Timing Matters: Impact of Pre-Transaction Estate Planning and GRATs– May 31, 2016

The Rolling Stones sang that “Time Is On My Side” in their 1964 hit of the same name, but in estate planning, that’s not necessarily the case. Owners looking to sell their businesses often seek tax advice prior to the actual sale, but they typically can receive significantly larger tax benefits the earlier they execute a wealth transfer strategy.

While there are many estate planning tools to help individuals maximize their opportunities, one often overlooked vehicle is the Grantor Retained Annuity Trust (GRAT).

How GRATs Work

A GRAT is an irrevocable trust, which pays a fixed annuity for a term of years back to the individual who established the trust. The annuity payment is based on a fixed percentage of contributed assets plus an IRS-prescribed interest rate. Once the GRAT term expires, the assets remaining plus any appreciation transfer directly to the trust’s beneficiaries — estate-tax free.

Much of the success of a GRAT, as well as many other estate planning techniques, depends on the rate of return of the contributed asset versus the current IRS interest rate. To illustrate the point, let’s assume we have a business owner, Mick, with 50% ownership in a business, Stone Inc., with a value of $40 million. Mick believes the business will grow 20% annually until his retirement in five years. After consulting with his advisors, Mick decides to transfer 25% of Stone to a GRAT with a five-year term.

Mick transfers units of Stone, which are worth $10 million; but for gift tax purposes those shares are valued at $7 million. Mick receives an annual annuity, and at the end of five years, models suggest that the trust will pass $9.1 million free of estate tax to its beneficiaries. With a current estate tax rate of 40%, this strategy produces estate-tax savings of $3.6 million five years after funding. Those savings will only grow since all future growth in the value of the business will benefit Mick’s heirs.

Mick’s co-shareholder, Keith, waits to implement a gifting strategy until a sale is imminent, so the expected growth rate, post-sale, may only be the 7% earned on a portfolio of marketable securities. Keith makes the same 25% transfer to a five-year GRAT, but, because of the timing of the impending sale, the $10 million gift is valued at $9 million. After annuity payments and future growth, approximately $1.8 million will transfer free of estate tax at the end of the GRAT’s term, producing an estimated tax benefit of $720,000.

The Value of Valuation Discounts

Valuation discounts can provide an added boost to tax savings before a sale. In the example above, even though economically a 25% interest in Stone was worth $10 million, the value for gift tax purposes was lower. Because the shares Mick and Keith transferred to their GRATs were non-marketable and non-controlling, a valuation analyst adjusted the shares’ value down for these limitations, thus creating a valuation discount.

While the rate of return is a huge driver of the success of many estate planning techniques, the valuation of the gifted asset makes a big difference too. In the above examples,

Mick’s early planning allowed him to receive a 30% valuation discount versus only 10% for Keith. That’s because both shareholders’ interests were valued based on all of the factors known at the time of the gift. Keith’s valuation discount needed to take into consideration the impending sale. With no sale on the horizon when Mick made his gift, a higher valuation discount was justified. Clearly, Mick’s early planning produced a larger benefit, because early on he transferred much of the business’ growth to his heirs. The benefit is there if business owners plan for it ahead of time.

As is the case with many fruitful tax strategies, planning early and executing well in advance are key. Identifying options before a sale is on the table can truly maximize the time value of money and any associated valuation discounts. Doing so can position a business owner for the best case scenario when it comes to minimizing estate tax and preserving family wealth.

Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.