valuation discounts.

Soon thereafter, the proposed rules were withdrawn by the IRS, lifting a cloud over discounts for family controlled entities. However, even without these new rules, the IRS may be expected to challenge discounts based on existing legal theories, in cases it deems appropriate.

A business owner wants to transfer a large amount of stock to a child and also transfer smaller amounts of stock to two grandchildren in a tax-efficient way.

Situation explaining A business owner wants to transfer a large amount of stock to a child and also transfer smaller amounts of stock to two grandchildren in a tax-efficient way.

Grantor Retained Annuity Trust (GRAT)

If you are planning for a sale or transfer of a portion of a business, GRATs can provide tax-efficient wealth transfer of the business or its sales proceeds to family or other beneficiaries.

Who is it for?
A business owner planning for a sale or IPO event in the next 2 to 4 years may benefit most from this strategy, but this strategy is also appropriate for a business owner looking to transfer a portion of ownership to the next generation.

What is it?
A GRAT is an irrevocable trust into which a business owner (grantor) can transfer an ownership interest, retaining a fixed annuity payment for a term of at least 2 years. At the end of this period, any remaining trust property (net of the grantor’s annuity payments) passes to the trust beneficiaries outright or in further trust. This technique is specifically sanctioned by the Internal Revenue Code (IRC).

GRATs work best when funded with a business interest expected to significantly appreciate, such as business interests prior to sale or an IPO.

A single-generation wealth-shifting strategy, GRATs are not well suited for transfers to grandchildren or later generations. In addition, should the grantor die during the term, some or all GRAT assets will be taxable in their estate.

How does it work?
As the creator of a GRAT, you generally retain two or more annuity payments from the trust. Those payments will usually be determined so that their present value is equal to the initial value of the business interest transferred into the trust. The rate used to determine present value is determined by the IRS and closely tracks mid-term treasury rates. If the business interest appreciates at a rate in excess of the rate used to determine the present value of the annuity payments, then the GRAT should have value remaining in it at the end of its term. This remaining value, or “excess”, passes free of gift tax to the beneficiaries outright or in further trust.

If the assets in the trust do not outperform this rate, all of the trust assets would be returned to you, the creator of the trust, by way of annuity payments, which is why this strategy is best for highly appreciating assets.

Why use it?
GRATs give you the ability to retain the current value of the assets contributed to the trust, while enabling subsequent growth and appreciation to be transferred tax-efficiently.

Section 7520 Rate

The IRS discount rate that applies to a GRAT is the IRC Section 7520 rate. It is a special rate used to discount the value of annuities, life estates, and remainders to present value, and is revised each month. It is equal to 120% of the mid-term Applicable Federal Rate (AFR). See Applicable Federal Rate further down for additional details.

While a GRAT lasts for several years, the discount rate applied to a GRAT is fixed for the term of the GRAT using the AFR rate that is in effect on its inception date.

A business owner anticipates selling his full ownership in a family business and seeks to tax-efficiently transfer some of the sales proceeds to his children. Well before the sale, the owner transfers 40% of the business to a GRAT when the value of the entire business is estimated to be $12.5 million. The initial value of the 40% ownership is $5 million and increases to $6 million next year, but the business is not yet sold. By the end of the second year, the business is sold for $20 million in cash, for which the GRAT received its proportionate share.

situation explaining A business owner anticipates selling his full ownership in a family business and seeks to tax-efficiently transfer some of the sales proceeds to his children.

Sale to an Intentionally Defective Grantor Trust (SIDGT)

Similar to a GRAT, the SIDGT can help you transfer equity in the business or reallocate proceeds from the sale of a business interest in a tax efficient manner among family or other beneficiaries. Unlike the GRAT, however, this strategy can span generations, enabling potentially greater efficiencies over time.

Who is it for?
A business owner seeking to minimize the ultimate estate tax liability associated with an appreciating interest in a business (or other asset). The strategy is particularly attractive for the business owner who anticipates selling their business and seeks to get that future growth to, or for the benefit of, multiple generations with limited gift tax cost. This strategy is also appropriate for a business owner looking to transfer a portion of the business to children or future generations.

What is it?
This strategy results in a “sale” of an asset to a trust, but is not recognized as a sale for income tax purposes. Therefore the technique is akin to a tax-free swap of an asset. If the assets sold to the trust (e.g., the business interest) earn or appreciate more than the property received in return from the trust (e.g., a promissory note), the excess remains in the trust or with the beneficiaries free of gift tax. The name of the trust refers to the important and favorable income tax treatment of the trust associated with this strategy. It is considered “defective” because the business owner is taxed on income earned by the trust even though the trust receives the economic benefit.

A SIDGT transfers income and appreciation on the sold or swapped assets that exceed the return of the asset received in exchange (generally interest on a promissory note). The interest typically is set at very favorable IRS-determined interest rates.

How does it work?
To initiate a SIDGT, you create a trust (i.e., a “defective grantor trust”), seeding it with a gift of cash or other assets. At a future point in time, you sell an asset (such as an interest in your business) to the trust. In exchange, you typically receive back a promissory note, bearing an interest rate determined by the IRS. There is significant flexibility in structuring the terms of the note. For example, it may provide for interest only or periodic payments of interest and principal. Over time, the cash flow generated by the business interest (or sales proceeds from the sale of the business) can be used to satisfy the note payments.

