Health Enterprise M+A

Smart Summary

• While family transitions can bring onerous estate and gift taxes (though for only a small percentage of the population), sophisticated trust planning can help owners avoid these taxes entirely.
• Implementing a Grantor Retained Annuity Trust (“GRAT”) allows an owner to transfer ownership of assets over time to the next generation while avoiding estate and gift taxes on future appreciation.
• Similarly, an intentionally defective irrevocable trust (“IDIT”) is a flexible tool that allows an owner to be treated as retaining assets for income tax purposes, but not for estate tax purposes, which allows for some unique planning opportunities.
• Major changes could be coming to the tax laws soon which may severely limit – or totally eliminate – some of these planning opportunities. So those seeking to take advantage of these strategies should consider taking action very soon.

If you stuck around for the first two installments of this treatise on the topic of family succession, in which we covered avoidable family succession landmines in Part 1 and transition through estate and gift planning in Part 2, you’re going to love Part 3 (I hope!).

And if family succession is on your mind, I’d be remiss if I didn’t give you the opportunity to check out the candid conversation I just had with renowned entrepreneur Jim Grote as part of the Exit Planning Institute’s programming on family transitions. In full disclosure, Kegler Brown is a founding member of the EPI Central Ohio Chapter.

Check out the interview

Anyway, we’re here to talk about another traditionally effective (if done correctly) strategy for transitioning family wealth and business interests to the next generation(s). To quote Billy Joel- it’s “A Matter of Trust.” But not just any kind of trust, mind you- we’re going to cover how business owners could leverage Grantor Retained Annuity Trusts and Intentionally Defective Irrevocable Trusts to achieve their goals! Who’s excited!?!

It's GRAT-Tastic

The first thing you need to know about tax lawyers is that they love their acronyms. Introducing the first acronym in our parade: the Grantor Retained Annuity Trust (GRAT). There will be a test.

I’ll spare you from all of the mind-numbing details, but at the most basic level, the GRAT provides a structure to transfer ownership of an asset over time by transferring future appreciation in the business’ value to the next generation free of estate and gift taxes.

How does that work? This strategy comes straight out of the tax code. Here’s the overly simple explanation. The business owner sets up this special trust known as a GRAT and transfers some of the company’s stock to the GRAT. Then, the IRS gives us a required rate of return to use. In the simplest form, the GRAT has to pay the business owner his or her initial principal, plus the required rate of return in the form of an annuity over the course of the GRAT’s term. Anything that remains after making the required annuity payments—being the additional appreciation in the value of the company’s stock over the required rate of return—passes free from estate and gift taxes to the next generation (or a trust for their benefit).

So the benefit of the GRAT in this scenario is a combination of discounting (as we mentioned in Part 2) and the ability to move appreciation to the next generation in an estate/gift tax-free manner. All with pretty minimal effort, other than setting it up and giving it time to work. How about that?

And what happens if the economy tanks again and the stock doesn’t appreciate (or worse, loses value)? In that case, the business owner just takes the stock back and we start over. It’s heads I win, tails I tie.

So what’s the catch? There are a few. Most notably, if the grantor (that’s the business owner in our situation) doesn’t survive the term of the GRAT, then the whole transaction gets canceled and all of the GRAT’s assets are returned to the grantor’s taxable estate. In one sense, the grantor is no worse off than had he done nothing at all, but it’s still not ideal when the tax benefits are lost in this way. In response, many business owners will employ a strategy of “rolling GRATs,” which are simply a series of short-term GRATs implemented in succession. The gains (if any) get captured with each short-term GRAT, and then the grantor starts all over again with a new GRAT. Rinse and repeat.

The rolling GRAT is a good strategy, but it still has some mortality risk—we’ve only limited the risk. It’s also a strategy that has long been under attack, particularly by Democratic administrations. Will the Biden administration finally be the one to kill the “rolling GRAT” with a mandatory 10-year GRAT term or something else? Time will tell.

In addition, the GRAT still requires—by virtue of the mandatory annuity payments—that all or most of the initial principal plus some additional amount be returned to the grantor over the course of the GRAT term. The hope is that, over time, the appreciation that passes to the next generation will dwarf the original principal, but in most cases that takes a lot of time to occur. So, as with virtually all estate/gift tax planning strategies, the GRAT needs a substantial amount of time to work as intended.

