KEEPING THE FAMILY
BUSINESS IN THE FAMILY
Prepared by:
Julius H. Giarmarco, Esq.
Cox, Hodgman & Giarmarco, P.C.
101 W. Big Beaver Road, 10th Floor
Troy, MI 48084
(248) 457-7200
[email protected]
© Julius H. Giarmarco, Esq. 2006
CIRCULAR 230 DISCLAIMER
THESE MATERIALS ARE NOT INTENDED
OR WRITTEN BY THE AUTHOR TO BE
USED, AND THEY CANNOT BE USED BY
YOU (OR ANY OTHER TAXPAYER) FOR
THE PURPOSE OF AVOIDING PENALTIES
THAT MAY BE IMPOSED ON YOU (OR ANY
OTHER TAXPAYER) UNDER THE
INTERNAL REVENUE CODE OF 1986, AS
AMENDED.
© Julius H. Giarmarco, Esq. 2006
Techniques to be Discussed
1.
2.
3.
4.
5.
Grantor Retained Annuity Trusts
Grantor Trusts
Private Annuities
Self-Canceling Installment Notes
Valuation Discounts
© Julius H. Giarmarco, Esq. 2006
Grantor Retained Annuity Trust
Typical Features
1.
2.
3.
4.
Grantor transfers income producing assets
(i.e., S corporation stock, FLP/FLLC interests) to
an irrevocable trust f/b/o children.
Grantor retains the right to a fixed annuity
payment for a set term of years.
At end of term, the assets remaining in the GRAT
pass to the remainder beneficiaries (the children).
If grantor dies before the set term, the assets in
the GRAT revert back to his/her estate.
© Julius H. Giarmarco, Esq. 2006
Grantor Retained Annuity Trust
Typical Features
5.
6.
7.
8.
The risk of inclusion can be “insured” against with
life insurance on the grantor’s life.
The gift tax value is the FMV of the assets
transferred to the GRAT, less the present value of
the annuity interest and the value of the reversion.
The grantor is taxed on all income and realized
gains on trust assets even if these amounts are
greater than the annuity payment.
All income and appreciation in excess of that
required to pay the annuity accumulate for the
benefit of the remaindermen.
© Julius H. Giarmarco, Esq. 2006
Grantor Retained Annuity Trust
IRC §7520 Rate
Grantor’s Age
Term of Trust
Annual Growth of Principal
Pre-discounted FMV
Income Earned by Trust (8% x $3M = $240K)
Discounted FMV
Percentage Payout (12% x $2M = $240K)
Payment Period
Annual Annuity Payout
Value of Grantor’s Retained Interest
Taxable Gift Value of Residual Interest in Trust
5%
60
10
5%
$3,000,000
8%
$2,000,000
12%
Annual
$240,000
$1,727,208
$272,792
© Julius H. Giarmarco, Esq. 2006
Grantor Retained Annuity Trust
Economic Schedule
Year
Beginning
Principal
5%
Growth
8% Annual
Income
Annual
Payment
Remainder
1
$3,000,000
$150,000
$246,000
$240,000
$3,156,000
5
$3,758,783
$187,939
$308,220
$240,000
$4,014,942
10
$5,425,367
$271,268
$444,880
$240,000
$5,901,516
$2,400,000
$5,901,516
Summary
$3,000,000
$2,008,150 $3,293,366
© Julius H. Giarmarco, Esq. 2006
Intentionally Defective
Irrevocable Trust (“IDIT”)
Do Nothing
During Life




FMV of S Corporation = $5,000,000
Dividend Distributions = 10% / year
Corporation’s Growth Rate = 3% / year
Donor’s Life Expectancy = 20 years
At Death



FMV of S Corporation
Estate Tax (45%)
Children’s Inheritance
=
=
=
$ 9,031,000
$ 4,063,950
$ 4,967,050
© Julius H. Giarmarco, Esq. 2006
IDIT
Recapitalization
1. Recapitalize the S Corporation
 Donor owns 10%, voting shares
 Donor owns 90%, non-voting shares
2. Obtain a qualified appraisal
substantiating a valuation discount for
the non-voting shares ranging from 10%
to 40%
© Julius H. Giarmarco, Esq. 2006
IDIT
Obtain Appraisal
S Corporation
Donor
Retains 100% Voting
Control
No Discount
10% $500,000
With 35% Discount
$500,000
voting
90% $4,500,000
$2,925,000
Nonvoting
Donor
Transfers 90% of
Corporation’s value
out of his/her estate
© Julius H. Giarmarco, Esq. 2006
IDIT
Fund Trust
1. Establish Intentionally Defective Irrevocable Trust (“IDIT”)
 Power of substitution - IRC §675(4)(c)
 Power to borrow without security - IRC §675(3)
 Power in non-adverse party to add charitable
beneficiaries – IRC §674(b)(5)
2. Gift 10% of shares (all non-voting) to IDIT using $325,000 of
gift tax exemption
 This “seed” money avoids potential estate inclusion under
IRC §2036
 Can allocate GST exemption to IDIT
© Julius H. Giarmarco, Esq. 2006
IDIT
Fund Trust
3.
4.
Sell 80% of shares (all non-voting) to IDIT
 Promissory Note with term of 20 years
 Interest payments only (annually) with balloon payment
at end of 20 years
 IRS assumed interest rate is 5.5% (long-term AFR)
 No capital gains tax, and grantor not taxed separately
on interest payments
Alternatives to an installment note
 Private annuity
 Self-canceling installment note (“SCIN”)
© Julius H. Giarmarco, Esq. 2006
Donor
• Donor retains control
as 10% voting
shareholder
• Donor receives
$193,000 annually
(from interest
payment and
dividends on the 10%
voting shares)
• Donor pays income
taxes of $210,000
($500,000 x 42%) - for
annual short fall of
$17,000
• Paying IDIT’s income
taxes is equivalent of
tax-free gift
IDIT
Donor gifts 10% of S Corp stock
(10% x $5,000,000 = $500,000
less 35% discount = $325,000)
Donor sells 80% of S Corp stock
(80% x $5,000,000 = $4,000,000
less 35% discount = $2,600,000)
IDIT pays interest only for 20
years of $143,000 annually
($2,600,000 x 5.5%)
IDIT’s Cash Flow
$450,000
($143,000)
$307,000
IDIT /
Dynasty Trust
• $500,000 FMV
• $4,000,000 FMV
• IDIT earns 10% on
$4,500,000 =
$450,000/ year
IDIT
IDIT Cash Flow
$450,000
($143,000)
$307,000
Excess cash flow could be used for
reinvestment, purchase of real estate,
and/or purchase of life insurance.
© Julius H. Giarmarco, Esq. 2006
Sale to IDIT Illustration
Grantor Gifts
S Corp Stock
$500,000
Taxable Gift
$325,000
Grantor Sells
S Corp Stock
$4,000,000
IDIT Issues Note
$2,600,000
Discounted Face
Principal &
Interest
$5,460,000
Value of IDIT
in 20 Years
$18,419,940
© Julius H. Giarmarco, Esq. 2006
Private Annuity
Parent
(Age 70)






