Freeze Assets in Your Estate Before a Liquidity Event

Tax-saving strategies to transfer wealth to family

For 15 years, John and Laura have been building a successful business manufacturing acoustic recording equipment. Now, as they look toward the next chapter in their life, they are contemplating selling the company. The question is how they maximize the sale proceeds for the benefit of their family.

Their current estate is worth over $20 million, and they face an estate tax of $3.6 million at death. One of their goals is to give large sums of money to their three children and eight grandchildren while preserving their lifetime gift tax credit to shield their assets from estate tax. The couple would like to keep their estate plan as simple as possible, but they are willing to use complex strategies to achieve results. Luckily, the upcoming business sale presents the opportunity for John and Laura to reach their goals by “freezing” the value of the company before the liquidity event.

A freeze is a technique where the value of an asset is frozen at its current value, allowing all appreciation to pass estate tax-free to family or other beneficiaries. Many freeze transactions leverage one’s gift tax exemption, currently $5.49 million per person for 2017, so large transfers can be made with little or no gift tax incurred.

Two common methods to freeze your estate and pass on the proceeds of a liquidity event to heirs are the grantor retained annuity trust (GRAT) and the sale to a defective grantor trust (DGT).

GRAT

A GRAT is a technique whereby a taxpayer transfers assets to a trust in exchange for an annuity equal to the value of the assets. If the assets appreciate in excess of an interest rate prescribed by the IRS (currently around 2%), the additional value will pass to the beneficiaries free of gift tax. Here’s how:

  • Step 1: Prior to the business sale, Laura and John transfer a portion of their business into a GRAT in exchange for a two-year annuity. The independently appraised value of the interest is $6.8 million, and the valuation includes a discount since the interest transferred is not currently marketable and does not convey voting rights to the GRAT.
  • Step 2: Later, when the business is sold, the GRAT receives $10 million in proceeds.
  • Step 3: The GRAT makes the annuity payments back to Laura and John equal to approximately $7.0 million ($6.8 million plus interest).
  • Step 4: As a result, at the end of the two-year term, the balance of the GRAT is about $3 million, and that passes gift tax-free to John and Laura’s children.

If the sale does not go through, and therefore the value does not increase, then the interest in their business would simply be returned to Laura and John. But, if they do sell the company, the couple will have saved more than $1.2 million in transfer tax — effectively a “win-tie” situation.

However, the GRAT does not work well for transfers to grandchildren due to separate generation-skipping transfer tax (GST) rules so we must look to other strategies to achieve that goal.

DGT

A sale to a DGT works a lot like a GRAT by freezing the value of an appreciating asset. With this strategy, however, the grantor effectively sells the asset to the trust in exchange for a promissory note equal to the transferred asset’s value, instead of an annuity. There are other differences between the two strategies, but one main benefit of the DGT sale is that the assets can be transferred to both children and grandchildren.

John and Laura would use the DGT strategy by taking the following steps:

  • Step 1: They establish a DGT for the benefit of their grandchildren and make a taxable gift equal to $350,000 to the trust. They allocate a portion of the lifetime gift credit and generation-skipping transfer tax credit so no tax is due.
  • Step 2: The couple sells an interest in their business to the DGT in exchange for a $2.7 million promissory note (which is the independently appraised fair market value with the minority and marketability discounts). Because the note is equal to the appraised value of the interest, they have not made an additional taxable gift.
  • Step 3: Later, when the business is sold, the trust uses the sale proceeds of $4.5 million to repay the note to John and Laura and keeps the excess of $1.8 million for later distribution to their grandchildren. As a result, by using only $350,000 of their lifetime exemption, they get five times that amount out of their estate and save approximately $600,000 in estate tax and $600,000 in generation-skipping transfer tax.

Plan ahead

Planning before acting often results in many benefits. This can be especially true when someone is facing a liquidity event like the sale of a business.

By consulting their wealth manager and estate planning attorney well in advance of their liquidity event, John and Laura were able to take advantage of the unique opportunities the business sale presented and more effectively reach their wealth transfer goals of:

  • Minimizing gift and estate taxes
  • Transferring wealth to children and grandchildren
  • Keeping their estate plan as simple as possible
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