Time to Take Advantage of Unique Opportunities for Family Business Succession Planning

The current combination of some of the lowest interest rates in history, high federal gift tax exemptions, and lower asset values creates a unique planning opportunity for those family business owners who wish to engage in succession planning and in other estate planning. The following very generally outlines the importance of the interest rates, discusses the federal gift tax exemption, and outlines several planning techniques that are ripe for use.

Section 7520 Rate

The "7520 rate" is an interest rate, set monthly, which is used to value a remainder interest in a trust.

The value of the remainder interest is important in determining, among other things, how much of a donor's federal gift tax exemption is used when making a gift to a GRAT or CLAT (described below). And, in the context of a GRAT, asset appreciation in excess of the 7520 rate passes to remainder beneficiaries tax free. For June, the 7520 rate is a historically low 0.6 percent.

Applicable Federal Rate (AFR)

These rates, also set monthly, set forth the minimum amount of interest that needs to be charged on a loan in order to avoid any gift element on the use of the loaned funds. There are three different rates, one for short-term loans of less than three years in term, one for mid-term loans which are of a duration of three years to less than nine years, and one for long-term loans of nine years or more.

Each of the rates varies slightly due to selected compounding schedules (monthly, quarterly, semi-annually, or annually). For annual compounding, the June 2020 AFRs are as follows:

• Short-term: 0.18 percent;
• Mid-term: 0.43 percent; and
• Long-term: 1.01 percent.

These rates are important for intra-family loans and any sale of assets to a trust for beneficiaries in exchange for a promissory note.

High Federal Exemption 

Between now and January 1, 2026 (absent earlier legislation), the combined federal gift/estate tax exemption is as high as it has ever been, and is indexed for inflation. For 2020, the exemption is $11.58 million.

Presently, this exemption will revert to $5 million, indexed for inflation, as of January 1, 2026. Many family business owners are looking to use the additional exemption amount through gifting before it goes away. The Treasury Department has issued regulations stating that there will be no "clawback" of gifts made using the excess exemption above the reduced exemption following a donor's death at a time when the exemption is lower than when the gifts were made.

"Zeroed-Out" Grantor Retained Annuity Trust (GRAT) 

A "zeroed-out" GRAT is an estate freeze technique which transfers any appreciation of the assets gifted to a GRAT, above the 7520 rate, to the remainder beneficiaries free of transfer taxes, and uses very little, if any, of the donor's federal gift tax exemption. Generally, that process is as follows:

• Assets that are likely to appreciate are transferred to the GRAT;
• The donor reserves an annuity right (which is based, in part on the 7520 rate) for a fixed term of years (the "GRAT term"); and
• Any property remaining at the end of the term goes to the remainder beneficiaries, typically children, in further trust or free of trust.

This type of GRAT is "zeroed-out" because the donor receives all or mostly all of the property initially contributed in the form of annuity payments, thereby making no, or a very small, taxable gift. GRATs are seen as a relatively safe planning technique because they are set forth in the Internal Revenue Code and accompanying regulations. However, GRATs are not without risk.

If the donor dies during the GRAT term, then the unpaid annuity amounts or the entire value of the GRAT may be included in his or her estate. While securities are often used to fund GRATs, family business interests may also be used if the value of the business is expected to increase during the GRAT term.

Presently, many family business values are lower due to the global health and economic crises, and with a 7520 rate of only 0.6 percent, there is an opportunity to use one or more GRATs to shift appreciation over 0.6 percent in the gifted assets to the next generation (in trust or free of trust) when values increase again.

Sale to "Intentionally Defective Grantor Trust" (IDGT) 

Another estate freeze technique similar to a GRAT, but not set forth in the Internal Revenue Code, is a sale of assets–which may be family business interests–to an irrevocable trust (typically for the benefit of children and other descendants) of which the donor is treated as the owner for federal income tax, but not federal estate tax purposes (which is why it is referred to as an "intentionally defective grantor trust" or "IDGT").

