In a prior blog post I described the unfortunate saga of a hypothetical business owner, “Louie Lucky”. A widower, Louie had built a successful medical supply company that, at the time of his death in 2009, was worth $8 million. Combined with his other assets, Louie had a gross estate of $9.3 million. Based on the $3.5 million estate tax exemption in effect in 2009, Louie’s three children were faced with a federal and New York State estate tax bill of over $3.6 million. Even worse, the kids had only $800,000 of liquid assets available to cover the tax, which is due nine months from the decedent’s date of death.
What could Louie have done during his lifetime to avoid this unfortunate result? One possible solution would have been for Louie to purchase a life insurance policy – typically owned in an irrevocable life insurance trust (commonly referred to as an “ILIT”) -- to help cover the estate tax obligation. Had Louie established an ILIT that owned, for example, $3 million worth of life insurance, the policy proceeds could have been available to cover most of the estate tax liability; a portion of his liquid assets could have been used to cover the balance of the taxes. This strategy would have spared Louie’s kids the hardship of trying to liquidate Louie’s business assets to cover the tax.
While life insurance can be a great estate planning tool, there are some limitations. Sometimes the business owner has health conditions that render him uninsurable. Also, if the value of the business grows rapidly, that increase in estate value may soon outstrip the amount of life insurance purchased to cover the projected estate taxes.
Another common estate tax planning strategy is for the business owner to gift shares in a company to his children. Given that the annual gift exemption is only $13,000 per donee, however, it would have been impractical for Louie to transfer his $8 million company to his children through the use of the annual gift exclusions. Even if he were to fully utilize his $1 million total lifetime gift exemption by making a lump-sum gift, Louie would still be left with $7 million worth of stock after such a transfer.
To address the limitations inherent with lifetime gifts of business assets, we have to consider alternative strategies. One advanced estate planning option that has gained traction over the past few years is the sale of assets to a Grantor Deemed Owner Trust, or “GDOT”. The GDOT strategy is based upon two key concepts. First, it is a fundamental business valuation principle that non-controlling interests in a closely held business are entitled to a valuation “discount” based upon both the lack of control of such minority interests, and a discount for their inherent lack of marketability. Second, an arms-length sale of the non-controlling business interests to a GDOT established by the business owner is not deemed a taxable transaction, and hence will not result in the imposition of a capital gains tax. Once the non-controlling minority interests have been sold to the GDOT, the value of such minority interests – as well as all future appreciation in the value of those interests – grows within the trust and outside of the controlling business owner’s estate.
Here’s how such a strategy might be used in Louie’s situation: Louie’s attorney would recapitalize Louie’s 100% voting stock into 1% voting shares and 99% non-voting shares. A qualified business valuation professional would be retained to determine the fair market value of the non-voting shares. Assume the valuation specialist determines that the non-voting interests are entitled to a “discount” of 34.5% for lack of marketability and lack of control. If Louie’s medical supply business is worth $8 million as a going concern, then applying the 34.5% discount to the 99% non-voting interests would give us a valuation for those non-controlling shares of $5,000,000.
Louie would then establish a GDOT. He could name one or more of his children, or a trusted advisor or corporate fiduciary, as Trustee. The children, or trusts for their benefit, would be the beneficiaries of the GDOT. Louie would make a “seed” gift to the GDOT, which is typically 10% of the value of the assets to be sold to the GDOT; in this case we would presume a seed gift of $500,000. Louie and the GDOT Trustee would enter into a contract of sale whereby he agrees to sell the 99% non-voting interests to the GDOT in exchange for a promissory note. Assume the note is structured as an interest only note payable in 25 years, using an applicable federal rate (“AFR”) of 4%. After the sale is completed, the GDOT Trustee would make monthly interest only payments of $16,666, or about $200,000 per year.
So, where is the money to come from to pay the note? Since the GDOT is now the owner of 99% of the company’s stock, a significant portion of the cash flow from the business can go to the GDOT. Louie’s regular salary of $300,000 can be reduced, if necessary to accommodate the shift in cash flow. The note payments to Louie will still be taxed as ordinary income, so this structure is income-tax neutral to Louie. At the end of 25-year term, the note can be extended or otherwise renegotiated; if the business has been sold in the interim, the note can be paid-off at its “frozen” value of $5 million. If the business has increased in value – say in ten years it is worth $12 million – all that appreciation grows within the GDOT, and outside of Louie’s estate. Only the $5 million note would be includable in Louie’s estate were he to die before the note is paid-off; the result is a reduction in the value of Louie’s estate by a cool $7 million.
What if the business continues to be a cash cow and produces cash flow in excess of the amount needed to pay back the note? Perhaps the GDOT Trustee can use some of this excess cash flow to purchase life insurance on Louie’s life. Since no gifts from Louie are required to fund the life insurance premiums, we reduce the administrative complexity inherent with ILITs that requires the sending of periodic “Crummey” notices to the beneficiaries. And, we are not then subject to the $13,000 annual gifting limitation that often makes the purchase of a large life insurance policy within an ILIT unfeasible.
These estate tax issues, of course, might be moot if the federal estate tax repeal that exists for 2010 were to be made “permanent.” As things presently stand, however, the federal estate tax will be reinstated in 2011 with a $1 million per person exemption, increasing the likelihood that larger estates will face significant estate tax liabilities in the years ahead. And, for New York residents, we still have in effect the limited $1 million per person estate tax exemption that is unaffected by the federal estate tax repeal.
The GDOT sale strategy requires the right facts to work successfully. It is particularly important that the assets sold to the GDOT produce adequate cash flow to fund the promissory note payments. But for many successful business owners – including real estate investors -- the GDOT sale strategy might be the “centerpiece” estate planning strategy to effectively transfer family business assets to subsequent generations in the most controlled and tax-efficient manner.