Think outside the box when you sell

At age 74, Bill knew it would be time to sell his retail propane business within the next few years. The founder and 70 percent owner of the company had three children, none of whom were in the business.

The investment bankers believed the company would sell for about $7.5 million. Advisors focused on the typical corporate issues in positioning the company for a private sale or auction: What were the tax consequences of a stock sale versus an asset sale? Should a tax-free exchange involving securities of a public company be considered? Should the sellers indicate a willingness to retain a minority interest in the company to encourage bids from private equity firms interested in a future public sale?

Bill’s lawyer came at the transaction from a different angle. She advised him to consider placing stock into an irrevocable Grantor Retained Annuity Trust, which paid him an annuity expressed as a fixed percentage of the original value of the stock for a term of years. The IRS currently assumes that the assets placed in a GRAT trust will realize an annual rate of return of 4.75 percent. At the end of the term, any appreciation in the stock at a rate greater than 4.75 percent would be transferred to Bill’s children.

Bill retained a 35 percent block of stock to provide a fund to satisfy his tax obligations arising from the transaction and to set up a private family foundation dedicated to his favorite causes. He placed his other 35 percent block of stock in a GRAT for a two-year term. The short term was recommended for tax considerations, as Bill must outlive the term to obtain the tax benefits.

The short term also was desirable from an economic standpoint. GRAT investments are more likely to achieve a return exceeding 4.75 percent over a short time. Investments over a longer period are more likely to achieve average results.

An appraisal valued the company stock at $3 million on a minority interest basis (vs. potentially $7.5 million on a control premium basis).

At the end of the first year, Bill received an annuity payment equal to 49 percent of the original value of the stock placed in the trust. He was paid 59 percent of the original value the second year, as finally determined for gift tax purposes. Overall, 100 percent of the original value was repaid, plus the 4.75 percent annual return.

If Bill had died within two years, any remaining annuity payments would be paid to his estate. Any remaining value in the trust would be distributed to his children.

Tax Consequences

A very nominal gift tax (less than 1/10th of 1 percent) is due on this particular gift made to the trust. In Bill’s case, $400 in gift taxes was due.

Since Bill survived the two-year term of the GRAT and the company was sold, all gains in excess of 4.75 percent per annum over appraised value would be transferred to Bill’s children free of estate or gift taxes.

What’s the tax impact on the deal?

• Scenario 1: If a GRAT had not been implemented, the gross amount
  of the state and federal capital gains taxes (assuming a stock sale) and
  estate taxes (assuming the estate value remained at $7.5 million) upon
  Bill’s death would have been $3.3 million.

• Scenario 2: If the company is sold in the first year of the trust
  and the stock valuation holds up with the IRS, taxes are reduced to $2.6
  million.

• Scenario 3: If the company is sold in the first year of the trust
  and its stock valuation does not hold up for tax purposes, there would
  still be a tax savings of $380,000. How is this possible?

The company was sold at a control premium, but Bill is unquestionably
entitled to a minority interest discount for the stock placed in the trust.
Remember, it is a grantor trust and Bill’s payment of the capital gains
tax is a tax-free gift to his kids.

• Scenario 4: The company is not sold. What is the downside for Bill?
  Only the $400 in gift taxes paid. He gets all of his stock back after two
  years.

In my opinion, a GRAT is even more compelling today. The primary appeal continues to be no economic risk. If the asset value goes up, you are a winner. If it goes down, you are not a loser.

Most other gifting strategies involve discounting the property value and paying current gift taxes to avoid estate taxes at higher tax rates. These strategies involve substantial gift tax exposure if the IRS voids the discounts taken.

There are other considerations when evaluating a GRAT. Ask your tax adviser if he or she has experience with these trusts, and whether they might be right for you.