The sale involves the IDGT giving the donor a promissory note for the sale price. Because the donor is treated as the owner of the trust assets, a sale of assets to an IDGT is not an income taxable event (i.e., you are selling assets to yourself) and the interest from the note is also not taxable to the seller.

In order for such a sale to be respected by the Internal Revenue Service on any gift tax return audit (these sales are typically disclosed on a gift tax return), it is generally recommended that the donor make a gift of assets to the IDGT with a value of at least 10 percent of the value of property later being sold to the IDGT.

Example: 

If a family business owner wished to sell $10 million in family business interests to an IDGT, she would need first to make a gift of $1 million in assets to the IDGT. Then, a purchase and sale agreement, promissory note, and security agreement (securing the note) would be executed. The note duration is agreed upon by the parties, as are all other transaction terms.

While it is important that the transaction terms be at arm's length, the AFR for the applicable note duration may be used. If a note term of 10 years at 1.01 percent AFR is used, all value in the business interests sold above the sale price and AFR interest rate passes to the IDGT beneficiaries free of transfer taxes. However, because of the large upfront gift, a sale to an IDGT is more effective than a GRAT only when the applicable AFR is lower than the 7520 rate.

Charitable Lead Annuity Trust (CLAT) 

A CLAT is a trust for a term of years (the "CLAT Term" or "lead interest") that benefits a charitable organization with the remainder passing to noncharitable remainder beneficiaries at expiration of the CLAT Term.

Like a GRAT, use of one or more CLATs may result in transfer of assets, such as family business interests, to children or other descendants (in trust or free of trust), for no or very little use of federal gift tax exemption, when the 7520 rate is low. If the family business outperforms the annuity set by the 7520 rate (the lower the 7520 rate, the lower the annuity amount), then the remaining family business interests are transferred to the trust's beneficiaries without additional transfer tax impact.

The CLAT is an attractive option for older business owners, business owners whose children are financially stable, and/or business owners that are charitably inclined. The charity receiving the "lead" or upfront interest in a CLAT may be a family business owner's donor advised fund (a charitable fund the family business may create at a local community foundation or at a commercial sponsor) or a private foundation. However, careful planning and implementation is needed with the latter to avoid potentially adverse consequences.

A CLAT is not a tax-exempt trust. Whether the CLAT pays its own income taxes depends on whether the trust is a "grantor trust" (i.e., whether the donor is the owner of the trust for federal income tax purposes and, thus, is taxed on the trust's income). Important elements of a CLAT include the following:

• If the CLAT is a grantor trust, then the donor may take an immediate charitable contribution deduction for the value of the charity's lead interest, but must pay the trust's income taxes;
• If the donor dies or the CLAT ceases being a grantor trust before the end of the CLAT Term, there is a recapture of the charitable contribution deduction;
• There is no charitable contribution income tax deduction available for a gift to a non-grantor CLAT; and
• A non-grantor CLAT pays its own taxes.

It should be noted that proper drafting is very important from an income and transfer tax standpoint for both grantor and non-grantor CLATs.

Intra-Family Loans 

When the various AFRs are as low as they are now, family members may loan each other money and both parties benefit. Unlike a gift that may use the donor's exemption and reduce assets for the donor's own benefit, an intra-family loan allows a donor to loan money to a family member at AFR interest rates and the donor recognizes a small amount of taxable interest.

Arm's-length terms and respect for the loan terms are important:

• The parties should memorialize the loan through a promissory note that sets forth the term, interest rate, security, and repayment terms.
• The borrower should also make sure to remit consistent interest payments so that the loan is not recharacterized as a gift.

Intra-family loans may eventually be forgiven by annual exclusion gifts and/or use of the lender's federal gift exemption, though there should not be any prearranged plan to do so when making such a loan.

What This Means for Your Family Business 

The combination of the temporarily high gift exemption, historically low interest rates, and lower asset values in many cases, means now is a great time to implement family business succession planning and other estate planning. If your family business is taxed as an "S" corporation, the above planning techniques are available, but extra care is needed in the drafting and implementation.

We are available to assist you with all such planning.