Plan Ahead When Cashing Out

The following excerpts are from Lauren Foster, Preparing for life after cash out, Financial Times, April 2, 2007:

When that private equity firm or strategic buyer comes knocking, it pays to have a plan: cashing out raises complex issues ranging from family wealth preservation and philanthropy to how best to invest the windfall, be it tens of millions or hundreds of millions of dollars. * * *

There are several pre-liquidity strategies that can help lower federal transfer taxes, which include the gift tax, the estate tax and the generation-skipping transfer (or GST) tax. They range from basic steps such as taking advantage of the annual gift tax exclusion-- you can make annual gifts of up to $12,000 tax-free to any number of people, with a lifetime exclusion of $1m per donor is to setting up a Grantor Retained Annuity Trust (GRAT) and making an instalment sale to a Grantor Trust. * * *

This is how a GRAT works: the business owner makes a gift of stock to an irrevocable trust and in exchange receives an annuity for the term of the trust, usually two or three years. The value of the gift for tax purposes is the difference between the amount contributed to the trust and the present value of the annuity payments the grantor will receive.

With a bit of financial engineering, an adviser can select a combination of annuity payments and trust term that will result in the present value of all future payments being equal to the amount contributed to the trust. By IRS calculations, the GRAT will have zero assets by the time the trust expires, so no gift tax is owed. * * *

Another popular tax-efficient strategy is a sale to an Intentionally Defective Grantor Trust.

With an IDGT, a grantor sells assets – say, stock in a closely held or family business, marketable securities, limited partnership interests or property – to an irrevocable trust in exchange for an instalment note with interest. This trust works best if the assets are subject to discounts in determining their fair market value and are expected to appreciate in value at a rate greater than the interest payable on the note.

When the grantor dies, only the fair market value of the note is included in the estate. This technique "freezes" the value of the assets in the estate.

Another benefit of the IDGT is that the grantor pays the income tax on any income generated by the trust. "That effectively allows the trust assets to compound tax free and the payment of the trust’s tax by the grantor is not treated as a taxable gift," says Mr Raaf, of Harris myCFO. Also, an IDGT can be used for very effective "GST" planning as the grantor can allocate his/her "GST" exemption to the trust.

Special thanks to Prof. Joel C. Dobris of the University of California-Davis for bringing this article to my attention.