Because the GRAT is a nifty but imperfect solution to the problem, smart people came up with another alternative with its own benefits and pitfalls…

Oops IDIT Again 

The next acronym you’ll need to know for the exam is IDIT: intentionally defective irrevocable trust (also sometimes known as IDGT—intentionally defective grantor trust). Now what the hell is that? And why would anyone intentionally make something defective?

Long story (and as far as most people are concerned, not a particularly interesting one). But the IDIT takes advantage of a quirk in the tax law that treats a particular kind of trust as though the grantor still owns the trust’s assets for income tax purposes but not for estate/gift tax purposes.

Cool story but who cares? Well that little peculiarity in the tax law can be used to do some powerful stuff. Suppose a business owner sets up one of these magical IDITs and sells stock in the business to the IDIT. What does that accomplish? Because the assets in the trust are outside of the grantor’s estate for estate/gift tax purposes, all of the future appreciation in that stock will grow free from estate/gift taxes. And when combined with discounting, the IDIT sale can effectively give us all of the same benefits as a GRAT.

And remember, this is a sale. Not a gift. So we aren’t constrained by the gifting limits noted in Part 2. There’s only a relatively small gift that needs to be made at the outset to implement this strategy. So we can move bigger values than we could with straight gifting.

Hold on, though. If the business owner sells her stock to the IDIT, won’t she trigger a capital gain on the sale of the stock? Excellent question, but the answer is no. That’s because the IDIT is treated as though the business owner still owns the trust for income tax purposes. You don’t have a taxable gain if you sell something to yourself.

Pretty neat, huh? But why’s this any better than a GRAT?

1. First, this sale can avoid the mortality risk associated with the GRAT. If the grantor dies when half of the note from the IDIT sale is paid off, only the remaining half of that principal is included in the grantor’s taxable estate. In the GRAT, the full value of the stock gets put back into the grantor’s taxable estate if the grantor dies during the GRAT term. Or, some healthy business owners can limit the mortality risk even more by using a so-called self-canceling installment note (SCIN). Another acronym! The SCIN is a unique animal that allows all of the remaining unpaid principal balance on the note to be canceled automatically (and without estate/gift tax consequences) upon the grantor’s death. While death remains inescapable for us all, the SCIN at least avoids the additional insult of losing your tax benefit due to a premature death.
2. Second, GRATs are pretty inflexible. The IRS tells us how and when the annuity must be paid, with limited room to maneuver. In contrast, IDIT sales have more flexibility. The IRS is still going to require a minimum interest rate on the note. And, if the SCIN feature is added, the IRS will also require an additional “mortality premium,” which depends on a number of factors, most notably the age of the grantor when the sale occurs. Depending on prevailing interest rates (which are incredibly low as of the time of this writing) and how and when an owner completes the IDIT sale, the hurdle that must be achieved may only be a few measly percentage points, allowing any growth in the business over that hurdle to pass free from estate and gift taxes. So long as we meet those minimum requirements and otherwise structure the plan appropriately, we have a lot more flexibility in how we structure the sale, including longer note terms (without fear of losing it all due to a premature death) and the ability to utilize some types of alternative payment schedules, the flexibility to make prepayments, etc.
3. Third, IDITs can do way more than GRATs. As noted above, GRATs exist for a period of time and then disappear. On the other hand, IDITs can be set up, in some cases, to continue in perpetuity—the so-called “dynasty trust.” If properly structured, a dynasty IDIT could hold stock in a manner that is not only free from inclusion in your own taxable estate, but also the taxable estates of your children, grandchildren, and beyond. This type of planning is incredibly powerful from a tax standpoint but also full of traps for the unwary.

IDITs can also give us additional flexibility to provide for the business owner’s spouse and include other provisions designed to provide for and protect the business owner’s family and the trusts’ assets. There are some important restrictions that need to be navigated, but the IDIT offers a lot of opportunity to achieve a business owner’s tax and personal goals.

