May 2003
By JAMES S. ANCHIN, CPA
Current economic conditions and historically low interest rates make it worthwhile to revisit a wealth transfer tool that is especially valuable to contractors.
If you're like many contractors, you have spent a great amount of time and energy building up the family business. Now, as you near retirement and get ready to "pass the torch" on to the younger generation, you're hit with bad news: you'll be slapped with big gift taxes or capital gains taxes if you give the business to your children or sell it to them.
There is a way out of this predicament, however, and it works especially well with S corporations, particularly with today's historically low interest rates. By establishing a trust and putting shares of your company into it, you'll receive an annuity (a guaranteed stream of income) for a fixed period of time into the future, from the trust's earnings, which come from the profits of your company.
When that periods ends, your annuity also ends, disolving the trust. The shares of stock go to your childrenÑfree and clear of gift or capital gains taxesÑno matter how much the company is then worth. (Or, if you wish, you can continue the trust with shares held for future distributions.)
This setup is called a Grantor Retained Annuity Trust (GRAT).
This arrangement offers two major advantages to contractors. First, because you're not selling your company to your children, you don't owe any capital gains taxes. Second, because of the way you can value minority interests in a family business, gift taxes are minimized.
Here's an example of how a GRAT might work in practice. Take the case of 52-year-old Harry, who has three children who work in a family construction business which has a net worth of about $2.5 million and has elected S corporation status. Each child owns 8-1/3 percent of the business and Harry owns the remaining 75 percent.
Harry decides to put his shares, representing 75 percent of the business, into a GRAT. Now the trust (rather than Harry directly) gets 75 percent of the company's distribution. Harry, in turn, gets an annuity from the trust; in his case, $162,000 a year for the next 10 years. This annuity is a fixed amount, regardless of the company's earnings. There's no income tax break, since Harry is subject to tax each year on his 75 percent share of the company's earnings.
However, there is a break in terms of how the shares that Harry transferred to the trust are valued for gift tax purposes. A concept called the minority discount, comes into play. Minority interest in a business is worth considerably less than its pro rata share of the entire company's value because it is not readily marketable.
Even though Harry's family will retain control of the company, none of his three children will own a majority stake in the business. So Harry uses the minority discount to value the shares he transfers to the trust. Instead of valuing his company as if it were worth $2.5 million, he values it at only $1.5 million. Seventy five percent of that, which goes into the trust, is valued at only about $1.125 million.
From that figure, Harry is able to subtract the present value of the annuity he will receive for the next 10 years. The calculation of present value is based upon interest rates in effect at the time the GRAT is set up Ð the lower the rate, the higher the present value. Consequently, with today's low interest rates, the gift tax on the shares Harry transferred will be pretty much wiped out.
All of this results in Harry and his children retaining control of the business within the family, and avoiding paying a substantial gift tax on the transfer of his shares to the trust. Harry received a comfortable retirement income and doesn't owe any capital gains on the transfer.
The only fly in the ointment is that if Harry doesn't survive the full 10-year term of the annuity, his 75 percent share of the business will be included in his estate as if the transfer had never taken place. Even so, Harry's family and estate will be no worse off than if the transfer hadn't occurred at all.
Now is a good time to set up a GRAT and make such a transfer, to take advantage of the current tax laws and low interest rates. The business valuation is also very important and the arrangement requires careful planning. If you think such an approach can help keep your family construction business afloat after your retirement, contact your accountant and attorney for assistance.
About the author: Mr. Anchin is a managing partner of Anchin, Block & Anchin, LLP, a regional certified public accounting firm with offices in New York City and Westchester, that specializes in meeting the needs of contractors in the tri-state area.