Family Business Succession and Estate Tax Planning: The Window May Be Closing

Family Business Succession and Estate Tax Planning: The Window May Be Closing

In the recent bills to change the tax code, there’s an effort to prohibit planning that’s very beneficial to passing a family business to the next generation. This planning has become known as an installment sale to a grantor trust.

This is how it works. G1 (the current owners of the family business) form one or more trusts for the benefit of G2 (the next generation of family business owners). G1 then makes a gift of 10% of the business interest to the trust. G1 sells the remaining 90% to the trust. The trust uses the profits from the family business to pay G1 back over the term of an installment note. When the loan is fully paid back to G1, the trust for the benefit of G2 owns the family business.

This seems like a typical transaction so why would Congress want to prohibit it?  Here’s why:

  1. The sale avoids income tax. The sale of a business interest to family members is almost always subject to income tax. In this case though, it’s not. How can this be? The trust is established by G1 and is a “grantor trust” (i.e. taxed to G1). When G1 sells the business interest to the trust, it’s essentially a transaction with himself or herself (i.e. no income tax liability). As a result, G1 receives 100% of the sale proceeds income tax-free.

  2. The sale minimizes estate tax. This structure minimizes G1’s estate tax liability in two ways. A business will typically grow and become more valuable. This will in turn increase G1’s exposure to estate tax over time. The installment sale to a grantor trust will freeze the value of the ownership and cap G1’s estate tax liability. Also, G1 will continue to pay the income tax on the company’s profits and this will further lower G1’s estate tax exposure. Also, if G1 doesn’t need all of the payments to live on, they could consider making a gift or forgiving a portion of the loan and using up gift/estate tax exemption before it may go down to $3.5 MM per spouse.

  3. This is a very favorable climate for this type of transaction. With the economy rebounding strongly, this should allow the family business to be profitable and create the cash flow necessary for the trust to make the note payments to G1. Also, interest rates are extremely low. This will also lessen the cost of the sale to the family business.

The current tax bills have proposed to prohibit an installment sale to a grantor trust. If this planning makes sense for your family business, it’s important to put it in place as soon as possible. 


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