Sale of $1M of S
Corporation Stock
(with basis of
$100K)
Annual Payout of
$109,469
Child
Annuity may not be secured.
Each payment is divided into capital gain ($58,065), interest income
($44,953), and a nontaxable recovery of basis ($6,452). Assumes the
Section 7520 Rate is 5%.
Child cannot deduct any part of payments.
When parent dies, payments terminate.
Calculation assumes a 16 year life expectancy.
Standard valuation tables may be used if annuitant has at least a 50%
probability of living one year. If the annuitant survives for at least 18
months, the 50% test is presumed to have been met. Regs § § 1.75203(b)(3) and 25.7520-3(b)(3).
© Julius H. Giarmarco, Esq. 2006
Self Canceling Installment Note
(“SCIN”)

Instead of a standard installment note, the sale can
be paid with a SCIN. In Estate of Costanza, the Sixth
Circuit, in a case arising out of Michigan, recognized
a SCIN as a bona fide transaction.

A SCIN is an installment note that by it’s terms is
extinguished at the death of the seller.

With a SCIN, nothing is included in the seller’s gross
estate (similar to a private annuity).
© Julius H. Giarmarco, Esq. 2006
Self Canceling Installment Note
(“SCIN”)

The purchaser must pay a “risk” premium to the
seller as consideration for the cancellation feature.
However, there is no statutory or regulatory
guidance as to how the risk premium should be
calculated.

Apparently, the premium can be reflected as an
increase in the sales price, or as an increase in the
interest rate.
© Julius H. Giarmarco, Esq. 2006
Self Canceling Installment Note
(“SCIN”)
IRC §7520 Rate
FMV of Property
Cost Basis
Initial Down Payment
Age
Term of Note
Type of Note
AFR
Payment Period
5.00%
$2,600,000
$1,000,000
$0
60
10 years
Interest Only
5.50%
Annual
© Julius H. Giarmarco, Esq. 2006
Self Canceling Installment Note
(“SCIN”)
Mortality Risk Premium (Principal)
Total Sale Price
Principal Amount of Note
Mortality Risk Premium (Interest)
Total Interest Rate
Risk Premium
Principal
Interest
$263,567
N/A
$2,863,567 $2,600,000
$2,863,567 $2,600,000
N/A
1.2790%
5.5000%
6.7790%
© Julius H. Giarmarco, Esq. 2006
IRS Support for IDITs
1.
Rev. Rul. 85-13

2.
Rev. Rul. 2004-64


3.
There is no capital gain on sales between a grantor and a grantor
trust.
The payment of income taxes by the grantor on behalf of a grantor
trust does not constitute a gift to the trust’s beneficiaries.
If an independent trustee has the discretionary power to reimburse
the grantor for income taxes, this does not cause the trust to be
taxed in the grantor’s estate under IRC Sec. 2036(a)(1).
Karmazin vs. Commissioner


This gift tax audit, which was settled out of court, treated a sale to a
grantor trust as a bona fide sale.
Trust was funded with 10% seed money.
© Julius H. Giarmarco, Esq. 2006
IDIT
 Assumed discount
rate is AFR
 Only note is
included in
grantor’s estate
 Can allocate GST
exemption
 End loading with
balloon payment
vs.
GRAT
 Assumed discount rate
is IRC §7520 rate
 All trust assets
included in grantor’s
estate
 Cannot allocate GST
exemption because of
ETIP rules
 Annuity cannot exceed
120% of prior year’s
annuity
© Julius H. Giarmarco, Esq. 2006
IDIT
vs.
 Cannot reduce gift to
zero because of seed
money
 Unintended gift may be
minimized with a
“formula” gift
 Potential capital gain if
grantor dies while note
is outstanding
 Non-statutory
technique
GRAT
 Can reduce gift to zero
with Walton GRAT
 Unintended gift is
minimized if annuity is
a percentage of FMV
 No capital gain if
grantor dies during the
term
 Statutory technique
© Julius H. Giarmarco, Esq. 2006
“When I go, I plan on taking at least two of
my estate-tax lawyers with me.”
© Julius H. Giarmarco, Esq. 2006
The End.
Thank You!
© Julius H. Giarmarco, Esq. 2006