There’s one other fun feature of the IDIT (and other grantor trusts, including GRATs) that’s worth pointing out: the business owner gets to pay all of the income taxes on the trust’s income during her lifetime! Isn’t that exciting?

Hold on. Why is it a “benefit” to pay the income taxes for the trust assets—particularly when the business owner doesn’t get the income from those assets anymore? I usually get eye rolls or groans when I share this one with clients. But hear me out on this. If a parent just gives a child cash to pay the child’s taxes, that’s a taxable gift. We already talked about the limitations on taxable gifts in Part 2 of this series. But if the business owner pays the income taxes generated by the IDIT, it’s not a gift because the tax law treats her as owning the IDIT for income tax purposes. Yet the effect is the exact same as giving the kids cash to pay the taxes themselves. It’s a handy way to make a gift without it actually counting as a gift for estate/gift tax purposes, meaning that it won’t reduce your estate/gift exemptions or fall within the other gift limitations described in Part 2.

And if our business owner decides one day that she doesn’t want to pay the IDIT’s income taxes anymore, there’s a way to “shut off” this feature, and the trust then starts paying its own income taxes going forward.

One final caveat on IDITs, however. Unlike the GRAT, which is created by the tax code and fairly clear in terms of how you implement it, IDITs are not explicitly sanctioned in the tax code. They’ve been under attack by the IRS—and targeted by a few presidential administrations—for years. That said, they have been battle-tested in many court cases over the years. Until the law changes, they work. But they’re also dangerous territory for those who don’t tread carefully.

Adding in features likes SCINs and dynasty trusts only makes this type of planning even more perilous. So be absolutely certain that you work with advisors who are experienced in this type of planning before embarking on an IDIT strategy. The rules in this area aren’t always black-and-white, and you want someone who’s been there and done that to guide you through. We’ve only scratched the surface in this article of all of the issues that need to be considered.

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Over the past few months, we’ve walked through—in layperson’s terms—some highlights of the more common strategies business owners use to transition ownership to the next generation without having to break up the business to pay taxes, but there are many others. We didn’t even try to cover everything, and there are many other issues and limitations with each of the strategies we discussed that aren’t covered here. There’s also a whole host of other business, operational, succession, buy-sell, tax, insurance, financial, and family considerations that need to be addressed before heading down the path of adopting any of these strategies (or others).

There’s almost always a push-pull to these things; when you implement a particular strategy, it creates other consequences, which, if not carefully addressed, can make the solution worse than the problem it was intended to solve. In some cases, you absolutely should not implement one of these strategies because it creates other issues. There’s no one-size-fits-all solution. And whatever tool you use needs to be specifically tailored to your specific situation. You absolutely need expert advice and guidance before implementing these strategies, or others. This world does not lend itself to DIY or an internet-generated form. You should not be relying on some internet article by a random (ahem) lawyer in Ohio.

While I wish it wasn’t the case, these strategies are complicated. They make your head hurt. And they require you to start taking action sooner than you might otherwise want. But when done properly, they work. Don’t believe me? I can introduce you to real-life clients who have used each of these strategies to position their businesses for continuation and to provide for their families for generations to come.

And to make things even more complicated, legislation is already pending in Congress that would severely limit or eliminate some of the planning techniques we’ve talked about. While it’s unclear whether and to what extent this legislation will ultimately be adopted, it’s clear that we probably have a relatively small window in order to implement some of these strategies. While we never want a tax strategy to dictate a business or personal outcome, now is the time to at least be thinking about the future and whether you should act!

Your business wasn’t built in a day. Your succession plan won’t be completed in a day. But one bad day (i.e., your untimely death) combined with a failure to plan could mean instantaneous disaster for your business and financial ruin for your family.

If a family transition is part of your goals, it’s literally never too early to start. It takes a lot of time and effort…and that’s on top of the immense time and effort you already invest in running the business. But if you’re willing to invest the time and effort required, the results can be immensely rewarding for you, your family, and all of the people who depend on your business’ success.

You can beat the odds. You can successfully transition your business to the next generation in a way that satisfies your personal, business, and financial goals. The next step is up to you.

Next Month: Oh Sh*t – Anatomy of an Indemnity Claim

Read last month’s piece: Crash Course in Family Succession Strategies – Part 2