Many closely held businesses are pass-through entities for income tax purposes and are operated by an entrepreneur and one or more children or other family members. As entrepreneurs advance in age, they must address the relinquishment of ownership and control over their businesses, with typical concerns consisting of the long term continuity of the business and the prevention of undesirable owners. Entrepreneurs will also be concerned about the costs of the process, which are generally measured in the resulting tax consequences.
The entrepreneur’s transfer of the ownership interests will freeze the value of the business for estate tax purposes at the value that which exists on the date of the transfer. If the entrepreneur acts before the value of the business has escalated, it may be possible to give ownership interest to the appropriate family members without realizing any gift tax consequences. If, however, the value of the business has escalated while the entrepreneur owns most (or all) of it, gifts of ownership interests in the business will produce an immediate gift tax liability which few entrepreneurs will be willing to pay. On the other hand, the entrepreneur could consider selling ownership interests to the appropriate family members, but will then face potential income tax consequences and concerns over the ability of the buyers to pay the purchase price. Fortunately, both of these issues may be successfully addressed by an installment sale of the ownership interest to an Intentionally Defective Grantor Trust (IDGT) formed by the entrepreneur to benefit the appropriate family members.
An IDGT is a type of irrevocable trust that a taxpayer can create to cause him to be treated as the owner of the trust assets for federal income tax purposes but not for federal gift or estate tax purposes. Accordingly, an entrepreneur’s sale of ownership interests to such a trust can result in federal income, gift and estate tax benefits that cannot be produced by a more conventional transfer of such ownership interest.
First of all, the entrepreneur will not be subject to federal income tax on any gain that is realized when ownership interests are sold to the IDGT. This results from the fact that, as the owner of the trust assets for federal income tax purposes, the Internal Revenue Code treats the entrepreneur as selling the business interests to himself. The consequential cash flow savings over a taxable sale can be sizeable.
Secondly, despite the fact that the sale to the IDGT will be ignored for federal income tax purposes, the entrepreneur’s sale to the IDGT will be recognized for federal gift and estate tax purposes. This occurs because a sale has in fact transpired and the value of the interest sold will be replaced in the entrepreneur’s estate by the sales proceeds received. As a result, the sale to the IDGT will freeze the value of the interest sold in the entrepreneur’s estate at the sales price along with the interest received under the installment sale.
The ability of the IDGT, as the buyer, to pay the purchase price is the result of the combination of the business being a pass-through entity and the entrepreneur being treated as the owner of the IDGT for federal income tax purposes. The distributions that the business has historically paid to the entrepreneur to allow for payment of the income tax that the entrepreneur is subject to are instead paid to the IDGT because it is the owner of the business interests. The IDGT applies those distributions to its installment sale obligations to the entrepreneur, who uses those distributions to satisfy the federal income tax that is owed as the consequence of being treated as the owner of the IDGT for purposes of that tax.
Although each situation has varying factors, an entrepreneur’s installment sale of interest in a pass-through business to an IDGT can accomplish the following business succession and federal tax objectives:
- The transfer of the business interest in a tax-efficient manner, as any federal income tax on the gain is deferred. In addition, although a relatively small gift to the IDGT should be made by the entrepreneur when the trust is created, the sale of the interest eliminates most gift tax issues. Moreover, any increase in the value of the business after the sale date will not increase the size of the entrepreneur’s taxable estate. Finally, the entrepreneur can cause the IDGT to have an inclusion ratio of zero for generation skipping transfer tax purposes by making an allocation of the exemption from such tax to the IDGT in an amount that corresponds to the value of the initial gift to the trust.
- The transfer of control of the business because the entrepreneur cannot be the trustee of the IDGT. Alternatively, the entrepreneur can retain control by selling only nonvoting interests to the IDGT. If this is done, the resulting purchase price will be reduced due to the sizeable discounts allowable with respect to interests in a business that lack voting power. The reduced purchase price will allow the IDGT to make its installment payments more quickly.
- The entrepreneur can regain any interest transferred to the IDGT at any time because the trust provisions typically allow for the reacquisition of any asset transferred to the IDGT by substituting one or more assets of equivalent value.
- Undesirable owners will be eliminated because the IDGT will benefit only the appropriate family members and such beneficiaries will be prohibited from transferring their interests as long as the trust remains in place. The prohibition on transfer will be applicable to prevent a beneficiary’s creditors from obtaining an interest in the business, including an ex-spouse through a divorce.
- The economic benefit produced by the increase in the value of the business following the sale date will be limited to the family members who are contributing to such increased value.
- During the term of the installment sale, the cash flow required by the income tax issues is much the same as it would be if no sale transpired. The entrepreneur remains subject to federal income tax on the taxable income produced by the business due to its pass-through nature and the aspects of the IDGT. The entrepreneur continues to receive the annual distributions traditionally made by the business to allow for payment of such tax, although such distributions are first made to the IDGT and then pass to the entrepreneur in the form of installment payments. As a result, the purchase price is actually paid to the entrepreneur in amounts that he would have received if the sale never occurred, as the installment payments are simply substitutes for the business’s tax distributions.
- Although the IDGT must pay interest to the entrepreneur with its installment payments, this cost is relatively low because the Applicable Federal Rate can be used. The IDGT will be financially successful as long as the growth rate of the business exceeds the Applicable Federal Rate that was in place on the date of the sale.
- If the business is an S Corporation, the IDGT is a permissible shareholder because it is a grantor trust. Although a typical IDGT terminates no later than the death of the entrepreneur, it can be drafted to continue indefinitely as a dynasty trust and remain a permissible shareholder by meeting the requirements of a QSST or an ESBT.
The use of an IDGT is a complicated process that may not benefit all entrepreneurs. However, for the entrepreneur who is concerned about both federal estate tax and the efficient succession of the ownership of his business, an IDGT may be the best alternative.