© julius h. giarmarco, esq. 2006 keeping the family business in the family prepared by: julius h....

© Julius H. Giarmarco, Esq. 2006

KEEPING THE FAMILY BUSINESS IN THE FAMILY

Prepared by:Julius H. Giarmarco, Esq.

Cox, Hodgman & Giarmarco, P.C.101 W. Big Beaver Road, 10th Floor

Troy, MI 48084(248) 457-7200

[email protected]


CIRCULAR 230 DISCLAIMER

THESE MATERIALS ARE NOT INTENDED OR WRITTEN BY THE AUTHOR TO BE USED, AND THEY CANNOT BE USED BY YOU (OR ANY OTHER TAXPAYER) FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON YOU (OR ANY OTHER TAXPAYER) UNDER THE INTERNAL REVENUE CODE OF 1986, AS AMENDED.


Techniques to be Discussed

1. Grantor Retained Annuity Trusts

2. Grantor Trusts

3. Private Annuities

4. Self-Canceling Installment Notes

5. Valuation Discounts


Grantor Retained Annuity Trust Typical Features

1. Grantor transfers income producing assets(i.e., S corporation stock, FLP/FLLC interests) to an irrevocable trust f/b/o children.

2. Grantor retains the right to a fixed annuity payment for a set term of years.

3. At end of term, the assets remaining in the GRAT pass to the remainder beneficiaries (the children).

4. If grantor dies before the set term, the assets in the GRAT revert back to his/her estate.


Grantor Retained Annuity Trust Typical Features

5. The risk of inclusion can be “insured” against with life insurance on the grantor’s life.

6. The gift tax value is the FMV of the assets transferred to the GRAT, less the present value of the annuity interest and the value of the reversion.

7. The grantor is taxed on all income and realized gains on trust assets even if these amounts are greater than the annuity payment.

8. All income and appreciation in excess of that required to pay the annuity accumulate for the benefit of the remaindermen.


IRC §7520 Rate 5%Grantor’s Age 60Term of Trust 10Annual Growth of Principal 5%Pre-discounted FMV $3,000,000Income Earned by Trust (8% x $3M = $240K) 8%Discounted FMV $2,000,000Percentage Payout (12% x $2M = $240K) 12%Payment Period AnnualAnnual Annuity Payout $240,000Value of Grantor’s Retained Interest $1,727,208Taxable Gift Value of Residual Interest in Trust $272,792

Grantor Retained Annuity Trust


Beginning 5% 8% Annual AnnualYear Principal Growth Income Payment Remainder

1 $3,000,000 $150,000 $246,000 $240,000 $3,156,000

5 $3,758,783 $187,939 $308,220 $240,000 $4,014,942

10 $5,425,367 $271,268 $444,880 $240,000 $5,901,516

Summary $3,000,000 $2,008,150 $3,293,366 $2,400,000 $5,901,516

Grantor Retained Annuity TrustEconomic Schedule


During Life FMV of S Corporation = $5,000,000 Dividend Distributions = 10% / year Corporation’s Growth Rate = 3% / year Donor’s Life Expectancy = 20 years

At Death FMV of S Corporation = $ 9,031,000 Estate Tax (45%) = $ 4,063,950 Children’s Inheritance = $ 4,967,050

Intentionally Defective Irrevocable Trust (“IDIT”)

Do Nothing


IDITRecapitalization

1. Recapitalize the S Corporation Donor owns 10%, voting shares Donor owns 90%, non-voting shares

2. Obtain a qualified appraisal substantiating a valuation discount for the non-voting shares ranging from 10% to 40%


S Corporation

No Discount With 35% Discount10% $500,000 $500,000voting

90% $4,500,000 $2,925,000Non-voting

DonorRetains 100% Voting

Control

DonorTransfers 90% of

Corporation’s value out of his/her estate

IDITObtain Appraisal


IDITFund Trust

1. Establish Intentionally Defective Irrevocable Trust (“IDIT”) Power of substitution - IRC §675(4)(c) Power to borrow without security - IRC §675(3) Power in non-adverse party to add charitable beneficiaries

– IRC §674(b)(5)

2. Gift 10% of shares (all non-voting) to IDIT using $325,000 of gift tax exemption This “seed” money avoids potential estate inclusion under

IRC §2036 Can allocate GST exemption to IDIT


IDITFund Trust

3. Sell 80% of shares (all non-voting) to IDIT Promissory Note with term of 20 years Interest payments only (annually) with balloon payment at

end of 20 years IRS assumed interest rate is 5.5% (long-term AFR) No capital gains tax, and grantor not taxed separately on

interest payments

4. Alternatives to an installment note Private annuity Self-canceling installment note (“SCIN”)

Donor

• Paying IDIT’s income taxes is equivalent of tax-free gift

• Donor retains control as 10% voting shareholder

• Donor receives $193,000 annually (from interest payment and dividends on the 10% voting shares)

