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BUSINESS SUCCESSION AND ESTATE PLANNING FOR CLOSELY HELD

BUSINESS OWNERS, PART 1 AND PART 2

First Run Broadcast: November 1 & 2, 2012

1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes each day)

Successful closely held businesses can create substantial wealth – but they are also substantial

estate planning challenges. The first challenge is succession of leadership from the founders to

outsiders or, if it’s a family business, between generations of a family. Beyond ensuring a

smooth transition in leadership, there are challenges surrounding providing current income for

the founders who want to transition out, or the senior members of a family, while attributing

subsequent increases in company value to their heirs. There are also myriad challenges of trust

planning with an operating business. This program will take an integrated approach to

succession and estate planning for closely held and family-owned businesses. The program will

cover advanced lifetime and post-mortem transfer strategies, including the use of FLP and

charitable giving techniques, buy/sell arrangements and recapitalizations, estate freezes and

more.

Day 1 – November 1, 2012:

Advanced strategies for lifetime and post-mortem transfers of closely-held and family

businesses

Differences between family-held and non-family closely held businesses

Identifying business succession planning challenges – founders v. outsiders, active v.

inactive members of a family, cash flow concerns

Techniques to facilitate business succession planning – separating ownership and

management structures, sales to outsiders, buy/sell agreements within the family

Integration of buy/sell, redemption and hybrid agreements with estate plans

Spousal Estate Reduction Trusts, Grantor Retained Annuity Trusts, preferred/common

recapitalization gifts, opportunity shifting

Day 2 – November 2, 2012:

Generation skipping Transfer Tax issues in family businesses

Valuation discounts, estate freezes and advanced Family Limited Partnership planning

Intersection of retirement asset planning and transferring a closely held business

Asset protection planning with closely held businesses

Charitable planning techniques

Speakers:

Daniel L. Daniels is a partner in the Greenwich, Connecticut office of Wiggin and Dana, LLP,

where his practice focuses on representing business owners, corporate executives and other

wealthy individuals and their families. A Fellow of the American College of Trust and Estate

Counsel, he is listed in “The Best Lawyers in America,” and has been named by “Worth”

magazine as one of the Top 100 Lawyers in the United States representing affluent individuals.

Mr. Daniels is co-author of a monthly column in “Trusts and Estates” magazine. Mr. Daniels

received his A.B., summa cum laude, from Dartmouth College and received his J.D., with

honors, from Harvard Law School.

David T. Leibell is a partner in the Greenwich, Connecticut office of Wiggin and Dana, LLP,

where he has an extensive estate, trust and charitable giving practice. He previously worked in

the financial services industry, specializing in the financial aspects of estate planning. Mr.

Leibell is a frequent lecturer on fiduciary topics throughout the United States, and has authored

many articles on charitable, estate and tax planning topics. He is the author of a monthly column

in “Trusts & Estates” magazine. He also authors a column for “Registered Representative

Magazine.” Mr. Leibell received his B.A. from Trinity College and his J.D. from Fordham Law

School.

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I will be attending:

Business Succession & Estate Planning for

Closely Held Business Owners, Part 1 Teleseminar

November 1, 2012

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Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: November 1, 2012 Seminar Title: Business Succession & Estate Planning for Closely Held Business Owners, Part 1 Location: Teleseminar Credits: 1.0 General MCLE Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

VT Bar Association Continuing Legal Education Registration Form

Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT 05601-0100. Fax: (802) 223-1573 PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name: _____________________ Middle Initial: _____Last Name: __________________________

Firm/Organization:____________________________________________________________________

Address:___________________________________________________________________________

City:__________________________________ State: _________ ZIP Code: ______________

Phone #:________________________ Fax #:________________________

E-Mail Address: ____________________________________________________________________

I will be attending:

Business Succession & Estate Planning for

Closely Held Business Owners, Part 2 Teleseminar

November 2, 2012

Early Registration Discount By 10/26/2012 Registrations Received After 10/26/2012

VBA Members: $70.00 Non VBA Members/Atty: $80.00

VBA Members: $80.00 Non-VBA Members/Atty: $90.00

NO REFUNDS AFTER OCTOBER 26, 2012

PLEASE NOTE: Due to New Hampshire Bar regulations, teleseminars cannot be used for New Hampshire CLE credit

PAYMENT METHOD:

Check enclosed (made payable to Vermont Bar Association): $________________ Credit Card (American Express, Discover, MasterCard or VISA) Credit Card # ________________________________________Exp. Date_______ Cardholder: ________________________________________________________

Vermont Bar Association

ATTORNEY CERTIFICATE OF ATTENDANCE

Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: November 2, 2012 Seminar Title: Business Succession & Estate Planning for Closely Held Business Owners, Part 2 Location: Teleseminar Credits: 1.0 General MCLE Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

Estate Planning for the Closely Held Business Owner

David T. LeibellWiggin & Dana, LLP - Greenwich, Connecticut

(o) (203) [email protected]

Daniel L. DanielsWiggin & Dana, LLP - Greenwich, Connecticut

(o) [email protected]

Copyright 2012, David Thayne Leibell and Daniel L.Daniels

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TABLE OF CONTENTS

Page

I. Introduction 3

II. The Critical Role of Family Dynamics3

III. Phase I Planning 10

A. Testamentary Transfer Tax Planning10B. Asset Protection Trust Planning for12

DescendantsC. Liquidity, Buy-Sell Agreements and13

Life Insurance PlanningD. Incapacity Planning 21

IV. Phase II Planning 22

A. Liability Protection Planning22B. Introduction to Advanced Lifetime Wealth25

Transfer PlanningC. Spousal Estate Reduction Trust26D. Grantor Retained Annuity Trust27E. GRAT Planning Examples 35F. Sale to Intentionally Defective Grantor38

Trust (IDIT Sale)G. Tabular Comparison of GRAT versus44

IDIT SaleH. How to Cause Grantor Trust Status44I. Self Canceling Installment Note52


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J. Private Annuity 53K. Recapitalizing the Corporation to Preserve53

The Owner’s ControlL. Charitable Strategies54M. Other Advanced Planning Concepts62N. Holding Closely-Held Business Interests62

In TrustsO. Post-Mortem Planning63

V. Executing the Plan 63


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Estate and Succession Planning for the Family BusinessOwner

I. Introduction

Estate and succession planning for a business owner is acomplex exercise. It can involve virtually all of the tools inthe estate planner’s toolbox, from straightforward testamentaryplanning, to advanced gift planning, insurance issues, buy-sellagreements, corporate recapitalizations, and the list goes on.If the estate planner attempts to address all of these issues atonce, he risks overwhelming the client, with the result that noplanning gets done at all. Some call this “analysis paralysis.”Our experience has shown that analysis paralysis often can beavoided by breaking down the planning into Phase I and Phase II.

Phase I planning involves those steps that the businessowner can take which produce a relatively large benefit to theclient or his family but which involve relatively low “cost.”We think of cost as involving not solely professional fees.Instead, for a business owner, the costs of implementing aplanning idea can also include such things as whether thestrategy involves a loss of control or access to cash flow, asignificant investment of the owner’s time, or even theemotional “cost” of addressing a particular family issue. For abusiness owner, essential elements of Phase I planning includetestamentary transfer tax planning; planning for the managementof assets left to a surviving spouse or children; assetprotection planning; incapacity planning; and liquidityplanning, including consideration of a buy-sell agreement andlife insurance.

Phase II estate and succession planning for the businessowner involves those planning ideas that may provide asignificant benefit to the owner or his or her family but at agreater “cost” in terms of a greater commitment by the owner interms of time to implement, more complexity and professionalfees, loss of control or access to cash flow or all of theabove. Examples of Phase II planning concepts that manybusiness owners will consider include liability protectionplanning; advanced lifetime wealth transfer planning; andtestamentary planning at a level of sophistication beyond thatconsidered in Phase I.


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The success of family business estate and successionplanning will improve by breaking down the planning into phases,but planning will only truly succeed if the advisor understandsand is able to navigate the underlying family dynamics issuesthat drive the decision making of the family business owner. Soit is with family dynamics that we begin our discussion, becauseif family dynamics issues remain unresolved, the world’s finestestate plan will only collect dust on the shelf.

II. The Critical Role of Family Dynamics

According to a study titled “Correlates of Success inFamily Business Transitions”,1 the authors found a consistentpattern of factors that led to breakdowns in the successionprocess. Sixty percent of succession plans failed because ofproblems in the relationships among family members. Twenty fivepercent failed because heirs were not sufficiently prepared totake over ownership and management of the family business. Onlyten percent failed because of inadequate estate planning orinadequate liquidity to pay estate taxes. That means that,eighty five percent of family businesses fail in the successionprocess due to inadequate planning to resolve intrafamilydisputes over the business and the inability to groom successorsto run the family business.

Yet those families that take their stewardship of thefamily business from one generation to the next seriously, canbe surprisingly successful in effective succession planning.The New York Times, Cargill and S.C. Johnson are among a vastnumber of examples of companies that have successfullytransitioned more than three generations. In fact, the oldestfamily business operating in the United States is the ZildjianCymbal Co., which was founded in 1623 in Constantinople andmoved to the United States in 1929.

Some Statistics

Approximately 90 percent of U.S. businesses are familyfirms, ranging in size from small mom and pop businesses to thelikes of Walmart, Ford, Mars and Marriott. There are more than17 million family businesses in the United States and theyrepresent 64 percent of Gross Domestic Product and employ 62percent of the U.S. work force. Thirty-five percent of thebusinesses that make up the S&P 500 are family controlled.Family businesses are also more successful than non-familybusinesses, with an annual return on assets which is 6.65

1 “Correlates of Success in Family Business Transitions”, Journal of Business Venturing 12, 285-301 (1997)


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percent higher than non-family firms. Unfortunately, only alittle more than 30 percent of family businesses survive intothe second generation, even though 80 percent would like to keepthe business in the family. By the third generation, only 12percent of family businesses will still be viable, shrinking to3 percent at the fourth generation and beyond.2

Family Dynamics – In General

The disconnect between what 80 percent of families intend,and the far bleaker reality, can in part be attributed to afailure to plan effectively for the family dynamics issuesinvolved in family business succession. Fortunately, over thepast three decades the family dynamics issues that are crucialto successful family business succession have been studied andwritten about by both academics and practitioners. We now havea large body of reference material to rely upon. Although eachfamily business commentator comes at the family dynamics issuesinvolved in family business succession in his or her own way,sometimes based on whether they are organizationalpsychologists, business strategy experts, historians,sociologists, economists, accountants or trusts and estatesattorneys (like the always inspiring James (Jay) Hughes, Jr.,3),there are certain universal themes that come through much of theliterature. While an exhaustive discussion of the varioustheories is beyond the scope of this outline, several of theuniversal themes can be communicated by discussing the followingaspects of three seminal books on family business successionplanning: (1) “family businesses as systems”, as described inGeneration To Generation, Life Cycles of the Family Business,4 byKelin E. Gersick, John A. Davis, Marion McCollum Hampton andIvan Lansberg, (2) the “Five Insights” and the “Four P’s” fromPerpetuating the Family Business: 50 Lessons from Long-LastingSuccessful Families in Business5, by John L. Ward, and (3) the“three stages of succession” from Succeeding Generations:Realizing the Dream of Families in Business,6 by Ivan Lansberg.

Family Businesses as Systems

Perhaps the best known family dynamics theory for familybusinesses is the three-circle family business systems model

2 Family Firm Institute, Inc., Global Data Points, www.ffi.org/default.asp?id=3983 James E. Hughes, Jr., Family Wealth – Keeping It In The family, Bloomberg (2004), Family – The Compact

Among Generations, Bloomberg (2007)4 Harvard Business School Press (1997)5 Palgrove MacMillan (2004)6 Harvard Business School Press (1999)


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first developed by Harvard in the early 1980s. As described inGeneration to Generation, the model defines the family businesssystem as three independent but overlapping subsystems: (1)business, (2) ownership, and (3) family. (See “The Circle Game”)Each person in a family business is placed in one of sevensectors formed by the overlapping circles of the subsystems.All owners, and only owners, are placed in the top circle. Allfamily members are somewhere in the bottom left circle. Allemployees are in the bottom right circle.

The Circle GameThe family business consists of independentbut overlapping systems

- Kelin E. Gersick, John A. Davis, MarionMcCollum Hampton and Ivan Lansberg,Generation to Generations, Life Cycles of

the Family Business

A person that has only one connection to the familybusiness will be in one of the outside sectors (1, 2 or 3). Forexample, a family member who is neither an owner nor an employeewould be in sector 1. An individual who is an owner but not afamily member or employee would be in sector 2. An individualwho is an employee but not an owner or family member will be insector 3.

Those individuals with more than one connection will be inone of the overlapping sectors, resulting in that person fallingwithin two or three of the circles at the same time. Anindividual who is an owner and a family member but not anemployee will be in sector 4, which is within both the ownershipand family circles. Someone who is an owner and an employee butis not a family member will be in sector 5, which is within theownership and business circles. An individual who is in thefamily and works in the business but is not an owner is insector 6, which is within both the family and business circles.Finally, an individual who is an owner, family member and


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employee will be in the center sector 7, which is within allthree circles. It is important to note that every person who ispart of the family business system has only one location withinthe three circles.

The three circle model is a highly effective tool foridentifying and understanding the sources of interpersonalconflicts, role and boundary issues in family businesses.Specifying different subsystems and roles helps to simplify thecomplex interactions within the family business system.Understanding family business succession is much easier when allthree subsystems, family, ownership and business, with theirvarious interactions and interdependencies are analyzed as onesystem. The goal is to create an integrated system thatprovides mutual benefits for all system members. By identifyingthe position of each member of the family business system withinthe three circles, it is easier to understand the motivationsand perspectives of the individuals as determined by their placein the overall system.

The three-circle model creates an effective snapshot of afamily business at any particular point in time. According toGersick et al, in Succeeding Generations, such a snapshot is animportant first step in understanding family dynamics in aparticular family business. But as a family business enters aperiod of transition during business succession planning, peopleenter and leave as well as change their positions within thecircles over time. Therefore the authors believe that it isimportant to see how the whole family business system changes asindividuals move across boundaries inside the system over time.Adding the dimension of time to the three-circle model allowsfor a more accurate understanding of the family dynamics issuesas the succession plan progresses over a period of years.

Ward’s Five Insights

According to Ward, there are certain overarching principlescommon to the world’s most successful and enduring familybusinesses. He refers to these as the Five Insights and theFour P’s and he considers these concepts “the framework andfoundation for family business continuity.” The Five Insightsrepresent seminal concepts that connect family life andoperation of the business into an integrated whole.

Insight #1: Respecting the Challenge.

According to Ward, successful business families understandthat the odds are against them when it comes to passing the


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business on to the next generation. Because of this knowledge,they take succession planning very seriously and put enormoustime and effort into it. They embrace the challenge and educatethemselves and take the steps necessary to foil the adage ofshirtsleeves to shirtsleeves in three generations.

Insight #2: Common Issues but Different Perspectives.

Ward believes that successful multi-generational familybusinesses understand the following two concepts: (1) thatvirtually all family businesses share the same problems andissues, and (2) that different people within the family businesssystem see these same problems and issues in predictablydifferent ways depending on their position within the familybusiness system.

Regarding the first concept, understanding that a familybusiness is not alone in the problems and issues it facesempowers a family to gain the knowledge necessary to perpetuatethe business from one generation to the next. The secondconcept, that how a family member or nonfamily manager perceivessuccession issues depends on his or her position within thefamily system, requires respect of each and every perspective,and an acceptance that it is healthy to disagree.

Insight #3. Communication is Indispensible.

Successful business families work very hard at encouragingeffective communication. Lack of communication and familysecrets are significant factors in business families that areunsuccessful in passing the business to the next generation.Effective communication requires putting in place the forums andstructures necessary to promote open dialogue. Ward finds thatsuccessful business families put in place the followingstructures to encourage communication: (1) formation of anindependent board of directors for the business; and (2)beginning the process of having regular family meetings.

Insight #4. Planning is Essential to Continuity.

Proper planning is crucial to the success and continuity ofa family business. It is also more complex than planning fornon-family businesses. Ward uses a concept he calls the“Continuity Planning Triangle” (See “The Shape of Planning”).


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to illustrate the challenges unique to planning in a familybusiness. Business-owning families have to plan simultaneouslyon the following four different levels: (1) business strategyplanning, (2) leadership and ownership succession planning, (3)personal financial planning for family members, and in themiddle of the triangle, (4) family continuity planning.

Business strategy planning deals with answering thequestion “Where are we going as a business?”. In the familybusiness context, Ward believes that the business strategy planis interdependent with leadership and ownership successionplanning. Personal financial planning is many times asignificant weak link in family business succession. Mostfamily members have little cash flow outside the business andare dependent on the business for their financial security.Without significant assets outside the business, the seniorgeneration may not feel comfortable handing over the reigns. Itis crucial that family members begin as early as possible theprocess of wealth generation outside the business. This meanscontributing to retirement and profit sharing plans instead ofreinvesting everything in the business. It also means thinkingabout where the liquidity will come from to pay any estate tax.Family continuity planning results in a family mission statementor constitution which sets forth the ideals and guidingprinciples that allow family members to act for the greater goodof the family rather than in their own self-interest.

Insight #5. Commitment is Required.

The fifth insight to successful multi-generational familybusinesses is commitment. This includes (1) commitment to thefamily’s purpose, (2) commitment to planning for the future of


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the family, (3) commitment to having effective family meetings,and (4) commitment to the business and its continuity within thefamily.

The Four P’s

According to Ward, the Four P’s deal with the fundamentalparadox in family businesses, which is, that what the familyneeds to be strong and healthy, frequently conflicts with whatthe business needs to be successful. Families resemblesocialist institutions where people are treated equally,membership is permanent and interaction is primarily emotional.Business, on the other hand, is basically capitalistic, peopleare treated differently depending on their perceivedcontributions, and behavior is basically rational and objective.Because family and business systems have such different rulesand norms, the two systems result in conflict over issues suchas who gets hired and promoted, compensation of family membersand which family members run the business. Ward believes thatsuccessful business families acknowledge the inherent conflictand contradictions between the family and the business asinevitable and they employ the Four P’s to minimize or avert anyconflict these contradictions can create.

1. Policies Before the Need.

Ward writes that successful business families don’twait for a conflict to arise before they establish policies onpredictable issues. They put in place employment policiessetting forth the requirements for family members who want tojoin the business. These policies also deal with issues such ascompensation and performance appraisals. By putting suchpolicies in place before the need, when the issues do arise theycan be dealt with before they become personal and emotional.Such policies also help manage expectations on the part offamily members. They allow the family to be more objective thanif the decisions had to be made in the heat of a crisis. Inaddition, many conflicts are avoided because the policiesalready set forth what behavior is appropriate.

2. Sense of Purpose.

Successful multi-generational business families focusa great deal of attention in defining a sense of purpose for thefamily, including the family business. Such sense of purposewill be different for each family, but such an over-archingpurpose can provide significant assistance in helping the familyperpetuate the family business in times of strife and conflict.


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Ward writes that having a sense of purpose, is what sustains afamily business from one generation to the next.

3. Process.

Even if a business has policies in place before theyare needed, there will come a time when a significant unexpectedissue arises. The process the family uses to resolve suchissues is crucial to the continued success of the familybusiness. How the family communicates, solves problems,collaborates and reaches consensus may differ from family tofamily, but one theme unites successful business families; theylook for win-win solutions to the difficult problems.

Although it may sound strange to discuss parenting asan important factor in successful business successions, it isindeed a crucial factor in family business succession planning.Good parenting lays the foundation for how family members willengage each other in the family business. Parents can helpchildren learn proper values and lessons about communication,wealth, being responsible and working as a team. Properparenting can also help create a healthy relationship betweenthe family and the family business.

The Stages of Succession

Many commentators, including Ward, speak of the need tolook at succession planning through the lens of the specificstage that the business is in during succession. Ivan Lansbergin his book, Succeeding Generations does an excellent jobputting the concepts of the stages of succession in perspective.According to Lansberg, family businesses come in threefundamental forms: (1) the controlling owner business, (2) thesibling partnership, and (3) the cousin consortium.

1. Controlling Owner Form

Controlling owners control all aspects of the familybusiness. They make all of the major decisions and delegatevery little. Because of their economic clout and strongpersonalities, controlling owners cast a large shadow over theirfamilies. This is particularly the case if the controllingowner is also the founder of the business. Controlling ownerstypically answer to no one other than themselves. They rarelyhave a functioning board of directors. If there is a board, itis merely a rubber stamp for the controlling owner. Passing thereigns to the next generation is not easy for most controlling


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owners. Not only is the controlling owner many times a hard actto follow, he or she may be unwilling to step aside.

2. Sibling Partnership Form

In the sibling ownership form, the ownership isdivided more or less equally among a group of siblings, eachwith a fairly equivalent amount of power. Unlike thecontrolling owner, sibling ownership requires that the siblingsare accountable to each other, and that they consider eachother’s needs, perspectives and preferences. Sometimes asibling partnership is set up in a first-among-equals form,where one sibling is the acknowledged leader. Other times,sibling partnerships take a shared leadership form, in which thesiblings act as an equal team. The form that a siblingpartnership takes (first-among-equals or shared leadership) canhave major implications on how succession unfolds in the nextgeneration.

3. The Cousin Consortium

The cousin consortium is characterized by fragmentedownership, where over a period of several generations,ownership has been distributed among various branches of anextended family. Managing the dynamics of this fragmentedownership among various branches of an extended family can bevery difficult particularly when it comes to reinvesting in thebusiness versus paying dividends. Successful cousin consortiumsbegin to buy out those family members who are not interested inthe business and put in place structures such as family holdingcompanies, truly independent boards and even non-family CEOs.

4. Transitions Between the 3 Stages

According to Lansberg, the three stages arefundamentally different in both structure and culture.Succession planning strategies that work well in one stage canbe a recipe for disaster in another. From a succession planningstandpoint, each stage must be viewed as unique and decisionsmust be made in the context of the stage that the particularfamily business is in, and the stage it will be in after thesuccession is complete. For example, a transition from acontrolling owner form to a sibling partnership form willrequire a fundamental change in the leadership structure of thefamily business. Similarly, when a sibling partnership istransformed into a cousin consortium, there is another complete


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redefinition of authority and governance structures in thefamily business.

As estate planners, we tend to focus on structures thatensure that a family business is passed to the intendedbeneficiaries and that it is done so in the most tax-efficientmanner. We many times only represent the patriarch and/ormatriarch of the family business. It is important that we notignore the family dynamics issues that are so crucial toeffective family business succession. If family dynamics issuescause 85 percent of succession failures and estate and taxissues only 10 percent, perhaps we are not spending sufficienttime understanding how bad family relations can destroy thebeautiful estate plan we put in place.

