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A Better Partnership


May 2013
May 10, 2013

Business Succession Opportunities Remain Significant – For Now

The threat of the gift and estate tax exemption significantly dropping, at least for the time being, was eliminated with passage of the American Taxpayer Relief Act in January. Many individuals took advantage of the lifetime gifting exclusion in 2012 by making significant gifts, but many others did not and therefore still have an opportunity to transfer assets using the  $5.12 million exemption amount. President Obama’s recent budget proposal not only calls for reducing the exemption back to $3.5 million, but also targets other significant planning strategies.

This is especially important for business owners who want business interests to stay in the family and ultimately want to pass them along to children or grandchildren with as little tax as possible. The opportunities that exist today may again be lost.

Although there are a number of opportunities and ways for a business owner to save on gift and estate taxes under the current rules, I want to focus on four that range from the fairly basic to the very complex. They include the use of annual exclusion gifts, lifetime exclusion gifts, GRATs and family limited partnerships.

Annual Exclusion Gifts

Current annual exclusion gift rules create fairly simple and straightforward opportunities that are attractive today, in part, due to our recent economic recession and the slow recovery. The recession’s silver lining is that it created an opportune time to take assets with depressed values, such as an interest in a family-owned business or real estate, and gift them to children or grandchildren.  When such gifts are made, the asset’s future growth is deflected to children or grandchildren.

From an estate tax perspective, gifting assets with depressed value is a savvy move because the asset and its growth will be outside the donor’s estate, thereby avoiding a possible future estate tax. Under current rules, an individual can gift up to $14,000 per year (or $28,000 as a married couple) of cash, securities, real estate interests or business interests to anyone and to any number of people, including children and grandchildren. Cash gifts can be made outright, to an irrevocable life insurance trust or to 529 college savings plans established for a child or grandchild. Interest in a business or real estate may be made outright or to trusts established for children or grandchildren.

Lifetime Gift Tax Exclusions

Utilizing the lifetime gift tax exclusion is a second opportunity that can be seen as an expansion of the first. Like the opportunity to gift assets with depressed values through $14,000 annual exclusion gifts, every individual also has the ability to gift up to a total of $5.25 million under the lifetime exclusion rules. Although large gifts can be made outright, they can also be made to trusts established for children or grandchildren and can even be made to irrevocable trusts created for the benefit of a spouse. These trusts can be structured to provide tax benefits and creditor protections for the beneficiaries.

Grantor-Retained Annuity Trusts

A third opportunity is more complex but attractive, especially to business owners who have assets believed to be on the verge of gaining value and who desire to transfer those assets and minimize taxes. This opportunity involves creating a grantor-retained annuity trust (GRAT). In a typical GRAT, a parent transfers assets, often an interest in a family-owned business, to a trust and receives a fixed annuity payment back from the trust for a set period of time. The annuity payments are typically set so that the taxable gift resulting from the GRAT creation is very small. Any excess growth above what is required to meet the annuity payments passes to the beneficiaries (typically children) free of gift tax.

This is a particularly good time to establish a GRAT for two reasons. First, the ability to use GRATs may become more restricted in the future if President Obama’s tax proposals are adopted. (The proposals include requiring GRATs to remain in place for a minimum of 10 years, making them less advantageous for those with shorter life expectancies.) Second, the gift tax consequences of a GRAT are based on a special interest rate published monthly by the IRS, known as the “7520 rate” or “hurdle rate.” (This rate generally tracks with market interest rates.) GRATs work best when interest rates are low, as they are now. The 7520 rate for April, 2013, is 1.4%. Because a GRAT’s interest rate is locked in when the GRAT is created, a low interest rate combined with depressed asset values means there is a greater likelihood that the GRAT will be successful in passing wealth to the next generation, free of gift tax.

Family Limited Partnerships

And finally, a family can establish a family limited partnership in order to pass business interests to lower generations with fewer taxes. Although the IRS has challenged a number of family limited partnerships, when they are done carefully these partnerships have been upheld in court. So they continue to be an effective way to move assets outside of your estate.

To do so, assets (often family business interests or real estate) are transferred to a partnership that is formed with children. Shares of the partnership can then be given to the children while the parent or parents retain management powers as general partners. Children are typically limited partners with no direct involvement in the operation of the business. Because the assets owned by the children are not controlled by the child and cannot be easily sold, the value of those assets is entitled to be discounted due to the lack of control and lack of marketability. This, in turn, lowers the gift taxes owed.

President Obama’s recent budget proposal not only included curtailing the benefits of GRATs, but also limiting discounts for family-controlled entities. As such, the tax advantages of a family limited partnership (or a similar structure called a “family limited liability company”) may not exist in the future.

All of these methods, even those that appear fairly basic, create possible opportunities and possible disadvantages.

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