© julius h. giarmarco, esq. 2006 keeping the family business in the family prepared by: julius h....
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© 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
© Julius H. Giarmarco, Esq. 2006
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.
© Julius H. Giarmarco, Esq. 2006
Techniques to be Discussed
1. Grantor Retained Annuity Trusts
2. Grantor Trusts
3. Private Annuities
4. Self-Canceling Installment Notes
5. Valuation Discounts
© Julius H. Giarmarco, Esq. 2006
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.
© Julius H. Giarmarco, Esq. 2006
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.
© Julius H. Giarmarco, Esq. 2006
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
© Julius H. Giarmarco, Esq. 2006
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
© Julius H. Giarmarco, Esq. 2006
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
© Julius H. Giarmarco, Esq. 2006
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%
© Julius H. Giarmarco, Esq. 2006
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
© Julius H. Giarmarco, Esq. 2006
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
© Julius H. Giarmarco, Esq. 2006
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
© Julius H. Giarmarco, Esq. 2006
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
© Julius H. Giarmarco, Esq. 2006
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
© Julius H. Giarmarco, Esq. 2006
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
© Julius H. Giarmarco, Esq. 2006
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).
© Julius H. Giarmarco, Esq. 2006
Self Canceling Installment Note (“SCIN”)
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.
© Julius H. Giarmarco, Esq. 2006
Self Canceling Installment Note (“SCIN”)
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
© Julius H. Giarmarco, Esq. 2006
Self Canceling Installment Note (“SCIN”)
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%
© Julius H. Giarmarco, Esq. 2006
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.
© Julius H. Giarmarco, Esq. 2006
Assumed discount rate is AFR
Only note is included in grantor’s estate
Can allocate GST exemption
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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
© Julius H. Giarmarco, Esq. 2006
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
© Julius H. Giarmarco, Esq. 2006
“When I go, I plan on taking at least two of my estate-tax lawyers with me.”
© Julius H. Giarmarco, Esq. 2006
The End.The End.Thank You!Thank You!