III. Phase I Planning

A. Testamentary Transfer Tax Planning.

Under current law, a federal estate tax is imposed on allassets owned by an individual at death at a rate of 35 percent.Each individual is entitled to an exemption from the tax of $5million. There is an exemption from the tax for transfersbetween spouses, known as the marital deduction, provided that

the recipient spouse is a United States citizen7. In addition,if an individual transfers assets to grandchildren, or tocertain types of trusts for children that terminate in favor ofgrandchildren or more remote descendants, a separate generationskipping transfer tax (or GST tax) is imposed, again at a 35percent rate and with a $5 million exemption. As of January 1,2013, unless the Congress acts to change the law, the topfederal estate and generation skipping tax rate will rise to 55

percent and the exemption will decrease to $1 million8. Inaddition, some states impose an independent state-level estatetax at rates that can run as high as 16 percent or more. Thereare some simple steps the business owner can take to minimizethese taxes at his or her death, including the following:

1. Two-Share Tax Planning.

7 If the recipient spouse is a non-U.S. citizen, the marital deduction is available only if the transfer is made to aqualified domestic trust for the benefit of the recipient spouse. Very generally speaking, a qualified domestic trust isa trust of which the recipient spouse is the only beneficiary and which has a United States resident trustee (which, insome cases, must be a United States bank).

8 The generation skipping tax exemption is indexed for inflation, with the result that the GST exemption in effect in2013 will be somewhat more than $1 million.


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(a) If the owner is married, his or her will or revocabletrust agreement should contain planning to guarantee optimal useof both spouse’s federal estate tax exemptions. Traditionally,this was accomplished by the business owner dividing his estateinto two shares. The first share, sometimes called the“exemption share,” would be an amount equal to the owner’sfederal estate tax exemption and the second share, sometimescalled the “marital share,” would be the balance of the owner’sestate. The exemption share would pass to a trust, sometimescalled a “Credit Shelter Trust” or “Bypass Trust” and themarital share would pass outright to the surviving spouse or toa qualifying Marital Trust for his or her benefit. Thesurviving spouse could be given generous rights over the CreditShelter Trust, including perhaps the right to the income,principal as needed and even a limited testamentary power ofappointment, but would not be given “enough” rights to be calledthe owner of the trust for estate tax purposes. In this way,the trust would pass through the owner’s estate with no federalestate tax (because it utilizes the owner’s estate taxexemption) and through the surviving spouse’s estate with noestate tax, as well (because the surviving spouse did not ownthe trust for tax purposes). There would be no federal estatetax on the marital share at the owner’s death because of theunlimited marital deduction. At the surviving spouse’s death,the first $5 million of assets included in his or her estatewould pass to the children, tax-free, as a result of thesurviving spouse’s estate tax exemption. As a result, thecouple would have succeeded in sheltering two estate taxexemptions—or $10 million under current law—to the nextgeneration rather than only one.

(b) The 2010 Tax Relief Act provides for “portability” ofestate tax exemptions between spouses. As a result, it shouldnot be necessary to utilize the two-share structure describedabove to shelter a full $10 million of assets from tax for thechildren’s generation. However, in our practice, we havegenerally recommended that client’s continue to use the twoshare structure rather than relying on portability, for thefollowing reasons. (1) The statute establishing portability isscheduled to expire at the end of 2012; (2) relying onportability gives the children only the benefit of the 5,000,000exemption but fails to capture increases in value of theexemption share between the date of the first and secondspouses’ deaths; (3) there is no portability of generationskipping transfer tax exemptions; and (4) relying on portabilityprecludes use of the general benefits of a Credit Shelter Trust,including creditor protection, ability to sprinkle income among


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various trust beneficiaries, thereby potentially saving incometax for the family, and ability to sprinkle principal amongvarious trust beneficiaries, thereby possibly enabling greatertax-free gifting than would be available by relying onportability.

2. Generation Skipping Planning.

The two-share plan described above can be supercharged byadding generation skipping planning. Under a generationskipping plan, the wills or revocable trust agreements of theowner and his spouse would provide that their exemptions fromGST tax would be fully utilized, such that the $10 million thatthe couple plans to transfer to the children tax-free using thetwo-share planning described above would instead be transferredto trusts for the children. The trusts would be designed sothat each child would receive income and principal from his orher trust as needed, but would not be treated as the owner ofthe trust for estate tax purposes. As a result, to the extentthe trust assets were not consumed by the child during thechild’s lifetime, they would pass to the child’s children,entirely free of estate and GST tax.

3. Marital Trust for Spouse.

(a) If the business owner does not want his or her spouseto have control over inherited assets, or if he simply wants toensure that the spouse cannot leave the inherited assets to anew spouse should he remarry after the business owner’s death,the business owner can establish a “Marital Trust” to receivethe spouse’s share of the estate. The business owner would namesome trusted individual or institution to serve as a trustee ofthis trust, often with the spouse as a co-trustee. The spousewould receive income for life, and the trust can be designed toprovide him or her with principal as needed as well. Upon thesurviving spouse’s death, the trust terms would provide that thetrust assets would pass to the owner’s children, therebyeliminating the ability of the spouse to give those assets to anew spouse should he or she remarry.

(b) The Marital Trust may also provide an additionalestate tax benefit for certain business owner families.Consider the following two examples. In the first example,suppose the business owner holds 90 percent of the stock inBizco (and that the remaining 10 percent is owned by outsideshareholders). If the owner leaves the Bizco stock outright toher husband (and the husband is a U.S. citizen), husband willinherit it tax free. However, when husband later dies, he now


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owns a 90 percent interest in Bizco which, presumably, will bevalued in husband’s estate with a control premium. In thesecond example, suppose instead that, during their lifetimes,the business owner and her husband were to divide the stockbetween them, with the owner taking 45 percent and the husbandtaking 45 percent. Further suppose that, instead of leaving thestock outright to her husband, owner were to leave the stock toa Marital Trust for his benefit. At husband’s death, instead ofhis estate including one 90 percent block of stock, it includesa 45 percent block owned by the estate and a second 45 percentblock owned by the Marital Trust. If the Marital Trust isproperly designed, case law supports the estate taking theposition that the two blocks of stock should be valuedseparately, with the result that a minority interest discountshould be available in the second example, as opposed to thecontrol premium that applied in the first example. In ourpractice, we find that, at least with business owners who are inlong, happy marriages, this technique is a simple—and for manybusiness owners, painless-- way to reduce the value of the

business owners’ estates for tax purposes.9

B. Asset Protection Trust Planning for Descendants.

Many business owners will not want to pass ownership of thebusiness, or of other assets for that matter, outright to achild or other descendant. Assets left outright to a child areexposed to the claims of creditors, divorcing spouses and otherswho may influence the recipient to sell or otherwise use theassets in a manner inconsistent with the owner’s intentions. Ifthe owner instead leaves the assets to a properly designed AssetProtection Trust, the assets can receive a significant measureof protection from the claims of the descendant’s creditors ordivorcing spouse. In our practice, we often find that businessowners think that they already have such protection in their

9 There is, of course, no guarantee that the IRS will accept the minority interest discount in connection with the auditof the surviving spouse’s estate tax return. See, for example, Field Service Advice 2001-19013 (5/11/2001), inwhich the IRS laid out guidelines for its auditors as to whether a minority interest discount should be permittedwhen ownership of an estate asset is divided between the decedent and a general power of appointment marital trust.This trust differs from a QTIP Trust in that the surviving spouse has an unfettered power to appoint trust propertyduring life and/or at death. See Code Section 2056(b)(5). See also, Estate of Fontana, 118 T.C. 318 (2002). (Thediscount was not permitted.) However, there would appear to be no downside risk to the technique given that it doesnot result in gift tax during the client’s life. Moreover, there is now a large body of case law supporting thetechnique, including Estate of Bonner v. United States, 84 F.3d 196 (5th Cir. 1996); Estate of Mellinger v.Commissioner, 112 T.C. 26 (1999); Estate of Nowell v. Commissioner, T.C. Memo. 1999-15; and Estate of Lopes v.Commissioner, T.C. Memo. 1999-225. The IRS announced its acquiescence in Mellinger on August 30, 1999. AOD1999-006, 1999-35 I.R.B. 314. In all of these cases, the IRS argued that the assets of the QTIP trust should beaggregated with the assets owned outright by the surviving spouse for valuation purposes. The IRS argument wasrejected in all cases.


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wills or revocable trust agreements, but are surprised to learnthat if the descendant has the right to withdraw the trust fundsat a particular age, the trust may not provide much protectionat all.

C. Liquidity, Buy- Sell Agreement and Life InsurancePlanning.

1. The Importance of Cash Flow.

According to the 2007 Laird Norton Tyree Family BusinessSurvey, an astonishing 93 percent of family business depend onthe business as their primary source of income. This statistichas far ranging ramifications for the success or failure offamily business succession. A family business owner’sdependency on the business for cash flow is often an unspokenobstacle to beginning a healthy succession process. Why would abusiness owner transfer management and ownership of the familybusiness to the next generation without being certain about hisown retirement security and that of his spouse?

Advisers to family businesses have all seen clients who fitthe following description: an entrepreneurial business ownerwith a very valuable business and business real estate, a largeprincipal residence and vacation home, but little money in abrokerage account or retirement plan. The business ownersupports his lifestyle by taking distributions from thebusiness. Aside from the lack of investment diversification,this approach is all well and good until the business ownerbegins thinking about passing ownership of the business to thenext generation with a minimum of transfer taxes.

Phase I of the estate planning process that leads todiscussions of ownership succession is sometimes the first timethat a business owner contemplates how he will maintain hislifestyle when the children own the business. This can be afrightening process for anyone, particularly in the context ofhaving to deal with the loss of control that comes withtransferring ownership of a business that he may have spent alifetime building. Many times, however, the cash flow concernremains unspoken, as many advisers are more concerned with (orinterested in) the tax-efficient transfer of shares to the nextgeneration than they are with taking time to discuss the cashflow needs of the business owner. But the business owner oftenrealizes that once ownership is transferred, access to thebusiness as a “personal piggybank” may be over. Failing tosolve the cash flow problem can result in the businesssuccession process effectively ending before it even begins.


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We advisers can do better. We need to be able to show thebusiness owner that there are many ways to replace some or allof the necessary cash flow from sources other than the ownershipof the business. Guaranteeing the cash flow of the businessowner and his spouse is the first step in a successful familybusiness succession plan.

A frank discussion of the owner’s and spouse’s cash flowneeds helps to frame the issue. Once the adviser determinesannual cash flow needs, she can propose alternatives to satisfythose needs. The family business will in all likelihood remainthe best way of satisfying the business owner’s cash flow needs.But, with a succession plan in place, how the business willsatisfy those needs will change. Historically, the businessowner’s cash flow has come from what has been described by

Michael D. Allen as “control assured” income.10 While thebusiness owner controls the business, cash flow comes fromcontrol assured income such as salary, bonuses, C corporationdividends and S corporation and partnership distributions.Before a business owner transfers control to the nextgeneration, Allen recommends that the business owner replace“control assured income” with what he refers to as “contractassured income,” such as rents from the business real estate,deferred compensation, salary continuation agreements, buy-outpayments and income from such estate planning vehicles asgrantor retained annuity trusts and installment sales tointentionally defective grantor trusts (or simple sales directlyto family members). Following the business owner’s death, lifeinsurance on his life may supplement or replace income fromthese other sources.

Once the business owner’s cash flow and financial securityissues are resolved, the business owner frequently becomes moreamenable to discussing transfers of ownership and control to thenext generation. By reducing dependence on the business forcash flow, the business owner frees himself to focus oneffective succession planning.

2. Buy-Sell Agreements.

(a) Buy-Sell Agreements In General.

10 Michael D. Allen, “Representing the Patriarch in Family Business Succession,” ALI-ABA Course of Study Materials,Estate Planning for the Closely Held Business Owner (July 2006).


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We place buy-sell agreements in Phase I of the estate andsuccession planning process because entering into a buy-sellagreement does not require the business owner to give up accessto either control of, or cash flow from, the business. For awealthy business owner, simple testamentary tax planningdescribed above typically will not be nearly sufficient toshelter the entire estate from federal and state estate taxes.Federal and state estate taxes are typically due no later than 9months after death. Accordingly, in order to avoid a forcedsale of the business at suboptimal prices, if there is atransfer tax exposure at the owner’s death, it is critical toensure that sufficient liquidity is available to pay the tax.This may be accomplished through a properly designed buy-sellagreement, often funded in whole or in part with insurance onthe owner’s life.

In its simplest form, a buy-sell agreement is a contractualarrangement providing for the mandatory purchase (or right offirst refusal) of a shareholder’s interest, either by the othershareholders or by the business itself (or some combination ofthe two), upon the occurrence of certain events described in theagreement (so called “triggering events”). Such triggeringevents typically include the death, disability, retirement,withdrawal or termination of employment, bankruptcy, andsometimes even the divorce, of a shareholder. Buy-sellagreements are appropriate for all types of business entities,including C corporation, S corporation, partnerships and limitedliability companies. A buy-sell agreement does not have to be astandalone agreement, since buy-sell provisions can beincorporated into the entity’s other organizational documents.In fact, it is typically the case that there are already buy-sell provisions in existing organizational documents which maynot reflect the true desires of the family but are merely partof a standard package of organizational documents provided bythe family’s business lawyer. These existing provisions mayneed to be amended or overridden by a stand-alone buy-sellagreement if the family’s business succession plan is to beeffective.

(b) Reasons for Establishing a Buy-Sell Agreement

The primary objective of a buy-sell agreement is to providefor the stability and continuity of the family business in atime of transition through the use of ownership transferrestrictions. Typically, the agreement prohibits the transferof ownership to unwanted third parties by setting forth how andto whom shares may be transferred. The agreement also provides


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a mechanism for determining the sale price for the shares andhow the purchase will be funded.

The other reasons for having a buy-sell agreement depend onyour role as a party to the agreement. For the founder of thebusiness, who has built the business from nothing and feels thatno one can run the business as well as he or she can, a buy-sellagreement allows him or her to maintain control of the businesswhile at the same time providing for a smooth transition ofcontrol to the founder’s chosen successors upon his or her deathor disability. Structuring a buy-sell agreement provides anonthreatening forum for the founder to begin thinking aboutwhich children should be managing the business in the future andwhich should not. Typically, the founder will only want thosechildren who are active in the business to own a controllinginterest in the stock, but will want to treat all childrenequally in terms of inheritance. A buy-sell agreement allowsthe founder to sell control to children who are active in thebusiness and use the proceeds from the sale to provide for thechildren who are not active in the business. By specificallycarrying out the founder’s intent, a properly structured buy-sell agreement avoids the inevitable disputes between childrenwho are active and want to invest in the business and those whoare not active and would rather have the business pay dividends.If the founder becomes disabled or retires, a buy-sell canprovide the founder with the security that his or her cash flowwill not disappear since the agreement can provide for thecorporation and/or the other shareholders to purchase theshares, at a predetermined price, either in a lump sum orinstallments, typically at preferable capital gains rates.Sometimes disability buy-out insurance is purchased to providecash flow should a shareholder become disabled.

For those children who are active in the business, aproperly structured buy-sell will allow them to purchase thefounder’s shares over time on terms that have been negotiated atarms length and will not cripple their ability to operate thebusiness effectively or has been at least partially paid forusing life insurance. The agreement also provides a mechanismfor not having to go into business with siblings (and spouses ofsiblings) who are not active in the business.

For the entity, a buy-sell agreement can help keep thebusiness in the family and ensure the smooth transition to thenext generation. The Agreement can also void transfers thatwould result in the termination of the entity is S corporationor partnership status.


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For the estate of the founder, a buy-sell can (i) provide amarket for an illiquid asset avoiding a fire sale because thesale price is determined by the agreement, (ii) provideliquidity to pay any estate taxes, (iii) provide income for asurviving spouse and (iv) under certain circumstances fix thevalue of the shares for federal estate tax purposes.

(c) Structuring the Terms of the Buy-Sell Agreement

A variety of factors must be taken into consideration whenstructuring a buy-sell agreement for a family business. It iscrucial to understand that each family business is unique andthat a buy-sell agreement needs to be more than mereboilerplate. What works well for one family could be a disasterfor another. A buy-sell agreement has to be tailored to theparticular circumstances, taking into consideration such factorsas the following: 1. Is the business a C corporation, Scorporation, limited liability company or partnership?; 2. Whatis the proper way to value this type of business-fixed amount,formula, appraisal or some other method?; 3. Are there nonfamily members who own shares and will family members be givenpreference?; 4. Are the owners young and healthy enough toqualify for life and/or disability buy-out insurance?; 5.Should the business or the other shareholders purchase theshares?; 6. Which family members should be allowed to becomeowners?; 7. How will the terms of the buy-sell agreement impactprovisions in the business’s other organizational documents orloan agreement?; 8. Other than insurance, what sources ofliquidity are available to fund the purchase of shares?; and 9.Which of the many triggering events (such as death, disabilityor retirement) will be included in the agreement and which willrequire a mandatory purchase by the business and/or the othershareholders as opposed to a right of first refusal?

(d) Types of Buy-Sell Agreements

There are three different types of buy-sell agreements: 1.a cross-purchase agreement, 2. a redemption agreement and 3. ahybrid agreement. In a cross-purchase agreement, the remainingshareholders are required to buy, or given a right of firstrefusal over, the shares of the deceased or withdrawingshareholder. In a redemption agreement, it is the businessitself that is required or given an option to buy the shares.In a hybrid agreement, the business typically has the firstopportunity to purchase the shares, with any shares notpurchased by the business required to be purchased by oroptioned to, the other shareholders.


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(e) How to Choose the Right Type of Buy-Sell Agreement

In choosing among the three types of agreements – cross-purchase, redemption or hybrid – the key decision to be made iswho should be the purchaser. Will it be the remainingshareholders (cross-purchase), the entity (redemption), or acombination of the two (hybrid)? This decision requires ananalysis of various factors. One of the most important factorsis whether the purchase of the shares will be partially or fullyfunded with life insurance. If life insurance will be used andthere are multiple shareholders, a cross-purchase agreement maynot be appropriate. The reason for this is that (unless apartnership or LLC is used to own the insurance), a typicalcross-purchase agreement requires each shareholder to own apolicy on every other shareholder. For example, if there werefour shareholders, there would need to be twelve policies, sinceeach shareholder would need to own separate policies on theother three shareholders. Six shareholders would require thirtypolicies. With a redemption agreement, there would only need tobe one policy on each shareholder because the business is theonly purchaser. But be careful, if the business is a Ccorporation and a redemption agreement is used, the corporatealternative minimum tax may apply, making taxable 75% of theotherwise non-taxable life insurance proceeds. Other factors indetermining which type of buy-sell agreement to choose includewho has the ability to pay for the purchase of the shares (thecorporation or the shareholders) as well as income taxconsiderations depending on the nature of the entity for taxpurposes. For example, if the family business is a Ccorporation, the attribution rules under Code Section 318(attributing shares owned by certain family members, estates,trusts and businesses to other family members) may result in theredemption not qualifying for capital gain treatment under CodeSection 302(b) and therefore being treated as a dividend (notcurrently a problem since capital gain and dividend rates areboth 15%). A cross-purchase agreement will always be considereda capital gain transaction. If the business is an S corporationor a partnership, a redemption agreement would not result inordinary income, so it is important to note that the nature ofthe entity can result in different income tax consequencesdepending on the type of buy-sell agreement chosen.

(f) Setting the Purchase Price Under a Buy-Sell Agreement

One of the most important things that a buy-sell agreementdoes is to set the purchase price for an otherwise illiquidasset. This decision as to price is determined at a time wheneach owner is negotiating from a position of strength because


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none of them knows to whom the terms of the agreement will applyfirst. There are several ways in which the agreement can setthe purchase price. One common way to set the price is by theperiodic agreement of the owners. The main concern here is thatthe owners fail to meet regularly and therefore the price doesnot reflect current values. A second approach is to set thepurchase price by formula which takes into consideration suchfactors as book value and multiples of earnings. It is a goodidea to use a valuation expert if a formula clause is used.Another very common way to set the price is to require that itbe determined by an independent appraisal of value as of thedate of the triggering event.

(g) Can a Buy-Sell Agreement Fix Estate Tax Values?

Perhaps the most complicated issue in buy-sell planning isthe extent to which the price set forth in the agreement will berespected by the IRS for estate tax purposes. The concern isthat in the family business context the price set forth in theagreement does not reflect true fair market value since using anartificially low valuation would benefit the family byminimizing the amount of any estate tax. Since familybusinesses represent such a large percentage of wealth in theUnited States, both Congress and the IRS are concerned about asignificant loss of estate tax revenue if families are allowedto fix the value of the business for estate tax purposes using abuy-sell agreement. As a result, a complex body of case law andstatutory responses has developed over the course of the lasteighty years. The bottom line is that it is now very difficultto use a value in a family business buy-sell agreement otherthan actual fair market value and have it respected by the IRS.Although the value set forth in the agreement is not binding onthe IRS, it will be contractually binding on the parties to theagreement causing potentially disastrous results. Let’s assumethat Dad agrees to sell the business to his daughter, Sally, for$100 as set forth in a buy-sell agreement. Dad later dies andSally pays dad’s estate the $100 agreement price. The IRS doesnot respect the agreement price and sets the value of thebusiness at $300 for estate tax purposes. Dad’s estate owes$105 in estate taxes ($300 x 35%) but is contractually onlyentitled to $100. Such a result, which is not uncommon, couldhave a devastating impact on the family and lead to a possiblemalpractice suit against the estate planner. It is thereforeextremely important to have an understanding of both thestatutory and common law concepts involved in determining when abuy-sell agreement price will be respected for estate taxpurposes and when it will not.


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Until about fifty years ago, the courts typically wouldrespect the price set forth in a buy-sell agreement forestablishing estate tax values. As long as the agreement wasbinding on the shareholders during both life and at death andwas legally enforceable, the agreement price would be respectedeven if it was significantly lower than actual fair marketvalue. In 1958, the IRS issued regulations under Code Section2031 meant to curb perceived valuation abuses. Treas. Reg.Section 20.2031-1(b) defines fair market value as the price awilling buyer would pay a willing seller for the property, bothwith reasonable knowledge of the relevant facts and neitherbeing under a compulsion to buy or sell. The regulations underCode Section 2031 concede that the restrictions in a buy-sellagreement do impact the value of closely-held businessinterests. However, according to Treas. Reg. Section 20.2031-2(h), the price set forth in the agreement will be disregardedin determining value for estate tax purposes unless it isdetermined under the circumstances of the particular case thatthe agreement represents a bona fide business arrangement andnot a device to pass the decedent’s shares to the naturalobjects of his bounty for less than an adequate and fullconsideration in money or money’s worth. The Regulations havebeen elaborated on by the courts to establish a four part testwhich if satisfied (at least until the enactment of Code Sec.2703 in 1990) meant that the agreement price would be respectedby the IRS for estate tax purposes. The four requirements areas follows:

1. The agreement sets a fixed price for the sharesor one that is determinable by an ascertainable formula;

2. The agreement is binding both during the deceasedowner’s lifetime as well as at his death. This requirement wassatisfied as long as the deceased shareholder’s estate wasrequired to sell, even though the other parties were notrequired to purchase the shares but instead had only a right offirst refusal.

3. The agreement prohibits lifetime transfers at aprice higher than the agreement price. Gratuitous transfersduring life are permissible as long as the donees become subjectto the restrictions of t he buy-sell agreement; and

4. The arrangement is a bona fide businessarrangement and is not a device to pass the business intereststo the natural objects of the decedent’s bounty for less thanadequate consideration.


