Tax-Efficient Planning for Business Continuity

Journal of Financial Planning: October 2024

David Haughton, J.D., CPWA, is senior corporate counsel at wealth.com, a next-gen estate planning platform. 

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Amid the demands of running a successful business, tax-savvy succession planning often takes a back seat. However, without it, the IRS may ultimately take a significant share of the wealth that business owners have spent a lifetime building. By embracing strategic tax planning, business owners have the potential to protect their estates from hefty taxes, secure their financial legacy, and provide for their families’ futures. Implementing these strategies early on can also foster a sense of security and continuity for employees and stakeholders.

Without proper planning, heirs may face unexpected tax burdens that could force them to sell off valuable assets or parts of the business to cover the costs. This can disrupt family dynamics and undermine the financial stability that the business was meant to provide. Further, proactive tax planning can ensure that the business owner’s intentions are honored, providing a stable financial foundation for their family members. It allows heirs to receive their inheritance as intended—without the stress and financial strain of unanticipated taxes. 

Utilizing Trusts for Business Continuity and Tax Mitigation 

Trusts are commonly used vehicles to ensure assets are distributed according to the wishes of an individual or entity. But there are different types of trusts, and numerous ways to structure them to ensure the best outcomes. Two varieties of trusts are revocable and irrevocable. Both have unique provisions that make them the most or least beneficial option in a given scenario. 

One key distinction is that revocable trusts offer flexibility to make changes, while irrevocable trusts typically do not. Another is that with an irrevocable trust, the business owner cannot act as their own trustee, so they must assign the control of their business to a trustee. At first glance, the inability to maintain control or make changes to a trust might be incomprehensible to someone who dedicated their life to building their assets. After all, oftentimes the business is a key piece of their identity. But in certain scenarios, the benefits outweigh the relinquishment of control. 

Consider the case of a healthcare executive who passed away prematurely without a clear succession plan. His substantial stock holdings, suddenly released into the market, caused a sharp decline in value due to oversupply. This not only diluted the value of his business, but also led to significant tax consequences, reducing the overall inheritance left to his family. Implementing a well-structured irrevocable trust could have mitigated these issues by providing a controlled and phased distribution of assets during the executive’s lifetime, preserving wealth for his heirs and supporting his business’s continued success. This scenario underscores the critical importance of tax-savvy succession planning, in which irrevocable trusts can play a vital role. 

By planning ahead and utilizing vehicles like irrevocable trusts, business owners can see that their enterprises do not follow them to the grave, but instead continue to thrive and benefit future generations.

Key Benefits of Irrevocable Trusts

Irrevocable trusts offer several significant advantages for business owners looking to protect their assets and minimize tax liabilities. These include: 

• Estate tax reduction. Assets transferred to certain types of irrevocable trusts are removed from the grantor’s taxable estate, potentially removing the appreciation of the value from the estate and thereby reducing estate taxes. This can be particularly advantageous for business owners with estates exceeding the federal estate tax exemption.
• Gift tax planning. Contributions to an irrevocable trust can often utilize the annual gift tax exclusion and lifetime gift tax exemption, minimizing the tax impact of transferring business interests to beneficiaries.
• Asset protection. Irrevocable trusts can provide a strong layer of protection against creditors and legal claims, safeguarding the business and other assets for future generations.
• Income tax advantages. Irrevocable trusts can shift income from the grantor to beneficiaries in lower tax brackets, potentially reducing the overall tax burden on business-generated income.

Strategic Applications of Irrevocable Trusts

Irrevocable trusts provide avenues for effectively managing and transferring wealth, offering business owners powerful tools to secure their legacy. Here are some strategic applications that demonstrate the versatility and effectiveness of these trusts:

