Estate planning is hardly a fun way to spend a weekend. Besides the obvious disincentive of contemplating the Grim Reaper, federal estate taxes alone can reach 55%, and years of tax reforms have virtually wiped out most ways of minimizing them.
There is still one way out, though, according to Jonathan Dubitzky, a partner in the Boston law firm Sullivan & Worcester. He urges owners of S corporations to set up a trust known as a GRAT (grantor-retained annuity trust), whereby owners pay income tax, comparable to the way they would under S-corporation rulings, but on money that eventually will belong to the kids.
Here's how a GRAT works. "Assume you own an S corporation with annual earnings of $10 million and a market value of $60 million," says Dubitzky. "Rather than waiting until after your death to leave the company to your adult child -- who might have to pay 55¢ in tax on every $1 of its value -- you want to start transferring a minority stake now, let's say 30% of the stock."
A GRAT can be viewed as a conduit. In the above example, the business owner would transfer the 30% stake to the GRAT, where the shares would remain for however long the trust was set up to last. People typically choose GRATs that last two to five years. Dubitzky's example assumes the GRAT will run five years; after that, the trust will expire, and its shares will pass to the child.
Tax laws dictate that for as long as the 30% stake remains in the GRAT, the business owner must receive an annuity -- a cash payment -- amounting to 30% of the company's annual income at the time of the GRAT transfer. In Dubitzky's example, the GRAT must pay the owner $3 million for each of five years. Since the owner still holds the other 70% stock stake, the owner also earns the remaining $7 million in annual income.
Here's the good stuff: Instead of having to pay a 55% estate or gift tax on the 30% stock transfer, the child pays much less because, the IRS says, the GRAT diminishes the value of the stock. "Assuming that current market value of $60 million, the 30% stake would be worth $18 million," explains Dubitzky. "Then, because it's a minority stake, the government might allow us to discount its value, say by another 30%, so the current value would be considered $12.6 million."
The IRS defines the taxes due on a GRAT transfer as follows: Take the value of the stock -- in this case, $12.6 million -- and subtract the value of the annuity the parents are receiving. "You calculate that with some actuarial tables," Dubitzky explains, "but at current values, it might be about $12.3 million. So you could actually end up transferring 30% of your company's stock -- $18 million worth -- to your child while paying a gift tax on what is defined as only a $300,000 transfer.
"The GRAT is simply too good to miss," Dubitzky continues. Consider a best-case scenario for a growth-oriented company: If revenues keep rising, tax savings actually wind up higher than predicted. For the hypothetical company Dubitzky describes, if income rises to $14 million, then $4.2 million -- 30% of $14 million -- in annual income would pass to the GRAT, which would still have to pay the business owner $3 million. The remaining $1.2 million in cash would remain in the GRAT, eventually to pass tax free to the children along with the stock when the trust expires.
One caveat: although the transactions can be structured to be virtually estate-tax free, the person who sets up the trust must pay income tax on all funds earned by the GRAT.