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Historically, courts considered the fourth requirement tobe satisfied as long as the price set forth in the agreementreflected actual fair market value at the time the agreement wasentered into, not at the date of the shareholder’s death. InRandolph v. United States,11 dealing with a buy-sell agreementthat predated Code Sec. 2703, the court rejected the IRSposition that fair market value should be determined as of theshareholder’s date of death, holding that the price set forth inthe agreement should be evaluated based on the facts inexistence as of the date the agreement was executed. So foragreements executed before the enactment of Code Sec. 2703 in1990, the price set forth in the agreement would be valid forestate tax purposes as long as the agreement met the four parttest of the regulations under Code Section 2031. This was thecase even if the agreement price was substantially lower thanthe actual fair market value. For example, in the Estate of

Hall v. Commissioner,12 the Tax Court accepted the agreementprice of a pre-1990 agreement that satisfied the four part testeven though the actual fair market value at the shareholder’sdeath without the restrictions was more than $170 millionhigher.

Over the years, the IRS and Congress grew increasinglyfrustrated over the fact that taxpayers were able to use thetechnical requirements of the regulations under Code Section2031, as interpreted by the Courts, to fix estate tax valuesusing a buy-sell agreement far below what the value would bewithout the restrictions. On October 8, 1990, Congress enactedCode Section 2703 to curb the perceived valuation abuses. CodeSection 2703 applies to all buy-sell agreements entered intoafter October 8, 1990, as well as those agreements that wereentered into prior to October 8, 1990 but substantially modifiedafter that date. In the case of family businesses, Code Section2703 effectively ends the ability of buy-sell agreements toartificially depress the value of the business for estate taxpurposes. Code Section 2703 expands on the four part testalready in existence, by breaking the fourth part of the testinto two requirements and then adding a third new requirement.

Under Code Section 2703(a), the estate tax value ofproperty shall be determined without regard to (i) any option,agreement or other right to acquire or use the property at aprice that is less than the property’s fair market value(without regard to such option, restriction or right), or (ii)any restriction on the right to sell or use such property. This

11 93-1 USTC 130 (S.D. Ind. 1993)12 92 T.C. 312 (1989)


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means that the general rule under Code Section 2703 is that therestrictions on price in a buy-sell agreement or similarprovision of any other document will be disregarded indetermining the estate tax value of the property. Code Section2703(b) provides that such option, agreement, right orrestriction will not be disregarded for estate tax valuationpurposes if the following three requirements are met:

1. The option, restriction or agreement is a bonafide business arrangement;

2. The option, restriction or agreement is not adevice to transfer such property to members of the decedent’sfamily (expanded to the “natural objects of the transferor’sbounty” in the corresponding regulations) for less than full andadequate consideration in money or money’s worth; and

3, The terms of the option, restriction or agreementare comparable to similar arrangements entered into by personsin an arms’ length transaction.

The first two requirements basically divide therequirements of the fourth requirement of the traditional testinto two parts, both of which now need to be satisfied. Notonly must the option, restriction or agreement be part of a“bone fide business arrangement” but such option, restriction oragreement must also not be merely a “device” to transfer suchproperty to the natural objects of the deceased owners bountyfor less than full and adequate consideration. The thirdrequirement under Code Section 2703(b) is something entirely newand it basically undermines completely the ability of buy-sellagreements to fix values for estate tax purposes for a familybusiness where the values are substantially lower than true fairmarket value. Code Section 2703(b) requires that in order tobe binding for estate tax purposes, the terms of the option,restriction or agreement must be “comparable to similararrangements entered into by persons in an arms’ lengthtransaction”. Treas. Reg. section 25.2703(1)(b)(4) providesthat a right or restriction is treated as comparable to similararrangements entered into by person’s in an arms’ lengthtransaction if the right or restriction is one that could havebeen obtained in a fair bargain negotiated among unrelatedparties in the same business dealing with each other at arms’length. In determining whether a right or restriction meets the“fair bargain” requirement, the regulations requireconsideration of such factors as (i) the expected term of theagreement, (ii) the current fair market value of the property,(iii) anticipated changes in value during the term of thearrangement, and (iv) the adequacy of any consideration given in


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exchange for the rights granted. The requirements of CodeSection 2703(b)(3), as interpreted by the Regulations, basicallyprecludes the ability of a buy-sell agreement to fix estate taxvalues in the context of a closely-held family business, becausethe only way to now truly know what the interest in the familybusiness will be worth for estate tax purposes is to wait forthe final determination of the IRS, either through an estateclosing letter or a settlement or valuation through the auditprocess or the courts.

Some commentators, including this one, believe that it isbest to base the purchase price in the agreement on one or moreappraisals at the owner’s death by independent valuation expertsusing valuation standards that would satisfy the comparabilityrequirements of Code Section 2703(b). This approach has thehighest probability for being respected by the IRS for estatetax valuation purposes. If the estate planner and/or the familyare concerned that the IRS will not respect the appraisals, thebuy-sell agreement can include an adjustment clause which wouldkick in if the IRS valuation was different from the appraisalvaluation, and adjust the purchase price under the buy-sellagreement to reflect the final valuation as agreed upon with theIRS for estate tax purposes.

It is important to note three additional points regardingCode Section 2703. First, the Regulations provide an exceptionto the requirements of Code Section 2703(b) if more than 50% ofthe value of the property subject to the agreement is owneddirectly or indirectly by individuals who are not the object ofthe transferor’s bounty. Second, Code Section 2703 does notapply to agreements that were in place prior to October 8, 1990,unless the agreement was substantially modified after that date.Third, Code Section 2703 is to be applied in addition to and inconjunction with, not in lieu of, the traditional four part testfor determining whether a buy-sell agreement will be respectedfor estate tax purposes.

(h) Funding the Buy-Sell Agreement

Proper funding of a buy-sell agreement is crucial to itssuccess. The primary funding alternatives are (i) insurance,(ii) an installment note, (iii) a sinking fund and (iv) somecombination of the first three alternatives.

Life insurance is an extremely common and effective fundingalternative. Whether owned by the business in a redemptionagreement or by the other shareholders in a cross-purchaseagreement, it provides the purchasers with the ability to


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guarantee a certain amount of money will be there at the deathof the owner as long as the premiums are paid. The type of lifeinsurance typically purchased in the family business context issome form of permanent insurance (such as whole life, universallife or variable life) rather than term insurance, which getsmore expensive as the insured ages and may not be able to berenewed beyond a certain age (usually between 60 and 70 years ofage).

There are downsides in certain circumstances to using lifeinsurance to fund a buy-sell agreement. As mentioned earlier,if a cross-purchase agreement is chosen and there are more thantwo shareholders, each shareholder will need to purchase a lifeinsurance policy on every other shareholder (unless apartnership is established to own the insurance). In addition,although life insurance proceeds are typically income tax free,if a C corporation uses life insurance to fund a redemptionagreement, 75% of the life insurance proceeds will be subject tothe corporate alternative minimum tax if the corporation hasgross receipts in excess of $7,500,000. Perhaps the biggestconcern with using life insurance in a corporate redemptionagreement is the possibility that the insurance proceeds will beincluded in the valuation of the business for estate taxpurposes. The Eleventh Circuit in Estate of Blount v.

Commissioner13 recently overturned a Tax Court finding thatinsurance proceeds should be included in the valuation of thebusiness, holding that the proceeds were offset by thecorresponding obligation of the corporation to pay the amountsto the decedent’s estate pursuant to the buy-sell agreement andtherefore should not be included in the estate tax valuation.

Life insurance also does not provide for handling lifetimetransfers under a buy-sell agreement, such as disability orretirement. In the case of disability as a triggering event,disability insurance could be purchased to satisfy theobligation. And in the case of retirement, the cash value ofthe life insurance could be used to satisfy a portion of thepayout.

The second most common funding alternative is to fund thepurchase using an installment note that qualifies for capitalgain deferral under Code Section 453. An installment note issometimes used in lieu of and sometimes in addition to lifeinsurance funding (for example, “any amounts not satisfied bythe life insurance will be paid pursuant to an installmentnote”). Structuring the installment note is like structuring

13 428 F.3d 1338 (11th Cir. 2005)


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any other kind of promissory note. You need to choose a term,which typically runs between ten and twenty years. Acommercially reasonable interest rate based on what lendinginstitutions would charge can be chosen or the interest rate canbe tied to the “applicable federal rate” set forth in CodeSection 1274(d). In the family business context, the applicablefederal rate should be the floor for the interest rate as itguarantees that the IRS will not recharacterize a portion of theloan as a taxable gift. In many cases the buy-sell agreementwill require the purchaser to pledge the purchased shares ascollateral until the loan is completely paid.

A third, and the least common, way to fund the agreement,is through the creation by the corporation of a sinking fundaccumulated over time for the purpose of funding the buyout.

(i) Coordinating the Buy-Sell Agreement with the EstatePlan

In order for a buy-sell agreement to have its best chanceat success, its terms should be coordinated with the rest of theowner’s estate plan. Many times we see estate plans where theterms of the owners will and the terms of the buy-sell agreementactually contradict each other. This is a recipe for disaster.Important issues to consider include (i) the choice offiduciaries (for example, is an independent trustee necessary),(ii) how should the estate tax be apportioned and who will payany additional tax if the IRS says the buy-sell price is toolow, and (iii) how will the terms of the buy-sell agreementimpact the ability of the estate to take advantage of certainpost-mortem planning opportunities, such as the ability of theestate to qualify for the election to defer estate taxes underCode Section 6166. Finally, the estate planning attorney needsto notify the parties to the agreement regarding the scope ofthe legal representation regarding the buy-sell agreement andinform them that each should consider obtaining his or her ownlegal counsel and obtain waivers of any conflict if a partychooses not to obtain separate counsel.

Although buy-sell agreements are no longer effective forartificially depressing the value of a family business forestate tax purposes after the enactment of Code Section 2703 in1990, they remain a foundational document in most businesssuccession plans for family businesses. A properly structuredbuy-sell agreement makes sure that the business passes to theintended beneficiaries and minimizes the possibility of familydiscord. The agreement also provides a market for an otherwiseilliquid asset and a source of funds to pay any estate taxesthat may be due.


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3. The Role of Life Insurance.

Business owner’s estates are inherently illiquid, with thebusiness and the business real estate representing the lion’sshare of the value of the estate. Family business owners areperfect candidates for life insurance, which provides instantliquidity at the business owner’s death in order to pay estatetaxes, provide for children not active in the business, fund thebuy-sell agreement, and provide for a spouse from a secondmarriage.

The type of life insurance that best suits family businesssuccession planning is permanent insurance and in particularguaranteed universal life insurance which typically provides thelargest guaranteed death benefit for the lowest cost. Althoughlife insurance proceeds are not income taxable to thebeneficiary, such proceeds are typically taxable in theinsured’s estate. That is why it is so important for theinsurance to be owned by an irrevocable life insurance trustwhere the proceeds will not be subject to estate tax becausethey are not considered owned by the business owner’s estate.Life insurance trusts can be structured to own single lifeinsurance policies that pay out on the death of the businessowner or second-to-die life insurance policies which pay out onthe death of the survivor of the business owner and his spouse,which is typically when estate taxes are due. It is importantto remember that if a business owner transfers an existing lifeinsurance policy and dies within three years of the transfer,the proceeds are brought back into his taxable estate under IRCSection 2041. It is always best, if possible, to have theinsurance trust trustee be the initial purchaser of the policyso the insurance is out of the business owner’s estate from dayone.

Paying for the insurance depends on who owns the policy.If the insurance is owned by the other shareholders or thecorporation in the context of a buy-sell agreement, there shouldbe no gift consequences on paying premiums. Sometimes theinsurance ownership is bifurcated between the business owner andthe corporation or between the business owner and certain familytrusts. This bifurcated ownership is known as split dollar, andit is crucial that the business owner work with an insuranceprofessional that specializes in split dollar, since it isfilled with tax traps. If the insured is providing the assetsnecessary to pay the premiums on the insurance owned by theirrevocable insurance trust, he can avoid paying gift tax byqualifying the transfers as present interests gifts to the trust


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following the process set forth in Crummey v. Commissioner andits progeny. If available annual exclusions are insufficient topay premiums, the business owner can consider funding theinsurance trust with some or all of his $5,000,000 federal gifttax exemption. Remember, the $5,000,000 exemption is onlyavailable, unless extended, through December 31, 2012.14

D. Incapacity Planning.

A final piece of Phase I planning is incapacity planning.If the owner becomes incapacitated and no planning has beendone, the family will be forced to go to court to obtain theappointment of a guardian or conservator to manage the owner’sfinancial and personal affairs. This result can be avoided inalmost all cases through the simple expedient of a properlydesigned power of attorney and health care proxy naming theappropriate individual to make financial and health caredecisions in the event of the owner’s incapacity. As a power ofattorney can sometimes be an unwieldy document to use to makedecisions regarding a complex business enterprise, we oftensuggest that the business owner also execute a revocable livingtrust agreement. The owner’s interest in the business can betransferred to the revocable trust agreement during the owner’slifetime and, while the owner has capacity, he or she can be thetrustee. However, upon the owner’s incapacity, a new trusteewould step in to make decisions regarding the business interestsheld in the trust. This approach can be preferable to a powerof attorney because the trust agreement can include detailedinstructions for the trustee as to how to make decisionsrelating to the business. The trust agreement can also providegreater flexibility for appointing additional or successortrustees; this can be more difficult to do in a power ofattorney.

IV. Phase II Planning

A. Liability Protection Planning.

1. In General.

The activities of the business may give rise to liabilityrisks. A well-constructed estate plan will address these risksand consider methods for insulating the owner’s assets fromthose risks. While it is tempting for clients—and sometimestheir advisers—to think that liability protection mainlyinvolves complex trust or corporate structures to shelter

14 Melvin A. Warshaw, “Life Insurance Planning After the 2010 Tax Act,” Trusts & Estates, April 2011, pgs 48-55


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assets, our usual advice is that clients first visit with theirproperty and casualty insurance adviser to ensure that theirliability insurance is adequate. A properly structured propertyand casualty insurance program (including a large liabilityumbrella policy) not only can protect the business and thebusiness owner from catastrophic losses, it often will provide abenefit that is less discussed but perhaps equally important,which is the payment of legal defense costs in the event of alawsuit against the business owner or the company. We typicallyadvise a thorough review of the insurance programs for both thebusiness and the business owner, including implementing ahealthy amount of umbrella coverage over and above the owner’sprimary insurance coverage.

Beyond property and casualty insurance, the business ownermight consider what we refer to as “insulation” strategies. Oneset of insulating strategies involves insulating each of thebusiness’s risky activities inside its own liability-shieldingstructure such as a corporation, limited liability company orlimited partnership. For example, suppose that the owner’sprimary business is manufacturing. Further suppose that thebusiness is operated in building owned by the ownerindividually. We would typically advise that each activity—themanufacturing business and the operation of the real estate inwhich the business is housed—be insulated inside its owncorporation or other entity. In that way, in the event of a lawsuit involving the manufacturing activities, arguably only theassets of the manufacturing business itself, and not the realestate owned in the separate entity or the business owner’sother assets, is exposed to the lawsuit. Although a fulldiscussion of choice of entity is beyond the scope of thisoutline, it often will be beneficial for the chosen entity to bea partnership or LLC, rather than a corporation, because thepartnership or LLC receives pass-through status for income taxpurposes.15

2. Goal of Asset Protection Planning. Asset protectionplanning can be summed up as the organization of the businessowner’s assets to minimize the ability of future unforeseencreditors to access those assets. The result of good assetprotection planning is to discourage lawsuits or encouragesettlements for less than the claim. For a business owner whoalready has claims against him, asset protection planning can bedifficult or impossible because of state fraudulent conveyance

15 An S corporation generally receives pass-through status as well, but can be less beneficial than a partnership orLLC at the death of the owner. Assets held inside a partnership or LLC can receive a stepped up cost basis if aproper election under section 754 of the Internal Revenue Code is made. The section 754 election is notavailable for assets held inside an S corporation.


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statutes. These statutes provide that if an individual attemptsto transfer assets out of his or her name with the intent tohinder or defraud a creditor, or if the transfer causes theindividual to become insolvent, a court can "undo" the transfer,thereby enabling the creditor to reach the transferred asset.

3. Carrying Adequate Liability Insurance.

Adequate insurance is the first line of defense in assetprotection planning. Therefore, it is critical that the businessowner have his insurance reviewed by an expert to ensure adequatecoverage. The goal is to transfer the liability exposure to theinsurance company. Sometimes, however, insurance will not covera particular claim or the policy limits are too low to satisfythe judgment. This is why it is important to have an assetprotection plan in place as a second line of defense.

4. One Size Does Not Fit All.

There are no cookie cutter solutions for asset protectionplanning. If a strategy sounds too good to be true, it probablyis and the client should avoid it. True asset protectionplanning is more of an art than a science and involves theappropriate application of available asset protection strategiestailored to the client's particular needs and integrated withthe client's estate plan. The plan should have the flexibilityto change with the client's changing circumstances.

5. Exemption Planning.

Under state law, certain types of assets are exempt fromcreditors' claims, even if the assets remain in the businessowner’s name. Depending on the particular state involved,exempt assets can include the business owner’s personalresidence, retirement accounts (some types are also exemptbecause of federal pension laws) and even life insurancepolicies. The size of creditor exemptions varies widely amongthe states. For example, Florida allows an unlimited exemptionfor the value of the individual's personal residence while theexemption for a personal residence for a New York resident isonly $10,000 for a single person. The business owner shouldcheck with his own legal advisers as to the availability andsize of exemptions under applicable state law.

6. Changing Title to Assets.

Proper asset titling, traditionally a goal of good estatetax planning, is also a key component of effective asset


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protection planning. Generally, if an individual does not ownan asset, his creditors will be unable to reach the assetunless the creditor can show that the individual’s transfer ofthe asset violated a state fraudulent conveyance statute.Transfers that are shown to have estate planning purposes, suchas equalizing an estate between a husband and wife, are lesslikely to be treated as fraudulent conveyances than transferswithout a separate estate planning purpose.

7. Charging Order Protected Entities.

One asset protection strategy that may be useful involvesthe creation of a limited partnership or limited liabilitycompany to hold a portion of the business owner’s assets. Evenif a creditor is successful in obtaining a judgment against alimited partner or member, the creditor should not be able toaccess the assets of the partnership or LLC to satisfy theclaim. Depending on applicable state law, the creditor shouldonly be entitled to a charging order giving the creditor theright to receive the distributions to which the debtor wouldhave been entitled. If no distributions are made, thecreditor gets nothing. This acts as an incentive for thecreditor to settle the claim at less than the amount of thejudgment. One caveat: single member LLCs may not provide thesame degree of protection as an LLC with multiple members.

8. Trusts.

Domestic irrevocable trusts may be effective mechanismsfor asset protection planning. Such trusts fall into two broadcategories - third party spendthrift trusts and self-settledtrusts. Third party spendthrift trusts do not include thegrantor as one of the beneficiaries. The spendthrift aspects ofthe trust give the trustee discretion regarding when and ifdistributions are made. This may make a spendthrift trust ahighly effective vehicle for family members with potentialcreditor problems, including divorce. Self-settled trusts areirrevocable trusts where the grantor is one of the beneficiaries.A trustee who is not the grantor has full discretion as towhether to make distributions. Historically, courts haveallowed creditors to access funds in a self-settled trust. Inrecent years, however, several states (for example, Delawareand Alaska along with at least eight other states) have adoptedstatutes allowing creditor protection for self-settled trusts.At this point, however, these statutes have not beenadequately tested to determine their viability for true assetprotection.


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Perhaps the most effective (and the riskiest) assetprotection strategies involve offshore trusts. A self-settledtrust may be established in a jurisdiction outside that UnitedStates that has enacted laws specifically designed to protecttrust assets from claims of the grantor’s creditors. Examplesof such jurisdictions are the Cook Islands and Gibraltar amongmany others. The trust agreement would name a local financialinstitution as a trustee. Such trusts have proven to beextremely effective as asset protection vehicles. The offshorecreditor protection jurisdiction generally has laws which do notrespect U.S. judgments and creditors must prove their case allover again in local courts applying very debtor-favorablestatutes. There is, however, a potential line of attack againstsuch trusts (and against domestic asset protection trusts),particularly those that contain a so-called duress clauses(prohibiting any repatriation of the assets even upon thegrantor's request). U.S. courts have been willing to hold thedebtor in criminal contempt and haul him or her off to jailuntil the debts are paid. This proves problematic if, as ismany times the case, the offshore trustee will not release theassets. Several individuals have spent significant time in jail.

Asset protection planning is most successful when acombination of the approaches discussed above (along with others)are used. No strategy can be said to "bullet proof" a client fromcreditors' claims. However, the layering of a number ofstrategies, as part of the client's overall estate plan, maypresent a creditor with sufficient hurdles that the creditor maybe willing to settle for a fraction of the original claim.

B. Introduction to Advanced Lifetime Wealth TransferPlanning.

For many advisers, wealth transfer planning is the startingpoint for planning for the business owner. For us, however,discussions about transferring assets to save estate taxes or tobring the junior generation into the business generally do notbegin until after Phase I of the plan has been implemented. Wefind that this approach produces two benefits. First, it helpsensure that the business owner gets some plan in place insteadof engaging in endless and sometimes confusing discussions aboutlifetime wealth transfer planning, all the while having possiblydone nothing to ensure the orderly passage and operation of thebusiness in the event of the owner’s death or incapacity.Second, time after time, we find that the very process of goingthrough Phase I planning can help the business owner develop acomfort level with estate and succession planning generally thatcan make it easier to come to terms with the hard decisions that


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often need to be made about asset transfers, managementsuccession, loss of control or loss of access to cash flow, inimplementing Phase II of the plan.

As complex as lifetime wealth transfer can be, from thestandpoint of taxes alone, it is actually quite simple. If anindividual attempts to transfer assets during lifetime in orderto avoid an estate tax, the transfer will generally instead besubject to a federal gift tax. Since the gift tax and theestate tax apply at the same rates and generally have the sameexemptions, there should be no incentive for an individual totransfer wealth during life as opposed to waiting to transfer itat death. In effect, by enacting the gift tax as companion tothe estate tax, the Congress created an “airtight” transfer taxsystem. There are, however, leaks in that system. The threeprimary examples of those leaks in the system are removing valuefrom the system, freezing value within the system anddiscounting values within the system.

Removing value from the system is hard to do. In mostcases, if an individual makes a gift during lifetime, that giftis brought back into the taxable estate at death. However,there are two exceptions to this general rule, which are theannual gift tax exclusion and the “med/ed” exclusion. If anindividual makes a gift using his or her $13,000 annual gift taxexclusion, the gifted property is entirely removed from thetaxable estate. Individuals are also permitted to make gifts ofunlimited amounts for tuition and certain medical expenses, aslong as the payment is made directly to the provider ofservices. Such med/ed gifts are entirely excluded from thetaxable estate.

