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Keeping the family business in the family is not easy.
Transferring significant value from one generation to another can raise serious tax hurdles. Once the successors are identified and prepared, financing usually is arranged and a standard installment note is established. Unfortunately, it is not uncommon for the former boss to incur significant tax liability during the buyout.
Fortunately, an alternative does exist. Stock can be sold to an intentionally defective irrevocable trust (IDIT), established for the benefit of the business successors, as opposed to selling directly to the successors themselves. By selling the business to this special trust instead of the successors, there’s no tax on the sale. That’s because the trust is a grantor trust. A grantor trust is treated as an extension of you for income tax purposes. If you sell something to yourself, there is no income tax. Let’s walk through the mechanics.
An irrevocable grantor trust is established naming your business successors as trust beneficiaries. Generally, it is recommended that you seed the trust with cash. Most experts recommend a seed gift equal to 10 percent of the installment.
After seeding the trust, you sell your stock to the trust in exchange for the $500,000 cash you gifted in, and the balance you take in the form of a $4.5 million note. There is no tax on this transaction. Annual payments from the trust to you are generally satisfied using S corporation distributions. These payments would be income tax-free. Because of the grantor trust status, you continue to be taxed on all S corporation income.
Why is that a good thing? In effect, you are paying the income tax for the benefit of the kids (successors). That creates a much bigger shift from the estate to their trust. And you don’t have to pay gift tax on it. So if the corporation has $1 million of income, you have, in essence, given the kids about $350,000 by paying the tax, without it being a taxable gift. Once the note is fully repaid, the business stock either stays inside the trust, often for asset protection, or is distributed to the successors.
Long story short, there are two differences between using an IDIT and a traditional installment-sale technique. With a regular installment sale, you would pay capital gains and tax on the interest on the installment note payments. With a grantor trust, you wouldn’t pay any of those taxes. The other difference is the note would be paid off with S corporation distributions, and those distributions are subject to income tax, just like now. But with the regular installment sale, those distributions would be taxed to the kids because they’d own the stock. With the sale to the grantor trust, those distributions would be taxable to you because the grantor trust owns the stock.
Recognize that at some point you may not want to pay those income taxes anymore. The trust can be written in a manner that gives you, or often an independent trustee, a one-time election to turn off the grantor trust provision, which means the trust’s income is no longer taxable to you.
As with any financial strategy, there are risks and considerations not mentioned in this brief article. Before proceeding, you should discuss this strategy with your professional advisers.
Garry is a CPA and personal financial specialist at Garry Associates LLP
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