If you are a business owner who owns an interest in a Sub-S Corporation or similar pass-through entity and desire to leave wealth to your heirs, then this article is for you. There is a wonderful planning tool that is available that will help transfer all or part of the value of your business to the next generation, estate tax free. Ahhh ... the power of time and discounts; put together, they are a powerful one-two punch.
The tool is called the Grantor Retained Annuity Trust or GRAT. Generally misunderstood, the GRAT is an irrevocable trust that allows the business owner (grantor) to contribute stock to a trust for a period of years. In return, they take back a series of fixed payments (called the annuity). The amount and period or length of these payments will determine if a gift has been made which is subject to the $1 million gift tax exclusion. The key here is that you can calculate all of this in advance and, in effect, “zero-out” the gift. In other words, the value of the annuity back to the grantor is equal to the value of the discounted gift of shares to the GRAT. At the end of the GRAT period, the shares transfer to the beneficiary outright or in trust for their benefit. On the surface, this may not seem like you have accomplished much and you might ask, “Where is the cash going to come from for the annuity payments?”
The answer to the cash question is actually simple: Sub-S corporations typically distribute enough cash to pay the taxes on the income allocated to those shares. Since this is a grantor trust, the business owner is required to pay the taxes on these shares. You can structure the terms of the GRAT (i.e. the number of years and fixed dollar amount of each annual payment) so that effectively the business owner is only taking cash that he/she would have had to pay to the tax man anyway.
In summary, the corporation distributes cash to the GRAT to cover the taxes much like it did to the owner previously. The GRAT in turn pays the annuity payment to the owner and the owner pays the taxes on those shares. If structured appropriately, no resources are actually used any different then they would have been and the business is transferred after the GRAT period. If the tax burden becomes higher than the annuity payment, there are provisions available to reduce or remove this risk.
What if you don’t want to give away 100% of your rapidly growing business? Just put a minority interest into the G.R.A.T. and structure the terms to “zero” it out. For example, assume it takes only 5 years because the company is very profitable and able to distribute out a high amount each year. By the end of year 5, you have transferred both the discount and all the appreciation on those shares. If the company sells before then, it likely will have sold for an amount significantly higher than the old appraisal with all it’s discounts.
What’s the catch? If the grantor dies before the GRAT term ends, the entire amount stays in the grantor’s estate. In order to deal with this issue, you can structure several GRATs each with different terms. This will increase the probability that at least some of the company value will transfer. Other options include the purchase of life insurance or splitting the ownership and contributing to two spousal GRATs.
There are hosts of planning issues that surround this tool; however, very few of these (including your control over these resources until the beneficiary/child is much older) are ones that cannot be planned for in advance. If this tool is of interest, it is important that you plan well in advance, consult both your financial advisor and a competent estate attorney.