Freezing value within the system usually connotes theindividual making a gift using some or all of his or herlifetime exemption from federal gift tax. For example, theowner might make a gift of $5 million worth of stock in thebusiness to a child. Upon the owner’s death, the $5 milliongift is actually brought back into the estate for purposes ofcalculating the owner’s estate tax. However, it is only broughtback into the estate at its value at the time the gift was madeand is sheltered from tax at that time via the use of the

owner’s $5 million estate tax exemption16. Accordingly, if the

16 In the view of some commentators, if the decedent makes a gift in a year when the gift tax exemption is $5million but dies in a year in which the exemption is some lower amount, the estate will be taxed on thedifference between the two exemptions. This is sometimes referred to as a “claw back” of the tax that “shouldhave been” paid on the gifted asset. For a good discussion of this complex issue, see Dan Evans,“Complications from Changes in the Exclusion,” LISI Estate Planning Newsletter #1768 (January 31, 2011) atleimbergservices.com


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value of the gifted property increases between the date of thegift and the date of the owner’s death, the appreciation avoidstransfer tax. In other words, the owner succeeds in “freezing”the value of the gifted property at its date-of-gift value.

A holy grail of estate planners has been to find a way offreezing the value of an asset at some number lower than what itis actually “worth” to the owner’s family, also known as“discounting” values. Suppose a business owner owns all of thestock in business with an enterprise value of $5 million. Ifthe business owner gives all of the stock to her child, she willhave made a taxable gift of $5 million. On the other hand,suppose that the business owner gives half the stock to onechild and half to the other child. An appraiser is likely toopine that the interests received by the children are subject tolack of control discounts, since either child could deadlock theother in a vote involving the stock. If the appraiser applies,say, a 20 percent lack of control discount, the value of thegift would be reduced to $4 million. Accordingly, the businessowner succeeds in freezing values at something less than thefull value of the business in the eyes of the family as a

whole17.

C. Spousal Estate Reduction Trust

One of our favorite examples of a technique that canremove, freeze and discount values all in one fell swoop is theSpousal Estate Reduction Trust, or SERT. In a typical SERT,the owner creates an irrevocable trust, naming her husband orsome other trusted individual or institution as trustee. Duringthe life of the owner and her spouse, the trustee is authorizedto sprinkle income and principal among a class consisting of theowner’s husband and descendants. Upon the death of the survivorof the owner and her husband, the remaining trust assets aredivided into shares for descendants and held in further trust.The SERT provides the following benefits. The owner’s gifts canqualify for the gift tax annual exclusion because the trustwould include Crummey withdrawal powers for each of the owner’sdescendants. This removes value from the owner’s estate. Ifdesired, the owner could use the trust as a repository for alarger gift utilizing her lifetime gift tax exemption, therebyfreezing values for transfer tax purposes. Moreover, the assetto be gifted to the trust can be interests in the closely held

17 In Revenue Ruling 93-12, 1993-1 C.B. 202, 1993-7 IRB 13, the IRS ruled that gifts of separate minorityinterests in stock would not be aggregated for purposes of determining whether a lack of control discountshould be applied.


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business, which a qualified appraiser may value by applyingdiscounts for lack of control and lack of marketability, therebyachieving discounted asset values for transfer tax purposes.

Beyond being a good vehicle through which to achieve thewealth transfer trifecta of removing, freezing and discountingvalues, the SERT provides a number of other benefits. The trustincludes the grantor’s spouse as a beneficiary. Although thegrantor can never have any legal right to the assets held in theSERT, and neither can there be any prearrangement orunderstanding between the grantor and her spouse that thegrantor can use assets in the trust, if the grantor is in ahappy marriage, it nonetheless can be comforting to know thather spouse will have access to the property in the trust evenafter the gift. As an additional benefit, the SERT would beestablished as a grantor trust for income tax purposes. As aresult, the business owner would pay income tax on the incomeand gains earned by the trust. This depletes the owner’sestate, and enhances the value of the trust, but is not treatedas a taxable gift, in effect providing a very powerfuladditional means of removing value from the transfer tax system.Finally, the business owner could allocate her GST exemption tothe SERT, thereby removing the gifted assets from the transfertax system for multiple generations.

D. Grantor Retained Annuity Trust

1. Introduction to GRATs.

The basic concept behind a GRAT is to allow the businessowner to give stock in the business to a trust and retain a setannual payment (an “annuity”) from that property for a setperiod of years. At the end of that period of years, ownershipof the property passes to the business owner’s children ortrusts for their benefit. The value of owner’s taxable gift isthe value of the property contributed to the trust minus thevalue of his right to receive the annuity for the set period ofyears, which is valued using interest rate assumptions providedby the IRS each month. If the GRAT is structured properly, thevalue of the business owner’s retained annuity interest will beequal or nearly equal to the value of the property contributedto the trust, with the result that his taxable gift to the trustis zero or near zero. How does this benefit the businessowner’s children? If the stock contributed to the GRATappreciates and/or produces income at exactly the same rate asthat assumed by the IRS in valuing the individual’s retainedannuity payment, the children do not benefit, because theproperty contributed to the trust will be just sufficient to pay


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the individual his annuity for the set period of years.However, if the stock contributed to the trust appreciatesand/or produces income at a greater rate than that assumed bythe IRS, there will be property “left over” in the trust at theend of the set period of years, and the children will receivethat property--yet the business owner would have paid no gifttax on it. The GRAT is particularly popular for gifts of hardto value assets like closely held business interests because therisk of an additional taxable gift upon an audit of the gift canbe minimized. If the value of the transferred stock isincreased on audit, the GRAT can be drafted to provide that thesize of the business owner’s retained annuity payment iscorrespondingly increased, with the result that the taxable giftalways stays near zero.

2. GRATs as Bifurcated Estate Freeze Devices.

GRATs (and the GRAT’s cousin, the IDIT Sale) are typicallyclassified by estate planners as “estate freeze” devices. Ingeneral, any completed gift constitutes an estate “freeze” inthat the value of the property is fixed at the time the gift ismade. Any income or appreciation in the property after the dateof the gift is removed from the transferor’s taxable estate.GRATs and Defective Trust Sales, however, accomplish a differentkind of estate freeze, one in which interests in the transferredproperty are bifurcated. In such a bifurcated freeze, a seniorgeneration member such as a parent or grandparent (“Senior”)transfers an interest in property, retaining the right toreceive fixed payments for a certain period, with the remainderpassing to junior generation members such as children orgrandchildren (“Junior”). If the transaction is structuredproperly, the value of the taxable gift to Junior is not thefull value of the transferred property but rather the value ofthe transferred property less the value of Senior’s retainedpayment flow. Senior’s retained payment flow is valued on apresent value basis using an appropriate discount rate. If thetransferred property performs at a rate better than the assumeddiscount rate, then the excess return will pass to Junior freeof transfer tax and the transaction will have effected asuccessful estate freeze.

The bifurcated estate freeze produces at least fourbenefits. First, if the transferor is adverse to paying gifttaxes, a bifurcated estate freeze can reduce the size of thetaxable gift to zero or near-zero. If the transaction isarranged either to comply with applicable provisions of section


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2702 of the Code or to fall outside the ambit of section 2702,then the value of Senior’s taxable gift will be discounted toreflect the value of Senior’s retained payment flow. In manycases, the value of Senior’s retained payment flow can bestructured in such a way that the taxable gift is at or nearzero. In this manner, a client who has utilized all of herremaining unified credit equivalent amount can continue toremove property from her estate on a transfer tax-free basis.

Second, the transferor is able to retain cash flow from thegifted property. Third, any appreciation in excess of the valueof Senior’s frozen retained interest passes to Junior free oftransfer tax. Fourth, the valuation of Senior’s retainedinterest assumed that the fixed payments to which Senior isentitled were actually made. Prior to the enactment of section2702 of the Code--and, in limited instances, even now--theactual amount of each year’s fixed payment to Senior might havebeen vastly smaller than the amount assumed in valuing Senior’sretained interest. This could result in significant transfertax-free shifts of value to Junior even if the transferredproperty failed to appreciate in value after the date of thegift, as described in the following section.

3. Section 2702 Limitations

Prior to enactment of section 2702 of the Code, estatefreeze transactions could result in undervaluation of Junior’sinterest due to the ability of Senior to administer trustproperty to reduce the amount of property returned to Senior farbelow the retained return assumed by the IRS in its valuationtables.

Example: On January 1, 1988, Senior transfers a $1,000,000securities portfolio to an irrevocable Grantor Retained IncomeTrust (“GRIT”), providing that income shall be paid to Seniorfor 10 years, remainder to Junior. Under the law in existenceat that time, Senior’s retained interest would have been valuedat a discount rate of 10%. Treas. Regs. §§ 25.2512-5A; 20.2031-7A. The effect for valuation purposes was to treat Senior as ifshe had received a payment of $100,000 annually throughout theten-year term of the trust, resulting in a valuation of Senior’sretained interest at $614,460 and a taxable gift of $385,540.However, the trustee could manipulate the investments of thetrust to produce little or no accounting income to be returnedto Senior. If, for example, the trustee were able to invest thetrust assets to produce no accounting income, Senior wouldreceive nothing and Junior would receive all of the appreciationon the gifted property. In effect, Junior would be placed in


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the same position as if Senior had made an outright gift of$1,000,000 but the gift would be valued at only $385,540.

In an effort to curb the perceived abuses presented by thevaluation structure described above, in 1990, Congress enactedChapter 14 of the Internal Revenue Code which includes section2702. Section 2702 generally attempts to limit theopportunities for significant gaps between gift tax and actualvalues of the senior generation member’s interest in the trustcaused by a Trustee’s manipulation of the amount of accountingincome in a trust. It accomplishes this result by providinggenerally that in the case of a transfer by a member of thesenior generation to a “family member,” any interest retained bySenior will be assigned a value of zero for transfer taxpurposes unless that interest is a “qualified interest.”“Family member” is defined to mean the transferor’s spouse, anyancestor or lineal descendant of the transferor or thetransferor’s spouse, any brother or sister of the transferor andany spouse of the foregoing. Treas. Regs. § 25.2702-2(a)(1).In general, an interest is a “qualified interest” only if itconsists of the right to a guaranteed payment, such as acumulative dividend or other guaranteed payment from a freezepartnership or a guaranteed annuity interest or a guaranteedunitrust interest from a grantor retained annuity or unitrust.See IRC §§ 2701, 2702; Treas. Regs. §§ 25.2702-3.18

With the enactment of Chapter 14, estate freeze techniquesgenerally can succeed only if either the transferred propertycan out-perform the applicable assumed interest rate--sometimesreferred to as the “hurdle rate”--used in valuing Senior’sretained interest or the transaction falls outside the ambit ofChapter 14.

4. GRAT Example.

In a typical GRAT, Senior transfers property to a trust,receiving back an annuity payment for a fixed term. At the endof the term, the remaining trust property passes to theremaindermen gift-tax free. Senior makes a taxable gift equalto the present value of the trust remainder valued under therules of IRC § 7520. Any appreciation in the transferred

18 Treas. Regs. § 25.2702-2(a)(1) excludes nieces and nephews and more remote collateral relatives, as well asindividuals not related to the transferor, from the definition of “family member.” Accordingly, even after theenactment of section 2702, it is possible for a transferor to establish a GRIT of the type described in thisExample if the remaindermen are nieces, nephews, unadopted stepchildren or other individuals who do not fallwithin the regulation’s definition of family member. The transferor’s retained interest would be valued usingthe applicable interest rate for the month of transfer under section 7520 of the Code.


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property in excess of the section 7520 discount rate passes tothe remaindermen gift tax free.

Example: In a month when the § 7520 rate is 2.4%, Senior,age 70, transfers commercial real estate worth $1,000,000 to aGRAT, receiving in return a $124,800 annuity for nine years.Under the 2.4% IRC § 7520 rate then in effect, the value ofSenior’s retained annuity stream is about $999,999 and the valueof the taxable gift is about $1.19 If the transferred propertyproduces an annual return of 2.4%, nothing will be transferredto the remaindermen at the end of 9 years. On the other hand,if the property produces an average annual return of greaterthan 2.4%, value will have been transferred to the remaindermenfree of gift tax, as shown in the following chart.

AverageReturnfor 9Years:

Amount Passing Tax-Free to Children

2.4% $ 0

4% $101,884

6% $254,608

8% $439,737

5. Suitable Property for a GRAT.

The ideal asset to place in a GRAT is property which hashigh growth or income-producing potential. Typical of the typesof property placed in GRATs are high-growth or high-yieldpublicly traded securities and junk bonds, commercial realestate and closely held stock, particularly if an initial publicoffering or other event resulting in a “spike” in value isexpected. A GRAT can be particularly useful as a repository ofhard-to-value assets such as closely held stock, real estate orfamily partnership units because the tax risk of anundervaluation can be minimized or even eliminated, as discussedlater in this outline. Moreover, any discount applied in

19 In old Treas. Reg. § 25.2702-3(e), Example 5, the IRS took the position that Senior’s retained annuity streamhad to be valued as an annuity for the shorter of nine years or Senior’s actuarial life expectancy. Under thisvaluation methodology, the value of Senior’s retained annuity stream is $936,880 and the value of the taxablegift is $63,120. However, Treas. Reg. § 25.2702-3(e), Example 5 was invalidated by the United States TaxCourt in Walton v. Commissioner, 115 T.C. 589 (2000), acq. Notice 2003-72, 2003-44 IRB.


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valuing the transferred property has the effect of increasingthe overall rate of return on the property held in the GRAT,thereby increasing the amount passing to the junior generation,as discussed in the Planning Examples later in this outline.

6. GRAT Governing Instrument Requirements.

Treas. Reg. §25.2702-3(b) sets forth a number of provisionswhich are required to be included in the trust agreementcreating the GRAT, as follows:

(a) Payment of Annuity Amount.

Under Treas. Reg. § 25.2702-3(b)(1), the followingprovisions relating to the payment of each year’s annuity amountmust be included in the trust agreement:

i. The annuity must be an irrevocable right to receive afixed amount payable each year. A right of withdrawal does notqualify.

ii. The annuity payment may be made after the close of thetaxable year as long as it is made no later than the due date ofthe trust’s income tax return for that year (without regard toextensions). In a GRAT where the annuity payments are payableon the anniversary of the funding of the trust, rather than on acalendar year basis, the annuity payment may be made after theclose of the anniversary year provided that it is made no laterthan 105 days after the anniversary date. Treas. Regs. sec.25.2702-3(b)(4).

iii. The fixed amount may be either a stated dollar amountor a fixed fraction or percentage of the initial fair marketvalue of the property transferred to the trust as finallydetermined for federal tax purposes.

iv. End-loading of the annuity is permitted provided thateach year’s payment may be no greater than 120% of the prioryear’s payment.

v. Income in excess of the annuity may be paid to thegrantor but this will not increase the value of the retainedannuity interest.

(b) Incorrect Valuations.

The governing instrument must contain provisions foradjustments to the annuity amount in the event of incorrect


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valuation of the property contributed to the trust similar tothose applied to charitable remainder trusts. Treas. Reg. §§25.2702-3(b)(2); 1.664-2(a)(1)(iii).

(c) Short Taxable Year; Last Taxable Year.

The governing instrument must contain provisions forprorating the annuity in short taxable years similar to thoseapplied to charitable remainder trusts. Treas. Reg. §§ 25.2702-3(b)(3); 1.664-2(a)(1)(iv).

(d) Additional Contributions Prohibited.

The governing instrument must prohibit additionalcontributions to the trust. Treas. Reg. §§ 25.2702-3(b)(4).

(e) Payments to Others.

The governing instrument must prohibit distributions toanyone other than the grantor during the trust term. Treas. Reg.§ 25.2702-3(d)(2).

(f) Trust Term.

The governing instrument must set the trust term for thelife of the grantor, a term of years or the shorter of those twoperiods. Treas. Reg. § 25.2702-3(d)(3).

(g) Commutation.

The governing instrument must prohibit commutation(prepayment) of the grantor’s interest. Treas. Reg. § 25.2702-3(d)(4).

7. GRAT Risks and Issues.

(a) Mortality.

If the grantor dies during the GRAT term, all or a portionof the GRAT property is brought back into the Grantor’s estate.The IRS position had been that death of the grantor during theGRAT term causes the entire trust property to be includible inthe grantor’s estate under section 2039 of the Code. PLRs9451056; 9448018; 9345035. However, the IRS modified itsposition in Reg. sec. 20.2036-1 (T. D. 9414, July 11, 2008).Under that regulation, the includible portion is only thatamount of principal necessary to produce income equal to therequired annuity payment under the section 7520 rate in effect


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at the grantor’s death. See also Rev. Rul. 82-105, 1982-1 C.B.133. For example, suppose that in the example we have beenusing in this outline, Sally Senior dies in the fifth year ofher GRAT. Suppose that the total value of the GRAT assets atthat time has grown to $5,000,000 and that the section 7520 ratein effect at Sally’s death has gone up to 5 percent. Thequestion is, what amount of corpus, if invested to produceincome at the section 7520 rate of 10 percent is necessary toproduce income of $124,800. Recall that the annuity payment inour example was $124,800. The answer is determined by dividingthe annuity payment of $124,800 by the section 7520 rate of 5percent, which equals $2,496,000. Practitioners preparingfederal estate tax returns for clients who die during a GRATterm should make careful note of this new regulation. As can beseen from the example above, the effect of the regulation is,in, in some cases to permit the transfer of wealth to the nextgeneration even in a “failed” GRAT.20 Estate tax inclusion wouldalso result under section 2033 of the Code if the annuity ispayable to the grantor’s estate after her death.

A GRAT is sometimes coupled with a life insurance trust,with that trust owning term insurance on the grantor in theamount of the expected tax-cost of inclusion of the GRATproperty in the grantor’s estate.

(b) Use of Loans to Pay Annuity Amount.

The “issuance of a note, other debt instrument, option orother similar arrangement” may not be used to satisfy theannuity of unitrust payment. In addition, the governinginstrument must include a provision prohibiting the use of anote, other debt instrument, option or other similar arrangementto satisfy the annuity or unitrust payment. The regulationregarding use of notes and similar arrangements applies to alltrusts, but under a transition rule, a trust created beforeSeptember 20, 1999, would satisfy the requirements of theproposed regulation if it issued no notes after that date and ifit pays off any existing notes by December 31, 1999. Reg. §25.2702-3(d)(5). See also TAM 9604005; PLR 9717008.

Although a loan from a third party would appear not toviolate the regulation, the IRS takes the position that if theGRAT property remains encumbered by the note upon cessation of

20 It has been suggested that it may be possible to avoid the mortality risk if the GRAT is structured to provide thegrantor with a contingent reversionary interest in the event that she fails to survive the trust term which interestis then sold to the remainder beneficiaries. Handler, “Guaranteed GRATs: GRATs Without Mortality Risk,”138 Trusts & Estates 30 (December 1999).


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grantor trust status, the grantor will recognize a taxable gainat that time. TAMs 200010010, 200010011 and 200011005, citingRev. Rul. 85-13, 1985-1 C.B. 184. See also Madorin v. Comm’r,84 T.C. 667 (1985); Crane v. Comm’r, 331 U.S. 1 (1946); Comm’rv. Tufts, 461 U.S. 300 (1982).

(c) Revaluation of the Transferred Property on Audit.

As noted above, under Treas. Reg. § 25.2702-3(b)(1), theannuity amount may be stated as a fixed percentage of theinitial fair market value of the trust as finally determined forfederal tax purposes. If the annuity amount is so stated in thetrust document, the GRAT can minimize the impact of valuationadjustments upon audit. If the property is subsequentlyrevalued upon an audit, the grantor’s annuity interest isautomatically increased, thereby reducing the impact of therevaluation on the size of the grantor’s taxable gift.Reconsider the example above. The table below shows the impactof a re-valuation clause.

WithRevaluationClause

WithoutRevaluationClause

Reported Value ofProperty Transferred toTrust

$1,000,000

$1,000,000

Reported Value ofAnnuity Payment

$124,800

$124,800

Reported Taxable Gift $1

$1

Audited Value ofProperty Transferred toTrust

$2,000,000

$2,000,000

Audited Value ofAnnuity Payment

$249,600

$124,800

Audited Value ofTaxable Gift

$2

$1,000,001

(d) Valuation of Property Used to Satisfy AnnuityObligation.

Note that the Treas. Reg. § 25.2702-3(b)(1) revaluationprovisions create a safe harbor to reset the size of the annuityamount as a result of a revaluation of the property initiallycontributed to the trust. They do not protect against a


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misvaluation of an in-kind distribution of property used tosatisfy the annuity obligation. Suppose, for example, thatcommercial real estate used to fund the GRAT failed to producesufficient income to satisfy the annuity obligation, requiringthe trustee to make an in-kind distribution of a fractionalinterest in the real estate itself. If the interest distributedto the grantor is overvalued (meaning that the annuityobligation was not fully satisfied), then the trust may havefailed to satisfy the requirement of Treas. Reg. § 25.2702-3(b)(1)(i) that the annuity be paid annually, therebydisqualifying the trust. Overvaluation could also support anIRS argument that the grantor had made a constructive additionto the trust, violating Treas. Reg. § 25.2702-3(b)(4)’sprohibition against adding property to a GRAT.

(e) Valuation of Taxable Gift - the Walton Case.

Prior to the Tax Court’s decision in Walton v.Commissioner, 115 T.C. 589 (2000), acq. Notice 2003-72, 2003-44 IRB, the IRS took the position in regulations that theannuity interest in a GRAT must be valued as if the annuity werepayable for a term equal to the shorter of the term stated inthe trust instrument or the grantor’s life expectancy regardlessof whether or not the trust instrument contained a lifeexpectancy contingency. Treas. Reg. § 25.2702-3(e), Ex. 5(referred to in this outline as “Example 5 valuation”).Including a life expectancy contingency has a depressant effecton the valuation of the retained annuity stream because therewould always be a chance that the grantor would die before thetrust term ended, without having received all of the paymentsdue under the annuity. Accordingly, Example 5 valuationeffectively made it impossible to create a GRAT with a zeroremainder interest. Treas. Reg. § 25.2702-3(e), Ex. 5 was heldinvalid in the Walton case, supra.21

(f) Use of Revocable Spousal Annuity.

21 In Walton, the taxpayer established two two-year GRATs, each funded with approximately $100 million worthof Wal-Mart stock. The GRATs provided for annuity payments to the grantor over the two-year term designedto “zero out” the value of the gift if the grantor’s life expectancy were not taken into account. Unfortunately forthe grantor, the value of Wal-Mart stock declined during the term of the GRATs and the GRAT assets wereexhausted in satisfying the annuity obligation to the grantor. The taxpayer filed a gift tax return reporting zerotaxable gifts to the GRATs. The IRS responded by issuing a notice of deficiency asserting that, based on Treas.Reg. § 25.2702-3(e), Ex. 5, the taxable gift to each GRAT was actually over $3.8 million. The Tax Court heldfor the taxpayer and found that Example 5 was an unreasonable interpretation of IRC §2702. Accordingly, itnow is possible to create a mathematically zeroed-out GRAT. Note that some commentators believe that it isimprudent to create a fully zeroed out GRAT because the IRS will not issue a private ruling approving a GRATunless the remainder interest is at least ten percent. We see no basis in the law for the IRS position


49

As noted above, prior to the Tax Court decision in theWalton case, supra, the IRS approach to valuing the grantor’sretained annuity interest takes into account the possibilitythat the grantor may die during the trust term, therebydecreasing the value of the annuity. The lower the probabilityof death during the term, the greater the value of the annuity.As a way of decreasing the probability of death during the trustterm, some practitioners structured the GRAT to provide anannuity for the shorter of (a) the joint lives of the grantorand her spouse and (b) the trust term. This approach appears tobe supported by Treas. Reg. § 25.2702-2(a)(5), which providesthat if the grantor’s spouse is given an annuity interest whichis revocable by the grantor, the grantor is deemed to haveretained the spousal interest. However, in PLR 9707001, 9717008and 9741061, the IRS ruled that the mortality risk associatedwith the spouse’s life would be ignored in valuing the retainedannuity. The IRS position was upheld by the Tax Court in Cookv. Comm’r, 2000 U.S. Tax Ct. LEXIS 45 (July 25, 2000). Giventhe Walton decision, it should no longer be necessary to utilizea revocable spousal annuity for purposes of depressing the valueof the remainder interest in any event.

