Here is one way to take advantage of today’s historically low interest rates, transfer your family business to the next generation, allow flexibility to have as many or as few family members be involved in running the business, and allow those family members not involved in running the business to still benefit from the company: Sell the company to a grantor trust.
With this technique, generally the founder of the company sets up an irrevocable trust while still alive. Unlike many irrevocable trusts, this trust will allow the income earned by the trust to be taxed to the person creating the trust. There are two main benefits to having trust income taxed to the grantor: first, there will be no capital gain on the sale to the trust because for income tax purposes, the transaction is viewed as being one with yourself; second, if the trust does not have to pay taxes on the income it earns, the assets held in the trust can grow even faster.
The beneficiaries of this trust are frequently your children and grandchildren. You would select an independent trustee such as a trusted advisor. After valuing the family business, you make a gift of approximately ten percent of the value of the business. You then execute a purchase and sale agreement with the trustee and receive a promissory note in return. You may also receive a down payment. Typically, the promissory note will be secured by the family business and all its assets. This will allow you to “foreclose” if any payments are not made. Often the note will call for payments of interest only and a balloon at the end of the term. The term can be almost any length, but is generally anywhere between two and nine years. Once the transaction is complete and the note paid off, the trust and therefore the children will control the company. The company will no longer be included in your estate when you die. If the value of the company continues to increase after the date of the sale to the trust, the entire increase in value will belong to your children and grandchildren and not you. This technique is often referred to as an “estate freeze” because the value of the asset to your estate becomes fixed at the sale price. For example if you sell your company to the trust today for $1 million and in five years the company is worth $1.5 million, the $500,000 increase belongs to your children as the beneficiaries of the trust. The million dollars (plus interest) will be in your estate.
If you have children who do not yet know if he or she will have an interest in the business, this technique can be structured to allow them to opt in or opt out of daily involvement in the business. You can create voting and non-voting ownership interests. For those children who want to be active in the business they can receive voting interests, while the other children can receive non-voting. This structure will work well with either a Limited Liability Company or an “S” Corporation. Special provisions must be included if the company is an “S” Corporation. It will also work with a “C” Corporation.
Additional language can be included to allow the children’s subtrusts to sell the shares owned to other family members if a beneficiary no longer wants an investment in the family business.
All in all this is an effective technique that can assist with estate tax issues, control issues and ensure that non-active family members are not frozen out of the monetary benefits of the company.
By John Hugg