• Intentionally defective grantor trusts (IDGTs). An IDGT allows the grantor to transfer business interests to the trust while still being considered the owner for income tax purposes. This means the grantor pays income taxes on the trust’s earnings (regardless of whether the income is actually distributed), allowing the trust assets to grow without the burden of the particularly disadvantageous trusts and estates income tax rates. Additionally, the transfer can be structured to “freeze” the value of the business interest for estate tax purposes.¹
• Grantor retained annuity trusts (GRATs). GRATs enable the transfer of appreciating business interests to beneficiaries while the grantor retains an annuity for a set term.²  If the value of the business interest that was contributed to the GRAT appreciates at a higher rate than the annuity payments, then the remaining trust value at the end of the term is transferred to heirs free of estate taxes. Whether there is a reportable gift at the time of the GRAT’s creation will depend on how the GRAT was initially structured. It is important to note that GRATs are particularly advantageous in low-interest-rate environments because it is far easier for the appreciation of the assets in the trust to exceed the IRS’s Section 7520 interest rate (“hurdle rate”).
• Family limited partnerships (FLPs). FLPs offer the potential for gift and estate tax advantages. With an FLP, the business owner can gift limited partnership interests in a business interest to heirs at a “discount” while retaining control of the interest. These vehicles also allow individuals a relatively frictionless way to pass profits from their business to heirs, which can increase a family’s generational wealth. 
• Charitable remainder trusts (CRTs). CRTs allow a donor to transfer assets into an irrevocable trust, providing income to beneficiaries for up to 20 years or for the beneficiaries’ lifetimes. At the end of the term, the remaining assets in the trust are donated to one or more qualified U.S. charitable organizations. CRTs are particularly advantageous when structuring the sale of a highly appreciated business interest because the CRT’s unique tax status permits the grantor to stretch out an otherwise immediate recognition of capital gains tax at the time of sale over the annuity term. CRTs offer benefits such as predictable income and a partial charitable deduction based on the value of the charitable interest in the trust.³  

Addressing Practical Considerations During Trust Setup

Establishing an irrevocable trust involves several critical decisions that can impact the effectiveness of your estate plan. Some important elements to consider include:

• Selection of trustee. Choosing a trustworthy and capable trustee is an important step, as they will manage the trust assets and ensure compliance with the trust terms. When selecting a trustee, it is important to consider their fiduciary expertise, reliability, potential longevity, understanding of financial and legal responsibilities, and their ability to act impartially in the best interests of the beneficiaries.
• Beneficiary allocations. Thoughtfully allocating business and non-business-related assets to beneficiaries is important, especially in a scenario where there are multiple beneficiaries, such as children. Failure to do so can result in potential inequity issues. For example, if a business interest is a large proportion of the total estate value, the grantor may need to consider whether the beneficiary who will not be a recipient of the business will receive an equitable share of the estate from other assets (or from the other beneficiaries).
• Valuation of business interests: Accurate valuation of the business is essential for determining the value of assets transferred to the trust and calculating potential tax liabilities. Engaging a professional appraiser can ensure compliance with IRS requirements.⁴
• Coordination with other estate planning tools. Irrevocable trusts should be integrated with other estate planning strategies, such as wills, powers of attorney, and buy–sell agreements, to create a comprehensive plan that addresses all aspects of the business owner’s estate.

Empowering Business Owners with Tax-Savvy Planning

Financial planners, often business owners themselves, are uniquely positioned to guide clients in tax-savvy succession planning. By implementing strategies like irrevocable trusts in their own practices, planners can provide firsthand insights as to the effectiveness and importance of these tools. This dual role allows them to lead by example, showing business owner clients how to secure their financial futures and minimize tax liabilities through proactive planning. 

Endnotes

1. Silverman, David L. n.d. “Installment Sales to Defective Grantor Trusts.” American Bar Association. www.americanbar.org/content/dam/aba/publishing/aba_tax_times/00fal/06-silverman.pdf.
2. Corporate Finance Institute. 2024, July 16. “Grantor Retained Annuity Trust (GRAT).” https://corporatefinanceinstitute.com/resources/wealth-management/grantor-retained-annuity-trust-grat/.
3. Internal Revenue Service. n.d. “Charitable Remainder Trusts.” www.irs.gov/charities-non-profits/charitable-remainder-trusts#how.
4. Internal Revenue Service. n.d. “4.48.4 Business Valuation Guidelines.” www.irs.gov/irm/part4/irm_04-048-004.