There are several estate-planning strategies that can be used to transfer business wealth efficiently.
A buy-sell agreement is a legally binding agreement for transfer of ownership when one owner exits. The agreement is usually funded with life and disability insurance. Typical models include cross-purchase and stock redemption. A cross-purchase arrangement involves business partners purchasing the insurance on each other with proceeds used to buy out the interest of the deceased partner. A buy-sell agreement:
• May prevent foreclosure and enable remaining owners to maintain control
• May provide much-needed liquidity to beneficiaries of the deceased owner
Family Limited Partnership (FLP)
A Family Limited Partnership allows business owners to create two types of ownership shares: general and limited. In doing so, they can name themselves as general partners and transfer ownership of limited partnership shares. This strategy creates opportunities for gift and estate tax savings.
• Through a gifting strategy, senior family members can transfer the value of their assets to children and grandchildren, and remove the assets from their taxable estates.
• Gifts of limited partnership shares are generally discounted to reflect lack of marketability and/or lack of control. This can help accelerate transfer in value while avoiding or mitigating federal gift taxes.
• Transferring ownership of shares can shift income from taxpayers in higher tax brackets to family members in lower tax brackets.
• An FLP may also provide asset protection in many states where law prohibits creditors of a limited partner from attaching partnership assets.
Grantor Retained Annuity Trust (GRAT)
A GRAT is a type of trust that can be funded with a range of investments, including ownership shares in a business. A GRAT is usually established with a term of two to five years. During that time, annuity payments are executed from the trust back to the grantor based on the value of the assets initially transferred to the trust and the prevailing Internal Revenue Service interest rate. At the end of the term, if assets have appreciated more than the IRS interest rate, the remaining value is transferred to beneficiaries free of gift and estate taxes.
Intentionally Defective Irrevocable Trust (IDIT)
This type of trust is generally established by the buyer of a closely held business and structured to facilitate transfer of ownership. The trust is “defective” because it is not recognized by the IRS as a separate taxable entity. This “defection” occurs because these trusts are considered grantor trusts, meaning that the owner of the trust assets (i.e., grantor) retains certain privileges and is personally responsible for income taxes.
Depending on the IRS interest rate and appreciation of shares in the trust, assets may be transferred to beneficiaries free of gift and estate taxes. Another advantage is the fact that the trust does not have to pay taxes, so more assets remain for potential appreciation. Taxes are paid by the business owner, which may reduce the owner’s taxable estate.
Learn more about key estate-planning strategies in this educational piece on succession planning.