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December 2, 2004 / Publications

Plan Before You Sell

by Robert E. Strauss

Every year, many business owners decide the time has come to sell their businesses. Accountants, independent corporate counsel, financial advisors, and especially the business owners themselves need to know that the sale of a business may constitute the single most valuable and important estate planning opportunity they will ever encounter.

However, since many business owners engage separate corporate counsel to assist them in connection with the sale of their businesses, estate planning counsel may be among the last to learn of the sale. In fact, we may not learn of the sale until a client, during an estateplanning strategy session, offhandedly drops this bomb: “Oh, I sold the business last year. Didn’t I tell you?” By then, it’s too late. The opportunity has passed.

The balance of this article explains in general terms how business owners can save significant gift and estatetax dollars by seizing this unique opportunity.

Leverage Through Discounting

“Leverage” is the term we use to describe how clients can make gifts of assets with a “real world” fair market value that is greater than the discounted fair market value of such assets for gift and estate tax purposes. The most effective estate planning leverages a business owner’s use of his or her $1 million lifetime exemption from gift tax ($2 million for married couples).

Typically, clients are able to make discounted gifts by utilizing one or more advanced estate planning techniques These techniques include family limited partnerships, grantor retained annuity trusts, intentionally defective grantor trusts, qualified personal residence trusts, and irrevocable life insurance trusts.

A business owner can achieve leverage by creating two types of discounts. The first discount relates to the transfer of a minority interest in the business. For gift tax purposes, the fair market value of a minority interest often should be discounted to reflect that its recipient usually has little control over the management or affairs of that business and, further, usually would have great difficulty finding a buyer for the minority interest (it “lacks marketability”).

Depending upon the nature of the business and the size of the minority interest, a minority interest/lack of marketability discount of as much as 35% or more might be appropriate. The actual amount of this discount must be confirmed by a professional appraiser.

The second discount results from the client’s transfer of a minority interest to an intentionally defective grantor trust, a grantor retained annuity trust, or another appropriate estate planning vehicle. These advanced techniques often create significant additional discounts, ranging from 25% to 90%, depending upon which technique is utilized and factors such as the business owner’s age, prevailing interest rates, and the size and nature of the minority interest transferred.

Example of leverage

The following example illustrates all three means of achieving leverage. Assume that, well in advance of any sale, the appraised fair market value of the business, organized as an S corporation, is $4 million.

The owner could achieve the first layer of discount by transferring a minority interest, say 40% of the corporation’s outstanding stock, to a grantor retained annuity trust. Although 40% of the stock would have a fair market value of $1.6 million prior to any discount, following the application of an assumed 35% discount, 40% of the stock would have a fair market value for gift tax purposes of only $1.04 million.

The owner could achieve the second layer of discount by virtue of the manner in which the grantor retained annuity trust works. During the term of that trust, the owner would retain the right to receive annuity payments from that trust. The longer the term of the trust and the greater the annuity payments from the trust, the greater will be this second layer of discount. It is possible to achieve an additional 50% discount or even more, depending upon the facts and circumstances of the particular matter, as well as the owner’s needs and desires. Thus, following the application of an assumed additional 50% discount, 40% of the stock would have a discounted fair market value of only $502,000.

Consequently, the owner could transfer assets with an underlying value of $1.6 million (40% of $4 million) with a gift tax value of only $502,000. The remaining $1.098 million in value would forever escape transfer (gift and estate) taxation. To this point, the owner would achieve a combined discount of 68% leverage of greater than 3 to 1.

The owner might achieve even more leverage. Suppose that in the year following the valuation, the owner sells the business to a competitor with a strategic interest in the acquisition, not for $4 million but for $6 million. Since the grantor retained annuity trust would also sell its 40% interest in the business, it would receive its prorata shares of the proceeds from the sale $2.4 million. This means that the business owner will have removed $2.4 million of assets from his or her estate (net of capital gains taxes due following the sale), all with a net gift tax value of only $502,000. Based upon the foregoing, the owner could achieve a combined discount of 79% leverage of almost 5 to 1.

Simply by engaging in estate planning before they sell their businesses, business owners can leverage their lifetime exemptions ($1 million and growing) by 50% or more. Shouldn’t every business owner work take advantage of this unique opportunity?

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