(g) Gift Splitting.

If the grantor dies during the GRAT term, total adjustedtaxable gifts are reduced by the amount included in the estate.IRC § 2001(b)(2). If gift splitting were elected, that portionof this reduction attributable to the non-donor spouse would bewasted.

8. GRATs and the Generation-Skipping Transfer Tax.

A comprehensive overview of the federal generation-skippingtransfer tax is beyond the scope of this outline. Briefly,however, a federal generation-skipping transfer tax applies tocertain transfers to “skip persons,” that is, persons assignedto a generation more than two generations beneath thetransferor. Transfers subject to the tax are “direct skips,”“taxable distributions” and “taxable terminations.” A directskip is a transfer subject to estate or gift tax to a skipperson. Although a bit of an oversimplification, a taxabletermination may be thought of as the termination of a trust infavor of a skip person. A taxable distribution is adistribution from a trust to a skip person other than a directskip or a taxable termination. Each person has an exemption(“GST Exemption”). The tax applies at a rate equal to thehighest estate tax rate then in effect, multiplied by the“inclusion ratio” applicable to the transfer. The inclusion


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ratio is that portion of the transfer subject to the tax,determined by multiplying the value of the transferred propertyby one minus the “applicable fraction.” The applicable fractionis a fraction whose numerator is the amount of GST Exemptionallocated to the transfer and whose denominator is the value ofthe property transferred.

Example: Suppose that the remainder beneficiaries of aGRAT were the grantor’s then living descendants, per stirpes.Further suppose that during the ten-year term of the trust, oneof the grantor’s children dies, leaving his own children (thegrantor’s grandchildren) surviving. Upon the expiration of theterm, the termination of the trust in favor of the grandchildrenwould be a taxable termination for GST Tax purposes. Althoughan exception to the tax exists for certain transfers tograndchildren whose parent has predeceased, the exception is notavailable where the parent predeceased the creation of the GRATitself. An allocation of GST Exemption to the value of theremainder gift at the inception of the GRAT will not beeffective to “inoculate” the GRAT from GST Tax. Under Treas.Reg. § 26.2632-1(c), an allocation of generation-skippingtransfer tax exemption to a GRAT will not be effective until theexpiration of the “estate tax inclusion period” or “ETIP.” TheETIP is the period during which, should the grantor’s deathoccur, the value of all or a portion of the property transferredto the GRAT would be includible in the grantor’s estate. As aresult, in order to avoid GST Tax, the grantor would be requiredto allocate GST exemption to the value of the trust at theexpiration of the ten-year term. In many cases, the value ofthe GRAT at that point may be far greater than the grantor’savailable GST exemption.

One possible solution to the ETIP problem would be to draftthe trust in a manner which will avoid a GST event altogether.For example, the instrument could provide that the trustremaindermen would be the grantor’s then living children ratherthan the grantor’s then living descendants, per stirpes. Ifthis approach is taken, care must be taken to “equalize” thedescendants of a deceased child through a different gift or inan equalizing bequest under the grantor’s will.

It may be possible to avoid the ETIP problem if thechildren’s interest in the GRAT is structured as a vestedremainder interest which the children would then gift or sell toa generation-skipping trust. Handler, “GRAT Remainder Sale to aDynasty Trust,” 138 Trusts & Estates 20 (December, 1999). TheIRS has privately ruled that a gift of a vested remainderinterest in a charitable lead trust will not be effective to


51

circumvent the generation-skipping tax as it applies to thosetrusts. Presumably, the Service would make the same argument toattack the technique in the GRAT context, as well. See LTR200107015 (November 14, 2000).

E. GRAT Planning Examples.

1. Discounted Assets in a GRAT.

Funding the GRAT with an interest in a closely held familybusiness, family limited partnership or limited liabilitycompany may maximize the remainder value of the GRAT if thegifted partnership or LLC interest is subject to valuationdiscounts. Suppose a grantor transfers to a 9-year GRAT anasset whose nondiscounted value is $1,000,000. Assuming an IRC§ 7520 rate of 2.4%, the annual annuity payment required to zeroout the GRAT is $124,800. The benefit of applying a valuationdiscount is shown in the table below.

9-Year Returnon PropertyPlaced in GRAT

Amount PassingtoRemaindermenAssuming NoValuationDiscount

AmountPassing toRemaindermenAssuming 20%ValuationDiscount

Amount Passing toRemaindermenAssuming 40%ValuationDiscount

2.4% $0

$247,588

$ 495,176

4% $101,884

$366,169

$ 630,455

6% $254,608

$541,582

$ 828,556

8% $439,737

$751,591

$1,063,444

2. End-Loaded GRAT to Maximize Remainder Value.

Treas. Reg. § 25.2702-3(b)(1)(ii) specifically authorizesthe use of a GRAT with an increasing annuity payment. By “end-loading” the annuity payments, the grantor leaves more assets inthe trust in the early years. Assuming level appreciation overthe term of the GRAT, this approach can result in a greaterreturn for the remainder beneficiaries, as shown in thefollowing example.

Example: Compare two scenarios. In the first, in a monthin which the § 7520 rate is 2.4%, Senior, age 70, contributessecurities worth $1,000,000 to a 9-year GRAT directing levelannuity payments of $124,800 per year. In the second scenario,Senior contributes securities worth $1,000,000 to a 9-year GRATtrust but the trust agreement does not direct level annuitypayments. Instead, it provides for an initial annuity payment


52

of $55,555, with each successive payment to be an amount equalto the prior year’s payment multiplied by 120%. Using thediscount rate of 2.4%, the taxable gift to the remainderbeneficiaries would be about $1 in either case. However, if thetrust assets perform at, say, 8% per year, the remainderbeneficiaries of the end-loaded GRAT will receive more than theremainder beneficiaries of the straight GRAT trust as shown inthe charts below.


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Straight GRAT

Beginning 8.00%Annual

Year Principal GrowthPayment Remainder

1 $1,000,000.00 $80,000.00$124,865.70 $955,134.30

2 $ 955,134.30 $76,410.74$124,865.70 $906,679.34

3 $ 906,679.34 $72,534.35$124,865.70 $854,347.99

4 $ 854,347.99 $68,347.84$124,865.70 $797,830.13

5 $ 797,830.13 $63,826.41$124,865.70 $736,790.84

6 $ 736,790.84 $58,943.27$124,865.70 $670,868.41

7 $ 670,868.41 $53,669.47$124,865.70 $599,672.18

8 $ 599,672.18 $47,973.77$124,865.70 $522,780.25

9 $ 522,780.25 $41,822.42$124,865.70 $439,736.97

Increasing GRAT

Beginning 8.00%Annual

Year Principal GrowthPayment Remainder

1 $1,000,000.00 $80,000.00$55,554.90 $1,024,445.10

2 $1,024,445.10 $81,955.61$66,665.88 $1,039,734.83

3 $1,039,734.83 $83,178.79$79,999.06 $1,042,914.56

4 $1,042,914.56 $83,433.16$95,998.87 $1,030,348.85

5 $1,030,348.85 $82,427.91$115,198.64 $ 997,578.12

6 $ 997,578.12 $79,806.25$138,238.37 $ 939,146.00

7 $ 939,146.00 $75,131.68$165,886.04 $ 848,391.64

8 $ 848,391.64 $67,871.33$199,063.25 $ 717,199.72

9 $ 717,199.72 $57,375.98$238,875.90 $ 535,699.80

3. Using Separate GRATs To Exploit Volatility.


54

If the business owner has two assets with varying rates ofreturn, it is generally advisable to place them in separateGRATs rather than risk diluting the return in a single GRAT.For example, if Asset A, worth $500,000, produces an annualreturn of 2% and Asset B, also worth $500,000, produces anannual return of 6%, the combined average return of the twoassets is 4%. As shown in the chart above, the amount passingto Junior at the end of 9 years assuming a 4% return is$101,884. On the other hand, if Asset A were placed in GRAT Aand Asset B were placed in GRAT B, both with the terms describedin the example above, then the total passing to Junior would begreater, as shown in the following chart.


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EntityAnnualRate ofReturn

Amount Passing Tax-Free to Junior After10 Years (see chartabove)

One GRAT Holding Both AssetClasses 4%

$101,884

GRAT A (assets perform at8%) 2%

$0

GRAT B (assets perform at12%) 6%

$127,304

Total of GRAT A and GRAT B $127,304

EntityAnnualRate ofReturn

Amount Passing Tax-Free to Junior After10 Years (see chartabove)

One GRAT Holding Both AssetClasses 4%

$101,884

GRAT A (assets perform at8%) 2%

$0

GRAT B (assets perform at12%) 6%

$127,304

Total of GRAT A and GRAT B $127,304

4. Short-Term “Re-GRATs” to Ameliorate Mortality Risk.

If the business owner does not need the cash flow from theannuity, a series of short-term (two-year) GRATs produce betterresults than one longer term GRAT because (1) the amount ofproperty retained in the grantor’s taxable estate is minimized,and (2) the risk that the grantor will die during the GRAT term,thereby eliminating the benefit of any GRAT still in place, isminimized.

F. Sale to Intentionally Defective Irrevocable Trust(IDIT Sale).

1. Introduction to the IDIT Sale.

When we suggest a GRAT to a business owner, we nearlyalways invite the client to compare the GRAT with its somewhatriskier cousin, the IDIT Sale. The general IDIT Sale concept isfairly simple. The business owner makes a gift to anirrevocable trust of, say, $100,000. Some time later, thebusiness owner sells stock to the trust in return for the


56

trust’s promissory note. The note provides for interest only tobe paid for a period of, say, 9 years. At the end of the 9thyear a balloon payment of principal is due. There is no giftbecause the transaction is a sale of assets. The interest rateon the note is set at the lowest rate permitted by IRSregulations.

How does this benefit the business owner’s children? Ifthe property sold to the trust appreciates and/or producesincome at exactly the same rate as the interest rate on thenote, the children do not benefit, because the propertycontributed to the trust will be just sufficient to service theinterest and principal payments on the note. However, if theproperty contributed to the trust appreciates and/or producesincome at a greater rate than the interest rate on the note,there will be property left over in the trust at the end of thenote, and the children will receive that property, gift taxfree. Economically, the GRAT and IDIT Sale are very similartechniques. In both instances, the owner transfers assets to atrust in return for a stream of payments, hoping that the incomeand/or appreciation on the transferred property will outpace therate of return needed to service the payments returned to theowner. Why, then, do some clients choose GRATs and otherschoose IDIT Sales?

The GRAT is generally regarded as a more conservativetechnique than the IDIT Sale. It does not present a risk of ataxable gift in the event the property is revalued on audit. Inaddition, it is a technique that is specifically sanctioned bysection 2702 of the Internal Revenue Code. The IDIT Sale, onthe other hand, has no specific statute warranting the safety ofthe technique. Unlike the GRAT, the IDIT Sale presents a riskof a taxable gift if the property is revalued on audit and thereis even a small chance the IRS could successfully assert thatthe taxable gift is the entire value of the property sold ratherthan merely the difference between the reported value and theaudited value of the transferred stock. Moreover, if the trustto which assets are sold in the IDIT Sale does not havesufficient assets of its own, the IRS could argue that the IDITassets should be brought back into the grantor’s estate atdeath. With the GRAT, on the other hand, the trust would haveno assets in it other than the gifted stock.

Although the IDIT Sale is generally regarded as posing morevaluation and tax risk than the GRAT, the GRAT presents morerisk in at least one area in that the grantor must survive theterm of the GRAT in order for the GRAT to be successful; this isnot true of the IDIT Sale. In addition, the IDIT Sale is a far


57

better technique for clients interested in generation skippingplanning. The IDIT trust can be established as a Dynasty Trustthat escapes estate and gift tax forever. Although somewhat ofan oversimplification, the GRAT generally is not a good vehiclethrough which to do generation skipping planning.

While these risks and benefits are important for thebusiness owner to understand, in our practice we have found thatthe primary driver behind whether a client chooses a GRAT versusan IDIT Sale is cash flow. With an IDIT Sale, the note can bestructured such that the business owner receives interest-onlyfor a period of years, with a balloon payment of principal andno penalty for prepayment. This structure provides maximumflexibility for the business to make minimal distributions tothe IDIT trust to satisfy note repayments when the business ishaving a difficult year and for the business to make much largerdistributions in better years. With the GRAT, on the otherhand, the annuity payments to the owner must be structured sothat the owner’s principal is returned over the term of theGRAT, and only minimal back loading of payments is permitted.Accordingly, the GRAT tends to be the technique of choice wherethe business produces fairly predictable cash flow while theIDIT Sale is chosen more often when cash flow is more erratic.

2. IDIT Sale Example.

In a month when the applicable federal interest rate for amid-term loan is 2.06 percent, the business owner contributes$100,000 to an irrevocable grantor trust. The business ownersubsequently sells $1,000,000 in corporate stock to the trust inreturn for trust’s nine-year promissory note of $1,000,000. Thenote provides for annual interest at the then applicable mid-term federal rate of 2.06% for nine years and a balloon paymentof principal of $1,000,000 in the ninth year. If the transferredproperty produces an annual return of 2.06%, nothing will betransferred to Junior at the end of 9 years. On the other hand,if the property produces an average annual return of greaterthan 2.06%, value will have been transferred to the remaindermenfree of gift tax, as shown in the following chart.

Average Returnfor 9 Years:

Amount Passing Tax-Freeto Junior

2.06%$ 0

4%$ 205,306

6% $ 452,7588% $ 741,761


58

3. Investment Results of IDIT Sale Versus GRAT

Generally an IDIT Sale will produce results for Juniorwhich are superior to those produced by the GRAT because thehurdle rate--the rate at which the assets must perform in orderto produce value for Junior--is lower for the sale transactionthan it is for the GRAT. The interest rate applicable in thesale transaction is the applicable federal rate under section1274(d) of the Code. The applicable interest rate for the GRATtransaction is the rate established under section 7520 of theCode. The section 7520 rate is always 120% of the federal mid-term rate under section 1274(d). Accordingly, if the term ofthe note is nine years or less, the “hurdle” rate for the notetransaction will always be lower than the hurdle rate for theGRAT. The long-term federal rate (for notes of 10-years orlonger) is usually lower than 120% of the mid-term rate.Results for the Sale over 9 years versus the 9 year GRATdescribed earlier are illustrated in the following chart.

Average Returnfor 10 Years

Amount PassingTax-Free toJunior UsingIDIT Sale

Amount PassingTax-Free to JuniorUsing GRAT

2.06%

$ 0 $0

2.4% $33,708

$0

4% $205,306

$ 101,884

6% $452,758

$ 254,608

8% $741,761

$ 439,737

4. IDIT Sale Risks and Issues.

(a) Gift Tax Issues.

An IDIT Sale should not result in a taxable gift providedthat the note has a value equal to the value of the transferredassets. If the interest rate on the note is set at theapplicable federal rate under section 1274(d) of the Code, thenthe note is valued at face. Prop. Treas. Reg. § 1.1012-2(b)(1);Estate of Frazee v. Comm’r, 98 T.C. 554 (1992).

(b) Section 2702 and section 2036.


59

i. If the note is characterized as equity ratherthan debt, IRS could assert that the transaction should berecast as a transfer in trust with a retained interest in thegrantor, subject to section 2702’s zero valuation rule.

ii. To avoid application of section 2702, the trust shouldbe capitalized with adequate “seed money.” It is oftensuggested that the trust be seeded with at least 10% of thevalue of the transaction apparently because the IRS privatelyapproved a sale transaction which reportedly involved thisamount of initial funding. PLR 9436006. See also IRC §2701(a)(4) (mandating 10% minimum value for common units inpartnership capitalization freeze). Rulings addressing thisissue include the following:

PLR 9251004. Despite the fact that trust was capitalizedwith seed money equal to 50% of the value, IRS ruled thattransaction should be recast as a transfer with a retainedinterest subject to section 2036.

PLR 9436006. Trust capitalized with 10% of the purchaseprice held not subject to section 2036 or 2702.

PLR 9535026. No ruling on debt-equity issue. Ruling heldthat 2702 did not apply but noted that ruling would be reversedif the note was subsequently determined to be equity rather thandebt. Ruling indicated that determination of whether note wasequity or debt is a question of fact for which advance rulingwill not be given.

PLR 9709001. No mention of note or debt-equity issue.

iii. If adequate seed money is not available or desirable,it may be possible to have a beneficiary guarantee the note inorder to avoid equity classification. See PLR 9515039 (section2036 inapplicable to joint purchase when annuity paymentobligation was guaranteed by the owner of the remainder interestand there was a showing that owner had sufficient independentassets to fund the annuity); Rev. Rul. 77-193, 1977-1 C.B. 273(section 2036 inapplicable to transfer of property in exchangefor personal obligation not satisfiable solely out of thetransferred property); Estate of Fabric v. Comm’r, 83 T.C. 932(1984) (sale by thinly capitalized trust in exchange for privateannuity not subject to section 2036 where annuity obligation wasa personal obligation of corporate trustee). The guarantee maybe treated as a gift to the trust by the guarantor, with theresult that the trust may not be a wholly grantor trust forincome tax purposes. PLR9515039; 9113009


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iv. The taxpayer could try to analogize to a series ofNinth Circuit private annuity cases to determine whether thetransaction possesses sufficient bona fides to be respected forpurposes of section 2036 and 2702. These cases include thefollowing.

Lazarus v. Comm’r, 513 F.2d 824 (9th Cir. 1975). In thiscase, a grantor purportedly sold assets to a trust in exchangefor a private annuity issued by the trust. The court held thatthe transaction should be recast as a transfer with a retainedinterest subject to section 2036 based on the following factors.First, the trust was thinly capitalized, having no seed moneyother than approximately $1,000 and a note receivable from thegrantor. Second, the note receivable was non-assignable and,interestingly, the interest payments made by the grantor on thenote equaled the annuity payments the trust was to pay back tothe grantor. Third, invasions of trust principal to make theannuity payments were prohibited. Fourth, the transactionlacked elements common to arms-length sales such as a downpayment, interest on the deferred purchase price or security.

Estate of LaFargue v. Comm’r, 689 F.2d 845 (9th Cir. 1982).This case also involved the sale of assets by a grantor inreturn for a private annuity issued by a thinly capitalizedtrust. However, the court in LaFargue held that the annuity wasa bona-fide arrangement sufficient to exclude the trust assetsfrom the grantor’s estate. The factors distinguishing LaFarguefrom Lazarus appear to have been the following: (i) There wasno “tie-in” (the court’s phrase) between the trust income andthe annuity payments; (ii) the grantor/annuitant did not controlthe trustee; and (iii) principal could be invaded to make theannuity payments.

Stern v. Comm’r, 747 F.2d 555 (9th Cir. 1984). This wasanother private annuity sale by a thinly capitalized trust.There was a showing of no “tie-in” between the annuity paymentsand the trust income, but the court went on to say that thatfact in and of itself was not sufficient to preclude inclusionof the trust property in the grantor’s estate. The courtconcluded that the annuity would be respected because, not onlywas there a lack of “tie-in” described above, but also thegrantor-annuitant did not have the power to control the trusteeor the trust investments.

See also Estate of Fabric v. Comm’r, 83 T.C. 932 (1984)(private annuity sale between grantor and thinly capitalizedtrust respected where corporate trustee personally liable for


61

annuity payments). Cf. Comm’r v. Clay Brown, 380 U.S. 563(1965) (sale-leaseback transaction between a grantor and acharity was respected for income tax purposes despite fact thattransferred property was only source of lease payments).

v. In order to avoid equity classification, trust shouldmake timely payments on the note as they become due.

(c) Revaluation of the Property Transferred Pursuant to anIDIT Sale Upon Gift Tax Audit.

With a GRAT, it is relatively easy to minimize the gift taxrisk of a revaluation of the transferred property in the eventof an audit. As noted above, the GRAT regulations specificallycontemplate an annuity payment structured as a set percentage ofthe initial fair market value of the trust as finally determinedfor federal tax purposes. If the value of the propertytransferred to the GRAT is increased upon audit, then the valueof the annuity will automatically increase--and the value of thetaxable gift automatically decrease--thereby minimizing theimpact of the adjustment. For IDIT Sales, there is no such“safe harbor” permitting an increase in the face amount of thenote or a reduction in the amount of property sold if the valueof the transferred property is upwardly adjusted upon an audit.Moreover, any attempt to design the sale documents to includesuch an adjustment may run afoul of the Proctor case and itsprogeny. See Comm’r v. Proctor, 142 F.2d 824 (4th Cir.1944)(invalidating clause requiring return of transferredproperty to grantor if deemed to be taxable gift). But see Kingv. U.S., 545 F.2d 700 (10th Cir. 1976) (upholding a transfersubject to a valuation formula); PLR 8611004 (same).22

(d) Statute of Limitations and the IDIT Sale.

Because the IDIT Sale transaction is to a grantor trust, itis not reportable on the grantor’s income tax return. Moreover,assuming that the sale is bona fide and for full fair marketvalue, it does not constitute a taxable gift and a gift taxreturn need not be filed. As a result, however, since the IRShas no notice of the transaction, the statute of limitationsnever begins to run. Accordingly, it may be advisable to reportthe transfer on a tax return. In our office, we typicallyadvise clients engaging in IDIT Sales to consider filing a gifttax return reporting the sale. Of course, in order for the

22 See also, Daniel L. Daniels and David T. Leibell, “Charitable Lids Triumph Again”, Trusts & Estates WealthWatch, January 20, 2010; Scott A. Bowman, “Defined Value Clauses Better Defined”, Trusts & Estates,February 2010


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statute to run against the IRS, the gift tax adequate disclosurerules should be followed. Treas. Reg. § 301.6501(c)-1.

(e) Estate Tax Inclusion and the IDIT Sale.

In the IDIT Sale transaction, the trust assets should notbe includible in the grantor’s estate regardless of when deathoccurs unless the grantor has retained some power or interest inthe trust mandating inclusion under sections 2035 et seq. of theCode. See section 4(b) supra for a discussion of the argumentsas to whether or not section 2036 would apply to a saletransaction. See also PLR 9251004. If not repaid prior todeath, the note will be included in the grantor’s taxableestate. Generally, the value of the note will be the unpaidprincipal balance although a discount may be appropriate if thetrust/borrower is thinly capitalized. On the other hand, if theestate asserts that a discount to the value of the note shouldbe permitted because the trust lacked independent funds tosatisfy its obligation, the estate is in effect providing theIRS with ammunition for an argument that the initial transactionwas not a sale for full consideration excepted from section2036. IRC § 2033.

