Succession planning can be an exciting, satisfying process for owners of closely held businesses, but it also involves difficult issues that must be tackled head on. One of the major challenges that entrepreneurs encounter is determining the best way to pass on the business to their children or other heirs.
People can choose any number of methods of transferring ownership of a company, while simultaneously minimizing gift and estate taxes and probate costs. One vehicle that may be useful is the grantor retained annuity trust (GRAT).
A GRAT may be appropriate for owners who have a life expectancy of at least several years and wish to:
How does a GRAT work?
In this case, the business owner - known as the grantor, settlor, or trustor - would make a gift of company stock to the GRAT. A GRAT is an irrevocable trust, meaning it cannot be changed or revoked, and the trustee is given sole control of the trust.
Under provisions set forth in the trust agreement, the owner would receive an annuity from the trust for a certain number of years, known as the retention period. The annuity may be paid in a fixed dollar amount or as a specific percentage of the initial value of the trust's assets. If income from the GRAT each year is not enough to pay the annuity, trust principal must be used to make the payments. This ensures that the grantor receives a steady stream of income.
When the retention period ends, assets in the trust, including all appreciation, go to the beneficiaries. In some cases, a business owner may wish to retain the right to have the assets revert back to his or her estate in the event of the owner's premature death.
When the GRAT is initially funded, the Internal Revenue Service considers it to be a gift to the beneficiary. The value of the gift, however, is reduced by the so-called "actuarial value" of the annuity that the business owner retains. The actuarial value is determined by a number of factors, including an interest rate set monthly by the IRS, the age of the business owner when the trust is created, the number of years that the owner will receive the annuity, and whether the remainder beneficiaries are members of the owner's family.
If the business owner survives the GRAT's term, none of the assets in the trust will be subject to federal estate tax upon his or her death. In addition, the value of the remaining property for gift-tax purposes may be much less than its actual value.
It should be noted that valuing the stock of a privately held company for the purposes of establishing a GRAT is no simple matter. It is a complex process that requires expert advice.
If you own a business that you wish to pass on to your heirs, a GRAT is certainly worth taking a look at. But keep in mind that a GRAT is just one of any number of tools that can be used as part of a sophisticated estate planning process and you should give serious consideration to consulting with your estate, tax, and financial planning professionals.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.