Succession is a critical issue for family business owners. There are many facets to consider, but once you design a succession plan, a sale to an intentionally defective grantor trust (IDGT) can be a great tax strategy for everyone involved. This is a complex and sophisticated technique. Let's examine why you may want to choose a sale to an IDGT and how to implement one.
Why Not a Traditional Sale?
If taxation wasn't a consideration and you wanted to transfer ownership of a business to your beneficiary, you could simply sell the business outright to him or her. The sale would likely be seller financed, and you would take back a note from the beneficiary. The note would provide for principal and interest payments over a period of time. After your beneficiary paid off the note, he or she would have no continuing obligation and would own the business free and clear of any liability. By that time you would have no further income from the business, would be fully retired, or would have taken a job as an employee or consultant with the company.
Unfortunately, under our tax system the sale would mean you have to pay capital gains tax on the difference between the sale price and the cost of the interest in the business. In addition, the interest on the note would be taxed as ordinary income. More important, the beneficiary would have to use mostly post-tax dollars to make the payout. In many cases, this would make the buyout too costly for your beneficiary. A traditional sale often doesn't help facilitate a succession plan.
Structuring an IDGT
The alternative to a traditional sale is to sell all or a portion of your company to a defective trust. This transaction is similar to a traditional sale except the buyer is a trust for the benefit of your beneficiary, rather than a direct sale to your beneficiary. This trust is irrevocable and, in appropriate circumstances, the beneficiary may be a trustee of the trust. Transactions have many variations, but typically the trust terminates after the note is paid off. The business interest purchased by the trust is then distributed to your beneficiary. After the beneficiary receives the family business from the trust, the result is the same as if he or she had bought the business outright. By using the trust and its special attributes, you can accomplish the transaction with pre-tax dollars.
Conventional wisdom dictates that for the transaction to work, the trust should have some economic viability before the sale. The grantor (selling parent) should gift 10% of the company's purchase price in cash or stock to the trust before entering into the sale - this is known as seed money. The seed money will use up some of your lifetime gift and estate tax exemption or cause a gift tax.
Special IDGT Attributes
A defective trust has a provision in it that causes the trust to be taxed to the grantor. Several grantor powers can make a trust defective. These were originally enacted to prevent a trust grantor from retaining control over the trust while shifting income into it. Taxpayers now use grantor powers to intentionally cause trusts to be taxed as grantor trusts. This is because any grantor sale to a grantor trust will be treated - for income tax purposes - as if the sale didn't happen. Thus, there is no gain or loss on the sale.
The Tax Effect of an IDGT
Since the sale to the grantor trust isn't taxable, the transaction doesn't appear on the selling parent's tax return, and the buyer (the trust) doesn't report the interest payment on the note. But the grantor does report the trust income. If the trust has purchased S corporation stock or limited liability company (LLC) or partnership interests, the grantor reports the same income on his or her tax return that appears on the company Form K-1 as if the grantor still owned all of the stock. While this increases the tax bracket of the selling parent on the proceeds, it gives the beneficiary an income reduction that he or she would have reported if buying the company outright, thereby giving the effect of a pre-tax buyout.
After the trust terminates, or the business interest is transferred out of the trust to the beneficiary, the parent no longer pays tax on the company income. The beneficiary receives the interest in the business by using company earnings to make the payments and in return gets no basis step-up in the business interest for the purchase price.
Variations
An IDGT transaction has many potential variations. In some instances, a grantor will want the company to stay in the trust and the trust to stay a grantor trust even after the note is paid off. This way, the trust income will be taxed to the grantor, and he or she will be able to pay the beneficiary's income tax on income from the interest in the business sold to the trust.
In other cases, the grantor may find it advantageous to renounce grantor power before the end of the trust to lower the tax bite. Each situation will be different - flexibility is the key in structuring these transactions.
Determining Appropriate Assets for an IDGT
Generally speaking, a family business must not be a C corporation for this type of transaction to work. If it's an S corporation, LLC or partnership, the flow-through attributes of the entity will be conducive to the sale. In addition, the entity in most cases needs to produce enough cash to support the debt service. If not, the transaction will collapse. Finally, real estate, owned outright or in an entity, could be an appropriate asset to sell to a defective trust. Ideally, you'll want an asset that's going to appreciate in value.
Defective or Effective?
An IDGT can be an effective solution to a problematic succession plan. Although we've discussed the various aspects of IDGTs, your needs are specific to your financial situation. Please feel free to contact one of our knowledgeable professionals for information on how to set up an IDGT or any other matter.