(f) Cessation of Grantor Trust Status While an IDIT Noteis Outstanding.

If the trust ceases to be treated as a grantor trust duringthe grantor’s lifetime, the grantor will report taxable incomeequal to the amount of gain represented by the unpaid balance onthe note. See Madorin v. Comm’r, 84 T.C. 667 (1985); Treas.Reg. § 1.1001-2(c), Ex. 5; Rev. Rul. 77-402, 1977 C.B. 222. Seealso TAMs 200010010, 200010011 and 200011005.

Grantor trust status ceases at the grantor’s death.However, the income tax status of the remaining balance due onthe note after the grantor’s death is not settled. The IRSlikely would take the position that when grantor trust statusceases for any reason, the grantor is treated as havingtransferred assets to the trust. See Treas. Reg. § 1.1001-2(c),Ex. 5; TAM 2000 11 005; see Dunn and Handler, “Tax Consequencesof Outstanding Trust Liabilities When Grantor Trust StatusTerminates,” J. Tax’n 49 (2001). Some commentators have argued,however, that notwithstanding the cessation of grantor truststatus there should be no income recognition at the grantor’sdeath. See Blattmachr, Gans & Jacobson, “Income Tax Effects ofTermination of Grantor Trust Status by Reason of the Grantor’sDeath,” J. Tax’n 149 (Sept. 2002); Peebles, “Death of an IDITNoteholder”, 144 Trusts & Estates 28 (Aug. 2005).


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G. Tabular Comparison of GRAT versus IDIT Sale.

GRAT Sale to Defective Trust

Auditrisk/possibility

Transaction is fullyreported to IRS butincentive to audit islow due to annuityrevaluation clause.

If bona fide sale tograntor trust, transactionneed not be reported onany return. By the sametoken, failure to reportresults in no statute oflimitations ever runningon the transaction.

Revaluation oftransferredproperty onaudit

GRAT can containautomatic annuityadjustment clausewhich will berespected by IRS.

Price adjustment clauseshave been held void asagainst public policy.May be possible for any“excess value” upon anaudit to be automaticallytransferred to anontaxable transferee suchas a spouse or charity orto a low-tax transfereesuch as a GRAT or CLAT.

Hurdle rate GRAT property mustoutperform section7520 rate.

Defective trust propertymust outperform applicablesection 1274 rate, whichis usually lower than thesection 7520 rate.

Generation-SkippingPlanning

Very difficult toimpossible to leverageGST Exemption with aGRAT.

Defective Trust can bestructured as an effectiveGST tax avoidance vehicle.

GrantorSurvivorshipRequirement

Grantor must survivetrust term for GRAT tobe effective.

If grantor dies during theterm of the note,inclusion should belimited to the value ofthe note.

Gainrecognition atgrantor’s death

Death should not be arecognition event ifnotes were not used tosatisfy annuityobligation.

IRS takes position thatdeath is a recognitionevent if note remainsoutstanding at that time.

Sections 2036and 2702

Properly structuredGRAT not subject tosection 2702 zero-valuation rule and notincludible under

No certainty thatDefective Trust will notbe subject to 2702 or2036. Adequate seed moneyand/or guarantees help to


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section 2036 ifgrantor survives trustterm.

blunt a section 2702attack.

H. How to Cause Grantor Trust Status.

1. Overview of Grantor Trust Rules.

For income tax purposes, sections 671 through 679 of theCode treat the grantor as the owner of a trust if the grantor orcertain other parties retain various powers over the trust.

Section 673 deems the grantor the owner of a trust in whichshe retains a greater than five percent reversionary interest.

Section 674(a) purports to treat the grantor as the ownerof any portion of a trust in respect of which the beneficialenjoyment of income or principal is subject to a “power ofdisposition” exercisable by the grantor or a nonadverse partywithout the consent of an adverse party. However, section674(a) is riddled with exceptions, which are described in moredetail later in this outline.

Section 675 causes grantor trust status if the grantor and,in some cases, certain other parties, hold various powers ofadministration over the trust, including the power to deal withthe trust for less than adequate and full consideration, thepower to borrow without adequate interest or security, actualborrowing without adequate interest or security, a power to votestock of a corporation in which the holdings of the grantor andtrust are significant from the standpoint of voting control, thepower to control trust investments, and a power to reacquire thetrust principal by substituting other property of equal value.

Section 676 treats the grantor as the owner of any trust inwhich the grantor or any non-adverse party has the power torevoke the trust and re-vest title in the grantor.

Section 677 treats the grantor as the owner of a trustwhose income may be distributed to the grantor or her spouse orapplied to the payment of life insurance premiums on a policy onthe life of the grantor or the grantor’s spouse.

Section 678 treats a person other than the grantor as theowner of the trust if such person holds a power to vest thecorpus or income in herself. At least as respects powers overincome, if a trust is otherwise a grantor trust under sections


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671 et seq., section 678 will not apply to treat another personas the owner of the trust in addition to the grantor. It is notclear why the statute only precludes multiple grantor-trusttreatment only as to powers over income. However, if a grantortrust is created which includes “Crummey” withdrawal powers, thetrust may lose its grantor trust status as to the originalgrantor to the extent that the power holders are taxed as ownersof the principal of the trust under section 678. But see PLRs9141027, 9309023 and 9321050 (ruling that the grantor is treatedowner of the entire trust notwithstanding the existence of awithdrawal power in another). Cf. PLR 200022035 (trustcontaining “five and five” power treated as a partial grantortrust, with portion so treated increasing each year that thepower is in existence).

Section 679 treats the U.S. grantor of a foreign trust asthe owner of such trust during any year in which the trust has aUnited States beneficiary. This section does not apply totransfers at death of the grantor or to transfers for fairmarket value.

2. Using Section 674 to Create Grantor Trust Status.

(a) Section 674 In General.

As noted above, Section 674(a) says that the grantor willbe taxed as the owner of any portion of a trust in respect ofwhich the beneficial enjoyment of income or principal is subjectto a “power of disposition” exercisable by the grantor or anonadverse party23 without the consent of an adverse party.

(b) The Eight Section 674(b) Exceptions for PowersRegardless of Who Holds Them.

Under section 674(b), the following powers will not causegrantor trust status, no matter who holds them.

i. The mere existence of a trustee’s power to applytrust income to satisfy the grantor’s obligation to support atrust beneficiary will not result in grantor trust status.Instead, only the actual use of the trust income for thatpurpose will result in grantor trust status. IRC §74(b)(1).

23 Under section 672(a) of the Code, an “adverse party” is “any person having a substantial beneficial interest in thetrust which would be adversely affected by the exercise or nonexercise of” a power held by the grantor over thetrust. For example, if G establishes a trust to pay income to B for life and retains the power to revoke the trust withB’s consent, the trust is not a grantor trust because B’s interest in receiving the income is adverse to G’s power torevoke the trust. If G only retained the power to direct the disposition of the remainder interest at B’s death, G’spower would not be adverse to B’s interest.


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ii. A power, the exercise of which can only affectthe beneficial enjoyment of the income for a period commencingafter the occurrence of an event such that a grantor would notbe treated as the owner under section 673 if the power were areversionary interest; but the grantor may be treated as theowner after the occurrence of the event unless the power isrelinquished. IRC § 674(b)(2). Note that under section 673,the grantor is treated as the owner of a trust if thepossibility that the trust may revert back to the grantor isgreater than five percent, using the tables promulgated undersection 7520 of the Code. For example, suppose a trust createdon January 1, 1995, provides for the payment of income to thegrantor's son, and the grantor reserves the power to sprinkletrust income and principal among a class consisting of all ofhis descendants on or after January 1, 2005. In that case, thegrantor would be treated as the owner of the whole trust eventhough his sprinkle power does not come into effect for 10 yearsbecause, if the sprinkle power were a reversionary interest, thelikelihood of the grantor receiving such power after only 10years greatly exceeds five percent under current section 7520rates.

iii. A power exercisable solely by Will, other than a powerof the grantor or her spouse to appoint the income of a trust inwhich income may be accumulated in the discretion of the grantoror a nonadverse party without the consent of an adverse party.IRC § 674(b)(3). For example, if G creates an irrevocabletrust, the trust is not a grantor trust merely because G gives anon-adverse trustee the power to appoint the principal among G’sdescendants by the trustee’s will.

iv. A power to allocate income or principal amongcharitable beneficiaries. IRC § 674(b)(4). For example, if agrantor creates a trust, the income of which is irrevocablypayable solely to educational or other organizations thatqualify under section 170(c), he is not treated as an ownerunder section 674 although he retains the power to allocate theincome among such organizations. Treas. Regs. § 1.674(b)-1(b)(4). The section 674(b)(4) exception is the reason that agrantor’s retained power to change the remainder beneficiariesof a charitable remainder trust does not cause the CRT to betaxed as a grantor trust (which would be a tax disaster since agrantor trust does not qualify as a qualified charitableremainder trust).

v. A power to distribute corpus if either (1) the poweris limited by an ascertainable standard, IRC § 674(b)(5)(A); or(2) any distributions of corpus may be made solely in favor of


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current income beneficiaries, and any corpus distribution to thecurrent income beneficiary must be chargeable against theproportionate part of corpus held in trust for payment of incometo that beneficiary as if it constituted a separate trust(whether or not physically segregated), IRC § 674(b)(5)(B).Note, however, that the exceptions set forth in IRC§ 674(b)(5)(A) and (B) are themselves subject to an exception:The trust will nonetheless be a grantor trust if any person hasa power to add to the beneficiary or beneficiaries of the trust(other than to account for after-born or after-adoptedchildren).

vi. Under section 674(b)(6), a power to distribute oraccumulate income with respect to any beneficiary provided thatthe accumulated income must ultimately be distributed either:

(A) To such beneficiary, her estate or her appointees (ortakers in default of the power of appointment); provided thatthe power of appointment cannot be limited to a class other thanto exclude the beneficiary, her estate, her creditors or thecreditors of her estate. IRC § 674(b)(6)(A); or

(B) Upon termination of the trust, to the current incomebeneficiaries in shares which have been irrevocably specified inthe trust instrument. IRC § 674(b)(6)(B).

Like section 674(b)(5), section 674(b)(6) is subject to theexception that the trust will nonetheless be a grantor trust ifany person has a power to add to the beneficiary orbeneficiaries of the trust (other than to account for after-bornor after-adopted children).

vii. A power to accumulate income during a beneficiary’slegal disability or such period during which the beneficiary isunder the age of twenty-one (21). IRC § 674(b)(7).

viii. A power to allocate receipts and disbursements asbetween corpus and income, even though expressed in broadlanguage. IRC § 674(b)(8).

(c) Section 674(c)’s Exception for Powers Held by anIndependent Trustee.

A power to distribute or accumulate income or to distributecorpus will not cause grantor trust status if it is held byTrustees who meet the following requirements:

i. No such Trustee is the grantor or her spouse;


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ii. No more than half of such Trustees are related orsubordinate parties subservient to the wishes of the grantor orthe grantor’s spouse; and

iii. No third party who is not a Trustee is required toconsent to the distribution. IRC § 674(c).

(d) Section 674(d)’s Exception for a Power toAllocate Income if Limited by an Ascertainable Standard.

A trust will not be a grantor trust solely because of apower solely exercisable (without the approval or consent of anyother person) by a trustee or trustees, none of whom is thegrantor or spouse living with the grantor, to distribute,apportion, or accumulate income to or for a beneficiary orbeneficiaries, or to, for, or within a class of beneficiaries,if such power is limited by a reasonably definite externalstandard which is set forth in the trust instrument. A powerdoes not fall within the powers described in this subsection ifany person has a power to add to the beneficiary orbeneficiaries or to a class of beneficiaries designated toreceive the income or corpus except where such action is toprovide for after-born or after-adopted children.

(f) Stacking the Trustee Roster to Fail Section 674.

Section 674 of the Code treats the grantor of a trust asthe owner of any portion of the trust over which the beneficialenjoyment of the corpus or the income therefrom is subject to apower of disposition, exercisable by the grantor or a nonadverseparty, or both, without the approval or consent of any adverseparty. However, as noted above, section 674 contains manyexceptions. One easy way to think about drafting around theexception is to follow the tests set forth in “(A)” and “(B)”below.

(A) Start with a trust that includes a power to sprinkletrust income and principal not limited by an ascertainablestandard. Such a trust will NOT be a grantor trust if all threeof the following tests are met:

i. No trustee is the grantor or her spouse; and


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ii. At least one-half of the trustees are not related orsubordinate parties subservient to the wishes of the grantor;and

iii. The sprinkle power does not require the consent of anyperson who is not a trustee.

(B) Conversely, intentionally failing any one of the abovethree tests will result in grantor trust treatment.

i. As to the first test, if the grantor or her spouse isthe trustee, grantor trust treatment will result. However, itis inadvisable for the grantor to have a sprinkle power becausethis would result in estate tax inclusion under section 2036 ofthe Code. Conferring the power on the grantor’s spouse shouldnot result in estate tax inclusion. However, it is notadvisable to rely solely on a sprinkle power held by thegrantor’s spouse since grantor trust status would be lost if thespouse died or in the event of divorce.

ii. Intentionally failing the second test provides a morereliable guarantee of grantor trust treatment. If the trusteeroster is “stacked” such that related or subordinate partiessubservient to the wishes of the grantor make up more than one-half of the trustee group, then grantor trust treatment isassured. Any of the following who are not adverse parties wouldqualify as “related or subordinate parties:” Grantor’s spouse,parents, descendants, siblings, employees, a subordinateemployee of a corporation of which the grantor is an executiveand a corporation in which the shareholdings of the grantor andtrust are significant from the standpoint of voting control.24

iii. The third test can be failed by giving a nonadverseparty the power to veto the trustees’ distribution decisions.Provided that the veto power is not given to the grantorherself, the veto power should not result in estate taxinclusion.

(g) A Belt and Suspenders to Stacking theTrustee Roster - Adding a Power to Add Beneficiaries

It can be difficult to fail section 674(a) because theseemingly simple rule that a trust over which the grantor or a

24 Related or subordinate parties are presumed to be “subservient to the wishes of the grantor” unless the contraryis proved by clear and convincing evidence. Query whether such income tax “subservience” would cause thetrust to be included in the grantor’s taxable estate on the ground that the trustee was in the control of the grantor.At least one private ruling has concluded that this would not be the case. PLR 9543050 (trust in whichgrantor’s children were trustees was a grantor trust for income tax purposes but was not included in thegrantor’s estate under section 2036).


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nonadverse party holds a power of disposition will be a grantortrust is replete with exceptions. See IRC §§ 674(b)(5), (6) and(7), 674(c) and 674(d).

However, these exceptions themselves are also subject to anexception. Notwithstanding that a trust may otherwise meet therequirements of one of the cited exceptions to grantor trusttreatment, it will nonetheless be a grantor trust if “any personhas a power to add to the beneficiary or beneficiaries or to aclass of beneficiaries designated to receive” the trust assets,unless the power to add beneficiaries is for the purpose ofincluding after-born or after-adopted children.

If the power to add beneficiaries is not held by thegrantor, it should not result in estate tax inclusion. Thepower also should not be held by a trust beneficiary as it seemslikely that the IRS would treat an existing trust beneficiary asadverse to the exercise of a power to add new beneficiaries.

A power to add charitable beneficiaries has been heldsufficient to cause grantor trust status. Madorin v. Comm’r, 84T.C. 663 (1985); PLR 200030018.

3. Using a Section 675(4)(C) Reacquisition Power toCreate Grantor Trust Status

(a) A commonly used power to intentionally violate thegrantor trust rules had been a power in the grantor or othernonadverse party to reacquire the trust assets by substitutingother property of equivalent value. The power is popularbecause it appears to cause grantor trust treatment undersection 675(4)(C). In addition, a reacquisition power held in afiduciary capacity was held not to cause inclusion in thegrantor’s taxable estate under section 2036. Jordahl v. Comm’r,65 T.C. 92 (1975), acq. 1977-1 C.B. However, it probably is nolonger safe to rely solely on such a reacquisition power tocreate grantor trust status. In a series of private rulings,the IRS has emphasized that in order for a reacquisition powerto cause grantor trust status, the power must be exercisable ina nonfiduciary capacity. See, e.g., PLRs 9407014; 9810019;9648045; 9416009; 9352007; 9352005; 9253010; 9248016. Theregulations under section 675 presume that a power held by aTrustee will be exercised in a fiduciary capacity, they containno “reverse” presumption that a power held by a non-Trustee willbe exercised in a non-fiduciary capacity. Indeed, the citedprivate letter rulings stress that the question whether thepower is exercisable in a non-fiduciary capacity is one of facton which the Service will not issue an advance ruling.


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(b) Estate Tax Issues Presented by Reacquisition Powers.

i. In Rev. Rul. 2008-22, 2008-16 IRB 796(April 17, 2008), the IRS provided guidance on whether and whena trust including a reacquisition power will be included in thegrantor’s estate under Code sections 2036 and 2038. The rulingprovides that the grantor’s retention of a substitution powerwill not, in and of itself, result in inclusion under either2036 or 2038 as long as (a) trustee has a fiduciary obligation,either under state law or the trust instrument, to ensure thatthe properties acquired and substituted by the grantor are infact of equivalent value; and (b) the substitution power cannotbe exercised in a manner that can shift benefits amongbeneficiaries.

ii. The ruling explains that a substitutionpower cannot be exercised to shift value among beneficiaries ifeither of two conditions are met. Either (a) the trustee musthave a power to reinvest trust principal (under local law or thetrust instrument) and has a duty of impartiality with respect totrust beneficiaries; or (b) the nature of the trust’sinvestments or the level of income produced does not impact therespective interests of the beneficiaries as, for example, whena trust is administered as a unitrust or when distributions fromthe trust are limited to discretionary distributions ofprincipal and income.

iii. The draftsperson should take care notto permit the grantor to reacquire a life insurance policy onher own life or stock in a controlled corporation in order toavoid estate tax inclusion under Sections 2036(b) and 2042 ofthe Code.

(c) The estate tax inclusion risk might also bereduced by ensuring that the power to reacquire assets is givento someone other than the grantor of the trust since section675(4)(C) states that grantor trust treatment will arise if thepower is held by “any person.” Having said that, if the poweris granted to someone other than the grantor, then the power maynot be a power to “reacquire” the trust assets and the trust may

not fail the test of the statute for grantor trust treatment.25

25 Presumably, it would be safe to give a power to reacquire assets to the grantor’s spouse. The power should beattributed to the grantor for income tax purposes under section 672(e) of the Code but should not be attributedto the grantor for estate tax inclusion purposes.


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4. Other Section 675 Provisions Which May Cause GrantorTrust Status.

(a) Section 675(2) Power to Borrow.

Section 675(2) provides that the grantor will be treated asthe owner of any portion of a trust in respect of which “a powerexercisable by the grantor or a nonadverse party, or both,enables the grantor to borrow the corpus or income, directly orindirectly, without adequate interest or without adequatesecurity except where a trustee (other than the grantor) isauthorized under a general lending power to make loans to anyperson without regard to interest or security.” A draftspersonmight include a power for the grantor to borrow from the trustat interest but without adequate security. Presumably,borrowing without adequate security would not raise estate taxinclusion problems provided that adequate interest is charged.

(b) Section 675(3) Actual Borrowing.

Section 675(3) provides that the grantor will be treated asthe owner of any portion of a trust in respect of which thegrantor has borrowed for less than adequate interest or securityif the grantor fails to repay the loan before the end of thetaxable year. Case law has interpreted section 675(3) in such away that the grantor would have to borrow the entire principaland income of the trust in order to cause the trust to betreated as a wholly grantor trust. See Bennett v. Comm’r, 79T.C. 470 (1982). Accordingly, actual borrowing by the grantoris not likely to be a feasible means of “intentionally” causinggrantor trust status.

5. Powers Resulting in Grantor Trust Status Under IRC §677.

Section 677 of the Code provides that the grantor will betreated as the owner of any portion of a trust whether or not heis treated as an owner under section 674, whose income withoutthe approval or consent of any adverse party is, or, in thediscretion of the grantor or a nonadverse party, or both, may be(a) distributed to the grantor or the grantor’s spouse; (b) heldor accumulated for future distribution to the grantor or thegrantor’s spouse; or (c) applied to the payment of premiums onpolicies of insurance on the life of the grantor or thegrantor's spouse.


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Generally, the draftsperson will not want to provide forincome to be paid to the grantor as that would result ininclusion of the trust in the grantor’s estate under section2036 of the Code.26 Providing for discretionary distribution ofincome to the grantor’s spouse, however, should result in

grantor trust status without resulting in estate tax inclusion.27

Of course, this cause of grantor trust status is only useful solong as the spouse is alive and married to the grantor.

There are a number of private letter rulings indicatingthat the power to pay life insurance premiums on a policy on thelife of the grantor should cause grantor trust status. See,e.g., PLRs 8126047, 8118051, 8112087, 8103074 and 8104078.Older case law, however, seems to indicate that the grantorwould not be treated as the owner except as to any portion ofthe trust from which the premiums were actually paid. SeeIversen v. Comm’r, 3 T.C. 756 (1944); Weil v. Comm’r, 3 T.C. 579(1944), acq. 1944 C.B. 29; Rand v. Comm’r, 40 B.T.A. 233 (1939),acq. 1939-2 C.B. 30, aff’d 116 F.2d 929 (8th Cir. 1941), cert.denied, 313 U.S. 594 (1941); Moore v. Comm’r, 39 B.T.A. 808(1939), acq. 1939-2 C.B. 25. The cited cases were decided undera predecessor statute to section 677 and, therefore, may nolonger be apposite. Nonetheless, it probably is not safe torely solely on a premium payment power to create grantor truststatus. Indeed, at least based on these older cases, it may benecessary to show actual payment of premiums and that the amountof each year’s premium equaled or exceeded the trust’s income.

6. Section 679.

Section 679 provides that a United States person whodirectly or indirectly transfers property to a foreign trustwill be treated as the owner for his taxable year of the portionof such trust attributable to such property if for such yearthere is a United States beneficiary of any portion of suchtrust. In some respects, section 679 is an attractive means of

26 Section 2036 generally requires inclusion in the estate if a grantor makes a transfer and retains the right toreceive the income from the transferred property. If the trust agreement merely gives a trustee discretion todistribute income to the grantor, that fact alone should not mandate inclusion under section 2036. However,under the laws of many states, including Connecticut, the assets of a self-settled trust are available to thesettlor’s creditors. Greenwich Trust Co. v. Tyson, 129 Conn. 211, 27 A.2d 166 (1942). If applicable state lawso provides, then the trust would be included in the estate under section 2036 on the theory that a grantor isdeemed to have retained the enjoyment of a trust which can be reached by the grantor’s creditors. See Rev. Rul.76-103, 1976-1 C.B. 293.

