Lifetime transfer strategies for succession planning


A significant part of estate and succession planning focuses on the lifetime transfer of property out of the senior generation’s taxable estate to or for the benefit of children, grandchildren and, perhaps, future generations of beneficiaries. Whether part of a succession or an exit strategy, property transferred often includes ownership interests in an operating business.

There are a number of reasons why a privately held business owner would want to make lifetime transfers of interests in the business. From a tax perspective the reasons include the following:

  • Gift tax is cheaper than the estate tax. Despite having the same 40% marginal rate, the estate tax (imposed on property transfers at death) is more expensive than the gift tax (imposed on property transfers during life). The estate tax is “tax inclusive,” — assessed on the cash used to pay the tax, while the gift tax is “tax exclusive,” -- the cash to pay the tax is not also subject to tax.
  • Greater opportunities for valuation discounts. Both the estate tax and the gift tax are imposed on the value of the property transferred. However, the focus for valuation for the estate tax is different than that for the gift tax. The estate tax focuses on what the individual owned at the time of death. The gift tax focuses on the property that is actually transferred. If the owner dies with voting control, the entire block of interests will be valued as a control block. If, on the other hand, the owner gifts during life a portion of the block that lacks control, then that portion will be valued as lacking control.
  • Value of tax benefit related to applicable tax rate. The value of the tax benefit which results from the tax basis step-up by reason of owning property at death is realized at capital gains rates (currently 20% federal, plus 3.8% in the event of passive ownership of a flow through entity). This is less than the tax benefit earned when the value escapes estate tax at 40%.
  • Tax savings allow for profitable business growth. Since a business can be viewed as a source of liquidity for purposes of meeting the estate tax obligations at death, each dollar of tax savings achieved through a lifetime transfer is a dollar that can be used by the business to grow into the future. Thus, this tax savings enhances the prospects for a successful transition of ownership to the next generation of owners.

Based on the foregoing, lifetime transfers of interests in the business form a significant part of the long-term strategic planning of the privately held business owner. A transfer strategy known as a freeze allows a business owner to transfer future growth to junior generation members free of both the estate and the gift tax. The freeze strategy has several variations including: outright gift, outright loan, installment sale, Grantor Retained Annuity Trust (GRAT), Charitable Lead Annuity Trust (CLAT), and a Preferred Partnership. Proper structuring (including use of grantor trusts) can also allow for income and gift tax avoidance on initial funding and implementation of the freeze.

In its simplest and most common form, a freeze is an intra-family installment sale that works as follows:

  1. A parent sells interests in the business to a child in exchange for an installment promissory note.
  2. The promissory note has a face value equal to the fair market value of the stock sold.
  3. The interest rate charged on the note is set at the minimum rate required by the IRS in order for a note between related parties to have a fair market value equal to its face value. This minimum rate is commonly referred to as the Applicable Federal Rate (AFR), which is directly tied to yields on Treasury bonds.
  4. By doing this, no gift tax would be owed on the initial transfer.

Economic conditions and timing are key variables that will impact the success of the transaction. The freeze works best when the future growth of the business interest transferred exceeds the interest rate required to be used.

Implementing a long-term succession strategy can be a daunting exercise with numerous variables. Lifetime ownership transfers, including an estate freeze, are often a cornerstone of a private business owner’s succession plan. Consulting outside advisors can provide insight and advice in guiding the private business owner in the development and implementation of a long-term succession strategy including a lifetime ownership transfer plan.





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