Why use it?
A grantor trust is considered to be the same taxpayer as you, the creator of that trust. Accordingly, the sale of a business interest by you to the trust does not generate a capital gain. Instead, the trust simply assumes your income tax basis in the asset. Additionally, payments of interest on the note by the trust to you do not generate taxable interest income for as long as the trust remains “defective.” You are responsible for the tax associated with trust income and realized gain. However, those tax payments are, in effect, additions to the trust, but are not treated as gifts under current tax law.

If the assets (e.g., the business interests) generate a total return greater than the interest rate on the note, the difference in value will be transferred to the beneficiaries, free of any gift or estate taxes. Unlike a GRAT, the SIDGT can be used as a generation-skipping transfer vehicle, enabling wealth to be shifted multiple generations free from estate and gift tax. If you die while the note is outstanding, the note will be included in your taxable estate, but the assets (e.g., the business interests or the sales proceeds) should not.

Applicable Federal Rate

The Applicable Federal Rate (AFR) is determined by the IRS and serves as the interest rate on the promissory note in a SIDGT. There are three different types of AFRs: short-term for notes with maturities of 3 years or less, mid-term for between 3-9 years, and long-term for more than 9. The AFRs fluctuate monthly, but the rate is generally fixed for the life of your note.

A business owner seeks to transfer most of the future growth in the business to subsequent generations in a tax-efficient way, while also maintaining some cash flow flexibility. The owner expects the business to grow and appreciate at a much higher rate than current (IRS) interest rates, so the owner “sells” 20% of the business to a “defective” grantor trust, in return for an installment note of 10 years.

Situation explaining A business owner seeks to transfer most of the future growth in the business to subsequent generations in a tax-efficient way, while also maintaining some cash flow flexibility.

Charitable Remainder Trust (CRT)

A CRT offers a thoughtful approach to combining income tax planning with philanthropy.

Who is it for?
A business owner with a strong charitable orientation, and with an expectation that the business would be sold on a near-term basis, may want to fund a CRT with an ownership interest in the business before the sale and avoid an immediate capital gain on that portion of the business.

Alternatively, a CRT may be appropriate for an owner who has already sold a business and is looking to not only offset income from the sale, but wants to benefit a public charity or family foundation.

What is it?
A CRT is an irrevocable trust established by the business owner (grantor) for a fixed term of no more than 20 years or the (joint) lifetime of the owner (and his or her spouse).

During the term of the CRT, an annual payout is made to a beneficiary, typically the owner and/or spouse. The payout may be fully or partially income taxable to the recipient. However, the CRT, itself, does not pay any income taxes. At the end of the term, the remaining assets pass to a charitable recipient.

How does it work?
You could create a CRT and fund it with stock representing ownership of the business, or after the sale of the business using a portion of the proceeds. If the CRT is funded with an interest in a business, the trustee can sell that interest tax-free and reinvest 100% of the proceeds for the CRT. Because the CRT is tax-exempt, no capital gains tax is triggered by the sale. If funded with an interest in your business, the charitable beneficiary needs to be a public charity or a donor advised fund to maximize the income tax charitable deduction. If funded with proceeds from the sale of your business, the charitable beneficiary could be a family foundation or public charity.

The annual payout from the CRT can either be a fixed amount — referred to as an annuity (CRAT) — or a stated percentage of the trust’s annual value — referred to as a unitrust amount (CRUT). In either case, payouts must be no less than 5% and no more than 50% of the value of the CRT.

Tax rules also require that the present value of the charity’s remainder interest (calculated at the commencement of the trust) be at least 10% of the total value of the CRT. In today’s low interest environment, it is generally difficult for those under the age of 60 to create a lifetime CRAT and satisfy these rules. However, if all the tax rules are met, the value of the charitable interest can be currently claimed as an income tax deduction on your tax return, subject to usual limits and thresholds.

Why use it?
If funded with a portion of the ownership in a business, the CRT enables that portion to be sold without the imposition of immediate taxes. The CRT can then reinvest the full proceeds on a tax-efficient basis. Annual payments made to you from the CRT may be taxable, and would effectively defer the tax on the sale of the business just like an installment sale.

Contributing Shares to a CRT

Not all businesses can be transferred to a CRT. Shares of a C-corporation can, but shares of an S-corporation cannot be used to fund a CRT without significant tax consequences. Those wishing to use shares of an S-corporation generally should affirmatively elect to terminate the S-status just prior to funding — turning it into a C-corporation. The buyer of the business could then consider re-electing S-status after the sale.

A business owner transfers 30% of highly appreciated stock in his C-corporation to a CRUT. The owner (and trustee) anticipates making a quick sale of the business — within a year after funding the CRUT — and wishes to avoid an immediate income tax on the proceeds from the 30% interest. Instead, the owner will receive an annual payment from the CRUT for his remaining lifetime, while the CRT can invest and reinvest the proceeds tax free.

situation explaining A business owner transfers 30 percent of highly appreciated stock in his C corporation to a CRUT

While these are the most common planning techniques to consider, there are other techniques available, as well. The table below sets forth some of these other techniques. Some are designed to achieve income tax savings while others emphasize estate planning objectives.

Tax transfer techniques and income tax techniques

Learn More

Consult with your private wealth advisor to see what approach makes the most sense for your circumstances.

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