27 The trust agreement should preclude use of the trust assets to satisfy any legal obligation the grantor has tosupport his or her spouse. This will prevent inclusion in the estate under section 2036. Treas. Regs. sec.20.2036-1(b)(2).


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establishing grantor trust status because it is so simple.Regardless of the other terms of the trust, as long as the trustis classified as “foreign,” it will be a grantor trust. A trustgenerally will be a foreign trust if either (a) a court withinthe United States is not able to exercise primary supervisionover the administration of the trust, or (b) one or more UnitedStates persons do not have the authority to control allsubstantial decisions of the trust. IRC § 7701(31)(B), citingIRC § 7701(30)(E). Notwithstanding this apparent simplicity,most clients will shy away from using a foreign trust toestablish grantor trust status because of the perceived expenseand complexity involved in using an “offshore” trustee.

7. Section 678: A Third Party as Grantor of a Trust.

Section 678 provides that even a person other than thegrantor of a trust will be treated as the owner of any portionof a trust with respect to which either (1) such person has apower exercisable solely by himself to vest the corpus or theincome therefrom in himself, or (2) such person has previouslypartially released or otherwise modified such a power and afterthe release or modification retains such control as would causehim or her to be treated as the owner of the trust undersections 671 through 677 of the Code.

For example, suppose T bequeaths his estate to B in trust.The trust provides for B to receive the income until age 30, atwhich point B has the continuing right to withdraw all of theprincipal. If B fails to exercise his withdrawal right, theproperty simply remains in the trust. Upon and after B attainsage 30, the trust is treated as a grantor trust as to B undersection 678.

A Crummey power also will cause a beneficiary to be treatedas the income tax owner of that portion of the trust subject tothe power. See Rev. Rul. 81-6, 1981-1 C.B. 385. The same istrue of a “five by five” power held by a spouse or otherbeneficiary over a trust. See PLR 200022035.28

I. Self-Canceling Installment Note (SCIN).

28 If the trust over which the Crummey withdrawal right is held is a grantor trust as to the original grantor underone of the other provisions of sections 671 through 679, who is taxed on the trust income—the original grantorunder sections 671 – 677 or the Crummey power holder under section 678. Section 678(b) attempts to answerthis question by providing that a third party will not be treated as the owner of a grantor trust as a result of thatthird party’s holding a “power over income.” A Crummey power, however, is not a power over income; it isgenerally a power to withdraw principal. The IRS has generally ignored this fine distinction in its rulings andheld that, if a trust is otherwise a grantor trust as to its original grantor, a Crummey power held by a third partywill not change that status. See, e.g., PLR 200730011.


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This transaction is similar to a standard installment sale,except that the installment note would contain a provisionstating that the note is canceled upon the death of the client.The term of the note should not be set for a period which ismore than the actuarial life expectancy of the client. If theterm is set for longer than the client’s life expectancy, thenote will taxed as a private annuity. The benefits of a SCINare as follows: (1) It provides a steady income stream toclient for the term of the note. (2) It provides the businessowner with security (in the form of a pledge of the assets soldand retained voting control if desired). (3) It removes growthin the value of the businesses from the taxable estate andremoves the principal value of the note from the estate.

The tax results of a SCIN should be as follows: The saleshould generate a capital gain to the seller equal to thedifference between the sale price and the seller’s basis in thestock. The seller recognizes this gain over the term of thenote. The seller also should recognize ordinary income on theinterest paid on the note each year. The purchaser should beentitled to an interest deduction.

A key benefit of the SCIN is that the unpaid balance on thenote will not be included in the seller’s estate at death.However, the seller’s estate will recognize income equal to theunpaid balance of the note at the seller’s death. This incomewould be deferred if the seller were to use a simple, non-canceling installment note. The SCIN approach gives the selleran income stream for the term of the note. However, if theseller should live more than the term of the note, the incomestream runs out. This result could be avoided through a privateannuity (discussed below). If the “risk premium” on the note isnot set correctly, the seller can be deemed to have made ataxable gift to the purchaser.

J. Private Annuity.

The private annuity is similar to the SCIN in that theseller will receive a payment in return for his interest in thebusiness and those payments will cease upon the death of theseller. However, unlike the SCIN or the simple installmentnote, with the private annuity the payments do not end after acertain term of years; they are guaranteed to continue for therest of the seller’s life.

The primary benefit of the private annuity is that itprovides a steady income stream to the seller for life. In


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addition, the technique can removes growth in the value of thebusiness from the seller’s estate and removes the principalvalue of from the seller’s estate. The sale will generate acapital gain to the seller equal to the difference between thevalue of the annuity and your basis in the stock. Under fairlyrecent regulations, the seller will have to recognize thisentire gain when he enters into the transaction. These newregulations eliminate much of what had been appealing in theprivate annuity transaction.

The unpaid balance on the annuity will not be included inthe seller’s estate when he dies and the estate should notrecognize income at the seller’s death.

K. Recapitalizing the Corporation to Preserve the Owner’sControl.

The desire of the senior generation to maintain votingcontrol over the family business is commonly a significantobstacle to effective family business estate and successionplanning. Family business owners tend to fall into one of twocategories when it comes to control. The “Monarch” seeks tomaintain control even if it is at the expense of a successfulsuccession plan. The less common “Steward” seeks to nurture thebusiness and willingly cedes control to the next generation.Unfortunately there are far more monarchs out there thanstewards in the family business world. Particularly, if thesenior generation founded the business, there is a tendency towant to maintain control even to the grave.

We have found that, even Monarchs can do effectivesuccession planning if we recapitalize the business into votingand nonvoting ownership interests. This can be done forpartnerships, LLCs and corporations. Even S corporations canhave voting and nonvoting stocks without violating the rule thatS corporations are not permitted to have two classes of stock.

For example, assume that we have a Monarch style businessowner who owns 100% of an S corporation, and is willing to dosuccession planning as long as he doesn’t have to give up anyvoting control. Further assume that we recapitalize thecorporation into voting shares equal to 10 percent of the valueof the corporation and nonvoting shares equal to 90 percent ofthe value of the corporation. The business owner keeps all ofthe voting shares, so that he completely controls thecorporation. But he is willing to use most of the nonvotingshares to do estate planning to reduce the taxable estate. Ifwe gift the nonvoting shares to the children, either outright or


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in some type of irrevocable trust, we have frozen the value ofthe shares for gift tax purposes and any income and appreciationon the gifted nonvoting shares will not be included in thebusiness owner’s estate. If the business owner leaves thevoting shares to the children active in the business at hisdeath, we have done effective succession planning.

If, however, there are children that are active in thebusiness who get the voting shares and non active children whoonly own nonvoting shares, we are setting up a possibleconflict. The children with nonvoting shares who are not activein the business will typically seek distributions, while theactive children would prefer to reinvest in the business or takedistributions in the form of compensation which does not have tobe shared with the non active children. In this case we wouldrecommend that the estate plan would be structured in such a way(perhaps through a shareholders agreement), whereby the nonactive children could be bought out by the active children at afair value payable over a period of years that would not cripplethe business.

L. Charitable Strategies.

1. Introduction to Charitable Planning for theBusiness Owner.

One of the defining characteristics of closely heldbusiness owners is their need to control. This need preventsmany from using lifetime transfer strategies, leaving onlytestamentary approaches, which are inherently less transfer taxefficient. Obviously, life insurance structured outside of thebusiness owner’s estate, and Internal Revenue Code sections likesection 6166 that extend the period to pay estate taxes can easethe burden on the next generation.

But there also are testamentary charitable strategies thatcan efficiently pass on the business. In the rightcircumstances, this kind of planning cannot only keep the nextgeneration of family members in control of the business but alsominimize or eliminate estate taxes and provide some amount forcharity even charitable organizations controlled by the owner’sfamily. There are techniques to achieve the optimal balanceamong these three, often competing goal.

Of course, none of these strategies is a panacea. But theydo end up being among the best approaches for business ownerswho either didn’t want to give up control during life or whosebusinesses grew so big that no lifetime strategy could ever besufficient to remove the entire business from the estate.


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2. General Tax Issues Presented by CharitablePlanning for the Business Owner.

(a) The Private Foundation Excise Tax Rules.

Although referred to as the “private foundation” excise taxrules, these rules actually apply to private foundations,Charitable Lead Trusts (CLTs) and, to a limited extent,Charitable Remainder Trusts (CRTs. In general, if one of theexcise tax rules is violated, a tax of 5 percent is imposedinitially, with the tax rate rising to 200 percent if theprohibited act is not corrected within a certain period of time.The two excise tax rules most relevant to charitable planningwith business interests are the prohibition against excess

business holdings and the prohibition against self-dealing.29

The excess business holdings rule prohibits a privatefoundation from owning more than a certain percentage of thestock in a business enterprise. CLTs are subject to the excessbusiness holdings prohibition only if the value of thecharitable interest in the assets transferred to the trustrepresents more than 60 percent of the total value of thoseassets. CRTs are not subject to the excess business holdingsrule. If the foundation or lead trust fails to divest itself ofthe excess business holdings within a prescribed period, theexcise tax is imposed. The self-dealing rule proscribes virtuallyany transaction between a private foundation, CLT or CRT and any“disqualified person.”

A disqualified person is defined as a substantialcontributor to the foundation or trust, his ancestors anddescendants (including their spouses), officers, directors andtrustees of the foundation or trust and their family members,and any trusts, corporations or partnerships in which theforegoing persons hold certain beneficial, voting or profitsinterests. A disqualified person’s estate also can be adisqualified person, as when a substantial contributor’s familymembers have a beneficial interest in more than 35 percent ofthe estate. Even when a disqualified person’s estate is notitself a disqualified person, if it’s controlled by disqualifiedpersons, such as the decedent’s family members, then the

29 The remaining private foundation excise taxes are the prohibition against taxable expenditures, the prohibitionagainst jeopardy investments, the tax on failure to make minimum required distributions and the tax oninvestment income. Although these taxes need to be considered in the context of testamentary charitableplanning for business interests, they generally present far less of a problem than the excess business holdingsand self-dealing taxes.


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indirect self-dealing rule can apply to prohibit the estate fromselling property bequeathed to the foundation or trust to thedecedent’s family members.

(b) Unrelated Business Income Tax.

Although private foundations and CRTs generally are notsubject to income tax, an exception applies if the foundation ortrust has income subject to the UBIT. Income is subject to UBITif the income is from an activity that constitutes a trade orbusiness, the trade or business is regularly carried on and theactivity is not substantially related to the tax-exempt entity’sexempt purposes. Most passive income, such as rents, royalties,dividends, interest and annuities, is not subject to UBIT.

Passive income is subject to UBIT to the extent it’sderived from “debt-financed property.” And debt-financedproperty generally means any property held to produce income(including gain from the sale of such property) for which thereis “acquisition indebtedness” at any time during the year (orduring the 12-month period before the date of the property’sdisposal, if it was disposed of during the year.)30

UBIT is a particularly significant problem for CRTS becausein any year that the trust has unrelated business income itloses its status as a tax-exempt trust and all of its income istaxed under the UBIT rules. If a private foundation has unrelatedbusiness income, that income is subject to UBIT at regularcorporate or trust income tax rates, depending on how thefoundation is organized, as compared to the foundation’s otherinvestment income, which is subject to the 2 percent (sometimes1 percent) excise tax on net investment income.

For lead trusts, UBIT presents much less of a problem,because CLTs are not tax-exempt. A testamentary lead trust istaxed as a complex trust, with the trust generally receiving anunlimited income tax deduction under IRC section 642(c) for theincome distributed to charity each year. If the lead trust hasunrelated business income, its income tax deduction fordistributing unrelated business income to charity is subject tothe same percentage limitation rules that restrict the amount of

30 Acquisition indebtedness is the unpaid amount of debt incurred under the following circumstances: (1) whenacquiring or improving the property, (2) before acquiring or improving the property if the debt would not havebeen incurred except for the acquisition or improvement, or (3) after acquiring or improving the property if: (a)the debt would not have been incurred except for the acquisition or improvement, and (b) incurring the debt wasreasonably foreseeable when the property was acquired or improved. The facts and circumstances of eachsituation determine whether incurring a debt was reasonably foreseeable.


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income an individual can shelter from income tax each year witha charitable deduction.

(c) Ascertainability of the Charitable Deduction.

To qualify for the estate tax charitable deduction, thevalue of a bequest must be “presently ascertainable” as of thedate of the donor’s death. The seminal case on ascertainabilityis Marine Estate v. Comm’r,31 a case in which the decedent’swill gave executors the discretion to make bequests tononcharitable beneficiaries, with the residue of the estatepayable to two public charities. The court denied an estate taxcharitable deduction, because the executors’ discretion to makenoncharitable bequests made the amount of the charitablebequests unascertainable as of the donor’s death. In thecontext of planning for a business interest, an owner may wish,for example, to provide that the business interest shall pass toone or more charitable vehicles to be selected by an executor orfamily member at the time of the owner’s death. Although thereare no cases or public rulings on this issue, the IRS hasprivately ruled that a beneficiary’s power to choose whether abequest should be used to fund one of two different CLTs did notfail the Marine ascertainability test. In PLR 9631021, thedonor’s will provided that one-fourth of the residuary estate(without reduction for any taxes, fees or other expenses ofadministration) be held under the terms of one of two CLATs(Annuity Trust I or Annuity Trust II) to be selected by thedonor’s daughter, or if she was not then living or wasincapacitated, by another individual. If the selected trustdidn’t qualify for the estate tax charitable deduction, theexecutor was directed to transfer the entire amount outright tothe named charities. The terms of each annuity trust were setforth in the will, along with the formula for determining theamount of the estate tax charitable deduction. The formula wasdrafted in such a way that the noncharitable interest would havean actuarial value of zero (resulting in a 100 percent estatetax charitable deduction) no matter which trust was selected.This type of CLAT is known as a “zeroed-out CLAT.” Because theestate tax charitable deduction was ascertainable at the donor’sdate of death, regardless of which trust was selected, theService ruled that the estate tax charitable deduction was“presently ascertainable” and therefore allowable.

(d) Charitable Deduction Whipsaw.

Suppose the owner’s estate includes his 100 percentinterest in the family business, valued at $10 million, and the

31 990 F.2d 136 (1993), aff’g 97 T.C. 368 (1991)


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owner’s will bequeaths 25 percent of the stock to a localcommunity foundation and 75 percent to his children. The estateincludes the 100 percent interest in the business, but thecommunity foundation receives a minority interest in thebusiness. In the context of the estate tax marital deduction,the IRS has ruled that, when a decedent’s estate includes acontrolling interest in a company but only a minority passes tothe surviving spouse, a minority interest discount should beapplied in determining the amount of the marital deduction. Thesame reasoning should apply for purposes of the charitablededuction as well. Accordingly, in our example a, it’s likelythat the amount of the charitable deduction would be less than$2.5 million (25 percent of the value of the business).32

(e) Special Issues if the Business is an SCorporation.

There are special problems when the business beingtransferred is structured as an S corporation. If the businessis bequeathed to a private foundation, all of the Scorporation’s income and gains and the foundation’s gain on saleof the S corporation stock by statute are subject to UBIT (atregular tax rates), even passive investment income (such asinterest and dividends) generated by securities the Scorporation owns. A CRT is not a valid S corporationshareholder. Therefore, a bequest of S corporation stock to aremainder trust voids the corporation’s S status, causing it toconvert to a C corporation. A CLT is permitted to be ashareholder of an S corporation—if the trust makes an electingsmall business trust (ESBT) election. But this produces highlyundesirable income tax results. As an ESBT, the lead trust istaxed on S corporation income at the highest marginal rates fortrusts, and, worse still, the trust is denied a IRC section642(c) deduction for the S corporation income the trustdistributes to charity.

3. Issues Presented by a Bequest of an Interest in aBusiness to a Private Foundation

32 See, for example, PLR 9050004 (49 percent interest in closely held corporate stock allocated to maritaldeduction trust with resulting reduction in marital deduction); PLR 9147065 (marital deduction reduced wheredecedent's Will bequeathed voting stock to decedent’s son and nonvoting stock to marital trust); Disanto v.Comm’r, T.C. Memo 1999-421, (marital deduction reduced where surviving spouse disclaimed a portion ofclosely held stock bequeathed to her, resulting in her receiving only a minority interest). The decedent had helda controlling interest in the stock. By reason of the surviving spouse's disclaimer, the surviving spouse receiveda minority interest in the stock. Cf. Chenoweth v. Comm’r, 88 T.C. 1577 (1987) (when 51 percent of a closelyheld corporation was bequeathed to the surviving spouse and 49 percent to the children, control premiumaccorded to marital share and minority discount accorded to nonmarital share). Citing such cases as Estate ofChenoweth v. Comm’r, 88 T.C. 1577 (1987), the court reduced the marital deduction by applying a discount tothe value of the minority interest (caused by the disclaimer) passing to the surviving spouse.


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The business owner could consider bequeathing the businessto a private foundation controlled by her family. This approachcan eliminate estate taxes on the business, because the bequestwould qualify for the estate tax charitable deduction. The familycan control the private foundation, too. But where the plan fallsshort is that it stops the family from controlling the businessafter the owner’s death. Family control is thwarted by twoprovisions of the private foundation excise tax rules, theprohibition against excess business holdings and the prohibitionagainst self-dealing.

Under the excess business holdings rule, the amount ofvoting stock the foundation can hold cannot exceed 20 percentminus the amount of voting stock held by all disqualifiedpersons (for example, close family members, officers anddirectors of the foundation and their family members, and anytrusts, corporations or partnerships in which the foregoing

persons hold certain beneficial, voting or profits interests).33

Limiting the bequest to the foundation to nonvoting stock doesnot solve the excess business holdings problem. A foundation ispermitted to own unlimited amounts of nonvoting stock—but onlyif the total voting stock owned by the foundation anddisqualified persons remains below the 20 percent limit. A deminimis rule allows the foundation to own up to 2 percent of thevoting stock and up to 2 percent of other classes of stock,without regard to how much voting stock disqualified personsown.

The foundation is permitted to keep excess businessholdings for a temporary period. Business interests received by afoundation in a bequest that would otherwise constitute excess

business holdings may be held for up to five years.34 The five-year holding period begins with the earlier of (1) the date the

33 The 20 percent limit is increased to 35 percent if the Internal Revenue Service is satisfied that effective controlof the business is held by one or more persons who are not disqualified persons. Effective control meanspossession, directly or indirectly, of the power to direct or cause the direction of the management and policies ofthe business. Because the plan for most business owners is to ensure that their family maintains control of thebusiness, the 35 percent limit is not likely to be available in planning for most closely held business owners.

34 Note that the five-year holding period applies only to stock owned by the owner at death and not to stockpurchased by his estate after his death. If during the permitted holding period, the foundation purchasesadditional stock in the business, it will have an immediate excess business holdings excise tax liability withrespect to the amount purchased. Also if during the permitted holding period a disqualified person purchasesadditional stock, the foundation will have 90 days in which to reduce its holdings by the amount purchased bythe disqualified person in order to avoid excise tax liability for the amount purchased by the disqualified person.Similar problems can also arise when corporate restructurings or redemptions increase the foundation’s and/or adisqualified person’s holdings.


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stock is distributed from the owner’s estate to the foundationor (2) the date the estate is deemed to be closed for income taxpurposes (typically about two years after death). Accordingly,in most cases the foundation has a maximum of about seven yearsafter the owner’s death in which to divest itself of thebusiness interest. The Internal Revenue Service may extend thepermitted holding period for another five-year period if thebequest is an unusually large bequest of diverse holdings orholdings with complex business structures, and the foundationdiligently tried to dispose of the holdings during the firstfive-year period, but was unable to do so, except at a pricesubstantially below fair market value, due to the size andcomplexity or diversity of the holdings. Although there havebeen a number of instances in which the IRS has permitted theadditional five-year extension, we counsel our clients not torely on obtaining such an extension.

Ownership of stock in the business by a private foundationalso poses significant problems under the self-dealing rules.IRC section 4941 provides that most transactions between aprivate foundation and its disqualified persons constitute aprohibited act of self-dealing, giving rise to onerous excisetaxes. Disposing of the excess business holdings can thereforebe problematic, because a sale of the foundation’s stock to oneof the owner’s family members would be a prohibited act of self-dealing.

Help is available, however, in the form of a limitedexception to the self-dealing rules for general redemptions.Under the general redemption exception, a business could redeemthe foundation’s stock without violating the self-dealing rulesif (1) the redemption offer is made to all holders of the sameclass of stock as that held by the foundation, (2) theredemption price is for the fair market value of the stock; and(3) the redemption is for cash. A redemption using a notecreates another act of self-dealing, because the self-dealingrules prohibit any extension of credit between a privatefoundation and a disqualified person.

In addition to prohibiting direct acts of self-dealingbetween disqualified persons and the foundation, the self-dealing rules can, in certain instances, be applied to prohibitacts of “indirect” self-dealing between disqualified persons andthe business itself—if the business is deemed to be “controlled”by the foundation. Under the self-dealing regulations, aprivate foundation is deemed to control a corporation forindirect self-dealing purposes if disqualified persons may—onlyby aggregating their votes or positions of authority with that


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of the private foundation—require the corporation to engage in atransaction that would be self-dealing if engaged in between theprivate foundation and the disqualified persons directly. Theregulation provides that the corporation is considered to becontrolled by the private foundation or by the privatefoundation and disqualified persons if such persons are able, infact, to control the corporation (even if their aggregate votingpower is less than 50 percent of the total voting power of thecorporation’s governing body) or if one or more of suchindividuals has the right to exercise veto power over theactions of the corporation relevant to any potential acts ofself-dealing.

For example, suppose ownership of voting stock in ABCcorporation is split such that a foundation owns 20 percent, onedisqualified person owns 16 percent, another disqualified personowns 15 percent, and the balance is owned by unrelated parties.The foundation controls the corporation because the twodisqualified persons “need” the foundation in order to go above50 percent voting control. In other words, by aggregating theirvotes, the foundation, the first and second disqualified personscan cause the corporation to engage in acts that would beprohibited acts of self-dealing if engaged in by the foundationdirectly.

By contrast, if the foundation owned 35 percent of thecorporation and the disqualified persons together owned 65percent, the foundation would not be deemed to control thecorporation for purposes of the indirect self-dealing rules,because the disqualified persons do not need to aggregate theirvotes with those of the foundation in order to be in a position

of control.35 Similarly, if the only stock owned by thefoundation is nonvoting stock, the foundation generally wouldnot be deemed to control the corporation for purposes of theindirect self-dealing rules.

Ownership of an interest in an active business also raisesunrelated business income tax (UBIT) concerns for thefoundation. There is little that the foundation can do to avoidthis tax unless and until it disposes of the business interest.

If the business is structured as an S corporation,ownership of the business by the foundation results in alldistributions of income and capital gains to be taxable to thefoundation under the UBIT rules.

35 Revenue Ruling 76-158, 1976-1 C.B. 354.


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4. Solving Problems Presented by a Bequest of theBusiness to a Private Foundation: the Option/Note Approach

An owner could bequeath his business to a privatefoundation without significant tax problems if the bequest iscoupled with an option in the family to purchase the businessfrom the estate. This approach can eliminate estate taxes andgive the family control over both the foundation and thebusiness. It also should eliminate the self-dealing and excessbusiness holdings issues. The downside is that it may place aheavy financial burden on the business.

