(Forbes) When making a gift, sometimes it truly is the thought that counts.
If you are considering making a sizable gift to a family member such as a partial interest in the family business, how you structure the transaction can have a meaningful impact on the success of the transfer, minimizing taxes, and the control you have even after making the gift. In my Irvine financial advisory firm, I work with many closely-held family business owners who tend to have two primary questions and concerns.
First, they want to make sure their children have the necessary skills and experience to successfully run the business. Second, they want to transfer partial ownership efficiently and in a way that affords them flexibility and helps minimize taxes.
In previous Forbes articles I've written about getting the kids ready to take over the business, but in this article I want to explore one strategy that business owners can use to gift closely-held business interest to their children.
When a person decides to transfer an asset to someone, he or she typically envisions making a direct gift to the recipient.
Often times, however, both the person making the gift and the recipient may benefit if instead of transferring the asset directly to the recipient, the asset was transferred to a trust for the benefit of the recipient.
Making a transfer in trust can reduce many risks and concerns that the person making the transfer may have. For example, many people are concerned about the recipient using the asset irresponsibly.
Others have concerns about the recipient losing the asset, such as through a divorce or to a creditor. These concerns are certainly legitimate, as future events such as legal problems, divorce, or substance abuse cannot be predicted.
Transferring the asset to a trust, rather than directly to the recipient, can help reduce many of these concerns because the trust can contain provisions to prevent the beneficiary of the trust from losing the asset.
In short, using a trust, rather than making a direct transfer, can provide extremely valuable protection against a number of unforeseen future events that a direct transfer simply cannot.
For assets of significant or unique value, such as an interest in a closely-held business, the additional cost and complexity of making transfers in trust may be outweighed by the benefits, including tax savings.
“When owners of closely held businesses first meet with us regarding succession planning, they typically believe the options for transferring their businesses are limited,” says Derek Early, an attorney for Brown & Streza LLP, “but there are various tools we can use to design and implement a plan to meet a particular owner’s goals and alleviate many of his or her concerns, often with tax savings as an added bonus.”
One of the tools that is frequently used for succession planning in closely-held businesses is an intentionally defective irrevocable trust or IDIT (also referred to as an intentionally defective grantor trust or IDGT). These trusts provide protection against the beneficiary’s creditors and help minimize the chance of the beneficiary’s spouse obtaining any interest in the business as a result of a divorce. An IDIT can also provide flexibility by allowing the owner to swap assets transferred to the trust for other assets tax free. For example, if an IDIT owns stock in the owner’s closely held business, the owner could effectively take the stock back by swapping the stock with cash of equivalent value. Why is this advantageous? This feature can be extremely valuable if an owner later determines that the transferee should not take over the business.
If you gift ownership of your family business to the kids, your estate tax exemption will be reduced by the amount by which the value of that stock exceeds the annual gift tax exclusion limit.
Selling the stock to the recipient is also tax inefficient because it will result in the owner owing capital gains tax. What’s the solution? As the owner, if you sell the stock to an IDIT and remain responsible for the ongoing income taxes, this does not trigger capital gains taxes because you and the IDIT are treated the same for income tax purposes. It is the tax equivalent of taking money out of your right pocket and putting it in your left pocket.
In addition to not having to reduce your estate exemption or pay capital gains taxes, you also have the option of paying the annual taxes on the income the asset generates each year. Why would you want to be responsible for ongoing taxes on an asset you gifted?
You can reduce your estate and potentially save on estate taxes. In fact, the “intentionally defective” portion of the trust’s name is a reference to the trust being intentionally structured so that the grantor, rather than the trust’s beneficiary, is responsible for the income taxes.
What if tax laws change and the parents decide they no longer want to be responsible for paying the ongoing taxes? The IDIT can provide flexibility by including a process to make the beneficiary responsible for those ongoing income taxes.
If you are considering making a meaningful gift, think through your options carefully and work with an experienced tax or estate attorney to determine if an IDIT might be appropriate. Although in many circumstances a simple gift is easiest, transfers in trust can provide significant benefits that you won’t have if you simply gift the asset.
I write about creating a richer life through personal finance and personal growth.
