Monday, February 16, 2009

Estate Planning Considerations for Business Owners

In addition to owners of construction businesses, many of you on this distribution list are professional service providers. You work in surety bond companies, insurance and surety brokerages, banks, law firms, CPA firms, etc. and all provide valuable services to your clients. One of our main objectives, as service providers, is to have a positive impact on the lives of our clients and their businesses. One of the areas of greatest import in the coming years to many of our clients will be addressing wealth transfer and succession planning. Although few of us on this distribution list are expert in this area, it is well within our sphere of influence to help facilitate this process for business owners in order to help them achieve their personal and professional goals. We all know the demographic landscape in our business community and the world around us. The first part of the Baby Boomer generation is nearing retirement. As our objectives are to help business owners achieve their most important goals, we should gain an understanding of some of the more basic estate planning tools as they relate to the transfer of business ownership. This article will address some of the more basic concepts, in more basic terms, in order to provide a general framework of some of the more utilized estate planning tools to transfer ownership, and wealth, from one generation to another. Keep in mind that estate tax rates historically (pre George W. Bush) approximate 55% if you have significant assets to pass on to your heirs. These tax levels return after December 31, 2010 unless Congress makes changes. The planning you do will result in significant tax savings for your heirs when you consider this level of tax rate.

Intentionally Defective Grantor Trusts (IDGT)

There are a variety of ways to transfer ownership and wealth from one generation to the next. I will offer a summary explanation of a few of these powerful tools. The first is the use of Intentionally Defective Grantor Trusts (IDGT). The feature that makes this trust “defective” is that it is considered incomplete for income tax purposes. That is to say the owner (grantor) will still continue to pay income taxes on the earnings of the company. One of the strongest features of the IDGT is the ability to transfer assets at a locked in, discounted valuation. There is a presumption that our client’s business will continue to increase in value over time. The ability to remove an asset from the business owner’s personal balance sheet (his or her stock in ABC Construction Company) at a locked in (as of the transfer date), discounted valuation today will result in a significantly reduced taxable estate at date of death. I’ve used the term “discounted” a few times. The discounts exist due to the fact that the shares sold to the trust are non-voting shares and therefore a lack of control factor is present making those shares less valuable. Before selling shares to the trust, an attorney will restructure the stock such that there are both voting and non voting shares. An example would be for the owner to retain the one “voting” share of stock while selling 99 “non-voting” shares to the trust. Although 99% of the shares have been sold, the one voting share retained by the business owner allows him or her to retain control of the company. A discount will be applied to the non voting shares for lack of control. An additional discount will be applied due to lack of marketability (you can’t sell these shares in your E-Trade account for example). A conservative approach would be to suggest that these discounts represent a combined 30% reduction in the valuation of the shares. This discount percentage is supportable, but you must have a qualified business valuation performed to determine fair market value as of the date of sale or transfer. The valuation should be performed by a reputable, properly credentialed valuation firm to ensure a proper fair market value is derived and can stand up to any potential scrutiny. Another benefit of the IDGT is that in moving this asset, the stock of the company, off of the personal balance sheet of the owner, is no longer available to be attached by the claims of the grantor’s creditors. The asset protection offered by this strategy is also a great benefit.

Grantor Retained Annuity Trusts (GRAT)

Another possible strategy is to first install a Grantor Retained Annuity Trust (GRAT) with an IDGT as the beneficiary of that trust. There could be circumstances, such as the current interest rate environment (due to the present value discounting calculations), where this makes good sense to consider. The GRAT is established with a set term in years. The stock, as explained above regarding voting/non-voting shares, is placed into the GRAT and tax is paid by the grantor at this time. The GRAT pays an annuity over the term each year to the grantor based on the valuation of the company. At the end of the GRAT term, the stock is transferred into the IDGT whose beneficiaries may be the owner’s children. One of the drawbacks to this structure is that if the grantor passes away during the GRAT term, the asset will become part of the taxable estate of the owner and all the planning becomes irrelevant.

Qualified Personal Residence Trusts (QPRT)

Qualified Personal Residence Trusts (QPRT) are also a very commonly used planning tool, allowing you to again remove one of your more significant assets from your personal balance sheet – your personal residence. There are some choices that can be made in structuring a QPRT including the term of the trust (at which expiration the asset becomes the property of the beneficiaries), whether the entire asset, or just a portion, will be contributed to the trust, etc. The concept again is to lock in a value of an asset at the date of sale or transfer and also gain the benefit of discounting either through valuation discounts as discussed above and/or the present value of the asset at date of transfer relative to the value at the end of the trust term (which is the case with a QPRT). The future appreciation of the home is excluded from your estate, which is an extremely valuable proposition for you and your family.


Succession planning often achieves maximum results with the best and greatest number of options available when done many years in advance of the targeted retirement date. Start gaining an education regarding the available tools and options now and you’ll get the maximum results when you are ready to execute your plan. The use of these tools can create very positive financial results for your family over time. It is obviously important to connect with the right estate planning firm (which you can easily do by talking with your business partners and getting a strong referral). Please be sure to communicate, during the planning process and not after you’ve finalized your planning, with your bond agent (and thereby your bond company), your bank, CPA and any other business partner whom it makes sense to notify and/or include in the process. Planning in a vacuum without the inclusion of your integral business partners often times leads to unintended consequences.