The private foundation excise tax regulations except fromthe self-dealing rules the exercise by a disqualified person ofan option to buy property bequeathed to a foundation—but only ifthe estate sells the property for its fair market value, and aprobate court approves the transaction. Fair market value isdetermined at the time of the transaction, taking into accountthe terms of any option subject to which the property wasacquired by the estate. In most cases, it’s unlikely that thefamily or the business itself will have the cash to exercisethis option. This is not a problem if the business producescash flow sufficient to support payments on a note. The IRS hasapproved the use of a disqualified person’s note to purchase thebusiness interest from the owner’s estate, the estate’sdistribution of the note to a foundation, and the foundation’sholding of the disqualified person’s note. As long as paymentsare made in accordance with the provisions of the note, thisextension of credit between a foundation and a disqualifiedperson is not a prohibited act of self-dealing. Moreover, theIRS has privately ruled, the foundation does not have excessbusiness holdings because it owns only a promissory note ratherthan stock in the business. If the note is structuredcorrectly, the holding of the note by the foundation should notbe subject the foundation to the excise tax on jeopardy

investments.36

The use of the option/note transaction also preventsimposition of the unrelated business income tax, and avoids theproblem of a foundation becoming a shareholder in an Scorporation if the business is structured as an S corporation.

There are a number of critical “i”s to dot and “t”s tocross. The owner needs to include in his testamentary plan anoption in the family or a family trust to buy the businessinterest otherwise bequeathed to the foundation for a note. To

36 See Treasury Regulations section 53.4941(d)-1(b)(3); Private Letter Rulings 200124029 and 200024052.


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comply with IRS rules, the family must exercise the purchaseoption and complete the purchase while the owner’s estate isconsidered open for estate-tax purposes, and the transaction hasto be approved by the probate court having jurisdiction over theestate or the foundation. According to IRS regulations, theestate has to receive that “amount which equals or exceeds thefair market value of the foundation’s interest or expectancy inthe property at the time of the transaction, taking into accountthe terms of any option subject to which the property wasacquired by the estate.” Also, the terms of the note need toplace the foundation in at least as good a position, in terms ofliquidity and security, as it would have been in had it receivedthe business interest rather than the note. The estate thendistributes the note to the foundation, and the family member(s)who exercise the option make payments to the foundation as theycome due.

The primary problem with the option/note approach is thatif the family member exercises the option, he’s locked into apurchase at a value the market may not sustain. The privatefoundation self-dealing rules also make it difficult orimpossible to renegotiate or even abandon the transaction. Anyfailure to make timely payments would result in the familymember having to pay self-dealing excise tax, and make thefoundation “whole,” as determined under the highest fiduciarystandards. Nonetheless, for business owners who have bothcharitable intent and confidence in the ability of theirbusiness to produce cash flow at a rate necessary to authorizethe note, the optional note strategy can make a great deal ofsense.

5. Turbo-charging the Note/Option Strategy: Adding aCLAT to the Mix

What if instead of a private foundation, the ownerbequeaths the business to a Charitable Lead Annuity Trust(CLAT)? The CLAT would be structured with a payout rate and termsuch that the value of the charitable interest is equal to thevalue of the business interest bequeathed to the trust, asfinally determined for federal estate tax purposes. Thepayments from the CLAT each year could be made to the owner’sprivate foundation. At the end of the CLAT term, any remainingproperty of the trust passes to the owner’s family members, or atrust for their benefit.


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This structure can produce better benefits for the owner’sfamily than a bequest of the business to a private foundation.If the business is bequeathed to a private foundation, allpayments on the note pass to charity. On the other hand, if thebusiness is bequeathed to a CLAT, any payments on the note inexcess of the amounts needed to service the required annuitypayments are distributed to the owner’s family at the end of theCLAT term.

Designing the CLAT itself can be tricky. Generally,planners should create a CLAT with a payout rate approximatelyequal to the cash flow the owner expects the business canproduce annually. The term of the CLAT then can be set byformula as that number of years necessary to produce a value forthe charitable lead interest that is equal to the fair marketvalue of the assets passing to the CLAT at the owner’s death, asfinally determined for federal estate tax purposes.

Planners also may want to draft a second, contingent CLAT,which might have a payout rate somewhat lower than the annualcash flow produced by the business. The owner’s executor couldbe given discretion to fund this contingent CLAT instead of thehigher-rate CLAT if, for example, the business was producingless cash flow at death than originally anticipated. A road mapfor establishing such a contingent CLAT is set forth in PrivateLetter Ruling 9631021.

6. A Different Approach to Solving Private FoundationProblems: A Bequest of the Business to a SupportingOrganization.

Business owners also can consider substituting a supportingorganization (SO) for the private foundation in their transferstrategy. An SO is classified as a public charity because itmaintains a certain relationship with other public charitiesand, although the donor and/or his family members canparticipate in its administration, they cannot control it. AnSO is often considered as an alternative when the privatefoundation excise tax rules make a private foundationunattractive. As a public charity, an SO is subject to the moreliberal “intermediate sanctions” rules that permit publiccharities and their disqualified persons to enter into fairmarket value transactions and arrangements. By comparison, theprivate foundation self-dealing rules prohibit almost alldisqualified person transactions and arrangements. If ourbusiness owner’s stock is bequeathed to an SO, the excessbusiness holdings rules do not apply to restrict the period oftime the SO can hold the stock. However, if the SO holds the


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stock indefinitely, there is a risk that the IRS wouldreclassify the SO as a private foundation on the theory that theSO is being operated to benefit private interests and,therefore, must be under the family’s control. State law alsomay limit an SO’s ability to hold the stock indefinitely ifholding the stock prevents the SO from diversifying itsinvestments.

If family members want to purchase the stock bequeathed toan SO, they can do so for fair market value, at any time andwithout probate court approval, as the private foundation excisetax rules do not apply. If, however, the SO finances thefamily’s purchase of the stock by accepting a note as paymentthen, unless the purchase is made from the estate using the sameprocedures as would be followed to avoid self-dealing for aprivate foundation, it would be advisable to obtain advanceapproval for the transaction from the Service. Otherwise, theIRS may reclassify the SO as a private foundation on the theorythat the SO’s loan to family members of the business owner isevidence of their control over the SO. In addition, the SOshould follow the procedures under the intermediate sanctionslaw for establishing that the purchase price is not an “excessbenefit” transaction that would subject purchasing family memberto personal liability for the public charity excise tax.

Finally, despite the avoidance of the private foundationexcise tax rules, substituting an SO for the private foundationdoes not improve the family member’s ability to control thestock owned by the SO, because if family members can control theSO, directly or indirectly, the Service will likely reclassifythe SO as a private foundation.37

M. Other Advanced Planning Concepts

Beyond the scope of a general family business successionoutline, are additional advanced techniques that in certaincircumstances can be highly effective. These include (1)common/preferred estate freezes that satisfy code section 270138;sales to an ESOP39, and the charitable stock bailout40.

37 Daniel L. Daniels and David T. Leibell, “Planning for the Closely Held Business Owner: The CharitableOptions”, 40th Annual Heckerling Institute on Estate Planning (2006)

38 Richard L. Dees, “Using a Partnership to Freeze the Value of Pre-IPO Shares”, Heckerling Institute on EstatePlanning (1999)

39 Louis H. Diamond, “Consider the ESOP”, Trusts & Estates, August 2009, pgs 22-2940 Daniel L. Daniels and David T. Leibell, “Planning for the Closely Held Business Owner: The Charitable

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N. Holding Closely-Held Business Interests in Trust.

Under the Uniform Prudent Investor Act, which has beenadopted in most states, trustees are required to diversify trustassets unless special circumstances or a specific directionjustify not diversifying. Diversifying many times defeats thepurpose of why most trusts that hold family business interestsare established; which is to preserve the business in thefamily. How do we protect trustees of trusts that holdconcentrated positions in family businesses from surchargeliability for failure to diversify?41

One way is to specifically indemnify the trustee forfailure to diversify out of the family business interests byspecifically referencing the business in the trust instrumentand instructing the trustee to continue to hold the stock unlesscertain specified events occur. These events could includecontinued poor performance of the business over a period ofyears or the consent of all or a super-majority of thebeneficiaries.

If the trustee is still concerned, even with the protectivelanguage, it would be prudent to establish the trust as adirected trust in a state like Delaware. Under a directedtrust, the trustee would serve primarily as an administrativetrustee and a committee not involving the trustee (but likelyincluding family members) handles investment issues regardingthe family business.42

N. Post-Mortem Planning.

Sometimes the family business owner never gets around todoing effective estate planning. If that is the case, the taxcode provides assistance by offering the ability under certaincircumstances for the estate tax to be paid over a period ofyears in order to avoid a fire sale of the business in order topay estate taxes. Section 6161 allows a one year hardshipextension (renewable with IRS approval) for reasonable cause inthe discretion of the IRS. Section 6166 allows a mandatory 14year extension if the business interest exceeds 35 percent ofthe decedent’s adjusted gross estate. The first five years areinterest only. Rigid rules accelerate the tax if there is adisposition of more than 50 percent of the value of the stock.

41 W. Curtis Elliot, Jr. and Briani L. Bennett, “Closely Held Business Interests and a Trustees Duty to Diversify”Trusts & Estates, April 2009

42 David A. Diamond and Todd Flubacher, “The Trustee’s Role in Directed Trusts”, Trusts & Estates, December2010, pgs 24-32


90

A non-statutory way of financing estate taxes is known as aGraegin loan, named after the case where it was permitted.43

V. Executing the Plan

Estate and succession planning for family business ownerscan be very frustrating for both the business owner and hisadvisers. It is very complicated from both a family dynamicsand estate planning viewpoint. Unfortunately, it is many timesmade harder by the lack of collaboration among the advisorsworking on the estate and succession plan. It is not unusualfor there to be a long term entrenched adviser that is in overhis head and threatened by the involvement of outside experts.This entrenched adviser can sometimes be more of an obstaclethan a facilitator of the estate and succession plan, withdrastic results for both the family business and the familyitself. As Rousseau posited centuries ago, and John Nash, of “ABeautiful Mind” proved mathematically, collaboration lifts allboats, including hopefully, that of the entrenched adviser.

1\310\2590357.1

43 Steve R. Akers, “Post Mortem Planning Tax Strategies: A Review of Income, Gift and Estate Tax PlanningIssues”, ALI-ABA Course of Study, Estate Planning for the Family Business Owner, June 22-24, 2009

© 2010 Wiggin and Dana

Daniel L. Daniels, Esq.David T. Leibell, Esq.Wiggin and Dana LLP

Estate Planning for the Closely Held Business Owner, Part 1


Introduction

• General Challenges

– Estate tax uncertainty

– Planning must be done on short time frame

– Business is valuable, but often illiquid, asset

– Business owners can be challenging clients

• Creating a Succession Plan Which:

– Passes the business to intended owners

– Doesn’t adversely affect the business

– Doesn’t treat anyone unfairly


Same Family BusinessSuccession Statistics

• 90% of U.S. businesses are family firms

• Represent 64% of Gross Domestic Product

• Only one-third make the successful transition to thesecond generation

• Only 15% make it to the third generation

• Recent studies indicate 25% will transfer control over thenext 5 years (40% over 10 years)

• 71% have not completed business succession plans

• 93% have little income diversification outside the business

• 80% want business to stay in family


Family Dynamics

• Family dynamics issues more important than proper estatetax planning to future success of business.

• Choice of successor manager

• Active vs. inactive family members

• Separating management structures from ownershipstructures

• Intergenerational communications

• Providing equally for children

• Cash flow concerns of senior generation

• Conflict Management and Dispute Resolution

• Role of professional facilitators


Fact Pattern

• Current Estate Planning Documents– Client and spouse each have wills leaving entire estates

to each other, then to the children• Planning Objectives

– Keep the non-active children (B and C) out of thebusiness

– Pass control of the business to A– Treat A, B and C equally financially– Pay as little estate taxes as possible– Avoid forced sale of business at death– Minimize probate– Minimize liabilities


“Phase One” Planning


Estate Planning

• Planning for Incapacity

• Planning for management and transfer ofproperty in event of death

• Planning to avoid taxes

• Without effective estate planning, property:

– May pass to unintended beneficiaries

– May be reduced in value by unnecessary taxes

– May have liquidity problems


Planning For Incapacity

• Durable powers of attorney

• Living wills

• Advance Medical Directives

• Revocable Living trusts


The 2001 Tax Act

The estate tax is repealed for 2010 and will increaseradically in 2011, unless Congress acts.

2004 $1,500,000 48%

2005 $1,500,000 47%

2006 $2,000,000 46%

2007 $2,000,000 45%

2008 $2,000,000 45%

2009 $3,500,000 45%

2010 SUSPENDED 0%

2011 $1,000,000 55%


Federal Estate Tax

• Taxed on value of assets on date of death

• Basic tools for tax avoidance and deferral

– Unlimited marital deduction

– Estate tax exemption


Federal Gift Tax

• $1,000,000 lifetime gift tax exemption

• $13,000 annual exclusion gifts

• Unlimited med/ed exclusion

• Unlimited marital deduction


Tax Planning for Married Couples

• Objectives

– Postpone estate taxes until surviving spouse’s death

– Maximize eventual inheritance of children

• Basic Plan

– Use estate tax exemption of first spouse to die byleaving exempt amount to Estate Tax Sheltered Trust

– Leave balance of estate to surviving spouse outright orin Marital Trust

• Improper ownership of assets and beneficiary designationscan defeat plan


For 2011

Simple Estate Plan Tax-Efficient Estate Plan

Husband’s Estate

$2,000,000

Husband’s Estate

$2,000,000

No Tax TaxNo

Wife’s Estate

$2,000,000 Wife’s Estate

$1,000,000

Estate

Tax Sheltered Trust

$1,000,000

Tax of $335,000 No Tax No Tax

Children

$1,665,000

Children

$2,000,000


Designing the Estate Tax-Sheltered Trust

• Spouse may be sole trustee or co-trustee

• Trustee may distribute income and principal to spouse

• Spouse can have:

– Right to withdraw up to 5% of principal annually

– Right to control disposition to others

• Co-trustee may have broad powers

– Accumulate or distribute income to family

– Distribute principal or terminate trust


Planning for the Marital Share

• Outright to spouse

• Marital trust

– Spouse must receive all income

– Establish trust:

• Asset protection

• Control disposition of trust funds at spouse’sdeath

• Management assistance

• Special planning for non-citizen spouses


Equalizing Estates

Estate

$0

Estate

$1,000,000

Spouse

$2,000,000

Children

$1,665,000

Spouse

$1,000,000

Estate

Tax Sheltered Trust

$1,000,000

No Tax

No Tax No Tax

Children

$2,000,000

Unequal EstatesEqualized Estates and

Tax Efficient Estate Plan

Tax of $335,000

H: No Assets

W: Assets of $2,000,000

H: Assets of $1,000,000

W: Assets of $1,000,000


The “Decoupling” Problem

• Prior to 2001, a majority of states had no separate statedeath taxes. Rather, these states relied on the “statedeath tax credit,” a form of federal and state revenue-sharing.

• The 2001 Tax Act increased the estate tax exemption, thusremoving many estates from Federal (and state) tax rolls.Exemption currently is $2,000,000.

• The 2001 Tax Act also repealed the state death tax creditover 4 years. Final phase-out occurred on January 1, 2005.


The State Response: “Decoupling”

1. “Freezes” state estate tax exemption regardlessof Federal law changes. (Generally at between$1,000,000 and $2,000,000)

2. Restores 2001 state death tax credit rates

3. Decoupling not an issue in 2011 unless Congresschanges law to go back to an “EGTRRA 2001-style estate tax system”, i.e., no state death taxcredit


Is It Time to Rethink the“Standard” Estate Plan?

Choices to consider:

1. Disclaimer

2. Mandatory “small” estate tax sheltered trust

3. Do Nothing


Planning for Children and other Descendants

• Issues:

– How many strings do you want to place on child’s inheritance?

– Is child responsible with money?

– Are there asset protection concerns (for example, creditors ordivorcing spouses)?

• Alternatives for structuring children’s inheritance:

– Outright bequest

– Trusts established under Will:

1. Principal paid out at specific ages (for example, 1/3 at 30, 1/2at 35, remaining principal at 40)

2. Lifetime trusts for children

– Some combination of above alternatives


Benefits of Trusts

• Minimize taxes

• Trust owns property, not the beneficiaries

• Protection from:

– Divorcing spouses

– Business creditors

– Personal injury plaintiffs

• Protection from beneficiary excess

• Professional asset management


Life Insurance Trust

• Lifetime transfer of ownership

• Guaranteed growth on investment

• Well suited for annual exclusion trust

• Tax savings in 2011 = 55% of insurance proceeds

• Single life or second-to-die


Second-to-Die Insurance Trust

• Solves a Problem for:

– Family businesses

– Retirement assets

– Real estate and other illiquid assets

• Provide source of cash to pay estate taxes at second death

• Increase inheritance of children (and grandchildren)

• Premiums generally lower than single-life policy

• May avoid some insurability problems


Generation Skipping Planning

• Theory behind the tax

• GST Fundamentals

– Taxable termination

– Taxable distribution

– Direct Skip

• GST Exemption and “Leverage”


Applying Phase One Planning toCharlie and Sally’s Situation

• Wills and revocable trusts utilizing all exemptions

• QTIP Marital Planning

• Abby’s share in asset protection trust

– We will discuss more advanced asset protectionplanning later

• Consideration of appropriate fiduciaries

• Living wills and powers of attorney

• Move existing life insurance policy to new insurance trust

• Consider additional insurance – single life or second to die– to pay estate tax


Phase Two Planning Introduced

• Creditor protection

• Advanced Lifetime Planning

– SERTS

– GRATS

– Sales

• Buy – Sell Planning

• Advanced Testamentary Planning

• Charitable Strategies

• Will cover in detail in second session


Contact Information

David T. Leibell, [email protected]

Daniel L. Daniels, [email protected]


Estate Planning for the Closely HeldBusiness Owner, Part 2

Presented by Daniel L. Daniels and David T. Leibell


Agenda• Non-tax planning

• Lifetime strategies

– GRATs

– IDIT sales

– Others

• Testamentary strategies

– Buy-sell agreements

– Testamentary discount planning

– Post-mortem planning


Some Family Business SuccessionStatistics

- 90% of U.S. businesses are family firms

- Represent 64% of Gross Domestic Product

- Only one-third make the successful transition to thesecond generation

- Only 15% make it to the third generation

- Recent studies indicate 25% will transfer controlover the next 5 years (40% over 10 years)

- 71% have not completed business succession plans

- 93% have little income diversification outside thebusiness

- 80% want business to stay in family


Family Dynamics

- Family dynamics issues more important than properestate tax planning to future success of business.

- Choice of successor manager

- Active vs. inactive family members

- Separating management structures from ownershipstructures

- Intergenerational communications

- Providing equally for children

- Cash flow concerns of senior generation

- Conflict Management and Dispute Resolution

- Role of professional facilitators


Non-Tax Planning

• Probate avoidance

• Liability limitation


Probate Avoidance

• The probate process

• Ancillary probate

• Consider revocable trust

• Consider LLC for out of state real estate


Liability Protection

• Insurance is first line of defense

• Consider transferring real estate to an entity

for additional protection

• Choice of entity– Pass through entity such as LLC, LP or S corporation

preferable to C corporation

– LLC or LP preferable to S corporation

– LLC simpler than LP

– Segregate separate activities/properties into separate entities


Lifetime Transfer Strategies

• Outright Gifts

• Spousal Estate Reduction Trust

• Grantor Retained Annuity Trust

• IDIT Sale

• Others

– Private Annuity

– SCIN

– Preferred/Common Recap


Spousal Estate Reduction Trust

• Trust with spouse and descendants as

beneficiaries

• Funded with:– Annual gifts using $13,000 exclusion

– Couple with LLC to simplify gifting

– Larger gifts using $1 million gift tax exemption

• Benefits– Estate reduction

– Simple to create and administer

– Continuing access and control for grantor’s spouse


A Zeroed Out GRAT

• Grantor transfers $1 million to a GRAT whenIRS assumed interest rate = 2%

• Grantor receives $111,000 annually for 10years

• After 10 years, remaining GRAT funds pass tochildren

• Value of taxable gift is approximately $0


Savings Dependent On InvestmentPerformance

Average Return

for 10 years

Amount Passing Tax-Free

to Children After 10 Years

2% $04% $143,000

6% $323,0008% $546,00010% $819,000


Property Suitable for a GRAT

• Growth stocks

• Commercial real

estate

• Closely held

business

• LLCs and LPs

Gift tax risk of undervaluation can beminimized


GRAT Risks

• What if grantor dies before termination of

GRAT?

– At worst, property is taxable in

grantor’s estate

– Nothing gained, but nothing lost

• What if trust investment performance is

less than IRS assumed rate of return?

– Again, nothing gained, but nothing lost


Sale to an Intentionally DefectiveIrrevocable Trust (IDIT Sale)

• Grantor Sells Property to Irrevocable Grantor Trust

• Grantor Receives Promissory Note From Trust

• Note Terms

– Interest Only at Applicable Section 1274 Rate

– Balloon Payment of Principal at End of Note Term

• Grantor’s Interest in Property Frozen at Face Value of

Note Plus Annual Interest Payments

• Objective: Outperform Required Interest Rate On

Note Under Section 1274


IDIT Sale Example

• Grantor Sells Property Worth $1,000,000 to

Irrevocable Grantor Trust

• Grantor Receives 9-Year Promissory Note

From Trust

• Note Terms

– Interest Only at Applicable Section 1274

Rate (1.59% for this example)

– Balloon Payment of Principal at End of

Note Term


Amount to Children Depends onInvestment Performance

Average Return

for 10 years

Amount Passing Tax-Free

to Children After 10 Years

1.59% $02% $40,0004% $265,0006% $537,0008% $864,000

10% $1,256,000


IDIT Sale Risks

• No Safe Harbor Under Code

• No Automatic Revaluation of Note Upon Audit– Will formula work to avoid Proctor?

• Possible Application of Sections 2036 and

2702

• Statute of Limitations

• Possible Gain Recognition At Grantor’s Death


Transfers at Death


Primary Purposes of Buy-sell Agreements

• Provide a market for an illiquid asset

• Provide liquidity to pay estate taxes

• Provide for continuing income for a surviving

spouse

• Under circumstances, fix the value of the

business for estate tax purposes


Other Purposes of Buy-sellAgreements

• Allow owner to maintain control during life and

control the transition of the business at death

• Avoid disputes between active and non-active

children

• Provide for owner’s disability

• Ensure business’s continued qualification as

an S corporation


Basic Provisions of Buy-Sell

• Triggering events

• Permissible buyers

• Business valuation

• Funding methods


Bequests of Business Interests

• Marital trust bequest to create discounts

• Christiansen planning

• Note-CLAT planning

• Insurance funding for non-active children


Post Mortem Options

• Section 6166 election

• Graegin note


Estate Planning for the Closely HeldBusiness Owner

Presented by Daniel L. Daniels and David T. Leibell

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