• Donor pays income taxes of $210,000 ($500,000 x 42%) - for annual short fall of $17,000

IDIT / Dynasty Trust

• $500,000 FMV

• $4,000,000 FMV

• IDIT earns 10% on $4,500,000 = $450,000/ year

IDIT pays interest only for 20 years of $143,000 annually

($2,600,000 x 5.5%)

Donor gifts 10% of S Corp stock(10% x $5,000,000 = $500,000 less 35% discount = $325,000)

Donor sells 80% of S Corp stock(80% x $5,000,000 = $4,000,000

less 35% discount = $2,600,000)

IDIT’s Cash Flow$450,000

($143,000)$307,000

IDIT


IDIT Cash Flow

$450,000

($143,000)

$307,000

IDIT Cash Flow

$450,000

($143,000)

$307,000

Excess cash flow could be used for reinvestment, purchase of real estate,

and/or purchase of life insurance.

IDIT


Grantor Gifts S Corp Stock

$500,000

Sale to IDIT IllustrationGrantor Sells S Corp Stock

$4,000,000

Taxable Gift $325,000

IDIT Issues Note$2,600,000

Discounted Face

Principal & Interest

$5,460,000

Value of IDITin 20 Years$18,419,940


Annuity may not be secured. Each payment is divided into capital gain ($58,065), interest income

($44,953), and a nontaxable recovery of basis ($6,452). Assumes the Section 7520 Rate is 5%.

Child cannot deduct any part of payments. When parent dies, payments terminate. Calculation assumes a 16 year life expectancy. Standard valuation tables may be used if annuitant has at least a 50%

probability of living one year. If the annuitant survives for at least 18 months, the 50% test is presumed to have been met. Regs § § 1.7520-3(b)(3) and 25.7520-3(b)(3).

Parent(Age 70) Annual Payout of

$109,469

Child

Sale of $1M of S Corporation Stock (with basis of $100K)

Private Annuity


Self Canceling Installment Note (“SCIN”)

Instead of a standard installment note, the sale can be paid with a SCIN. In Estate of Costanza, the Sixth Circuit, in a case arising out of Michigan, recognized a SCIN as a bona fide transaction.

A SCIN is an installment note that by it’s terms is extinguished at the death of the seller.

With a SCIN, nothing is included in the seller’s gross estate (similar to a private annuity).



The purchaser must pay a “risk” premium to the seller as consideration for the cancellation feature. However, there is no statutory or regulatory guidance as to how the risk premium should be calculated.

Apparently, the premium can be reflected as an increase in the sales price, or as an increase in the interest rate.



IRC §7520 Rate5.00%

FMV of Property $2,600,000

Cost Basis $1,000,000

Initial Down Payment $0

Age 60

Term of Note 10 years

Type of Note Interest Only

AFR5.50%

Payment Period Annual



Risk Premium

Principal Interest

Mortality Risk Premium (Principal) $263,567 N/A

Total Sale Price $2,863,567 $2,600,000

Principal Amount of Note $2,863,567 $2,600,000

Mortality Risk Premium (Interest) N/A 1.2790%

Total Interest Rate 5.5000% 6.7790%


IRS Support for IDITs

1. Rev. Rul. 85-13 There is no capital gain on sales between a grantor and a grantor

trust.

2. Rev. Rul. 2004-64 The payment of income taxes by the grantor on behalf of a grantor

trust does not constitute a gift to the trust’s beneficiaries. If an independent trustee has the discretionary power to reimburse

the grantor for income taxes, this does not cause the trust to be taxed in the grantor’s estate under IRC Sec. 2036(a)(1).

3. Karmazin vs. Commissioner This gift tax audit, which was settled out of court, treated a sale to a

grantor trust as a bona fide sale. Trust was funded with 10% seed money.


Assumed discount rate is AFR

Only note is included in grantor’s estate

Can allocate GST exemption

End loading with balloon payment

IDIT vs.

Assumed discount rate is IRC §7520 rate

All trust assets included in grantor’s estate

Cannot allocate GST exemption because of ETIP rules

Annuity cannot exceed 120% of prior year’s annuity

GRAT


IDIT

Cannot reduce gift to zero because of seed money

Unintended gift may be minimized with a “formula” gift

Potential capital gain if grantor dies while note is outstanding

Non-statutory technique

vs. GRAT

Can reduce gift to zero with Walton GRAT

Unintended gift is minimized if annuity is a percentage of FMV

No capital gain if grantor dies during the term

Statutory technique


“When I go, I plan on taking at least two of my estate-tax lawyers with me.”


The End.The End.Thank You!Thank You!

© julius h. giarmarco, esq. 2006 keeping the family business in the family prepared by: julius h....

Documents

annuity trust slide

trust assets

annuity trusts

grantor trusts

hodgman giarmarco

annuity trust typical

grantor transfers income

fixed annuity payment