To begin with, it is important to note that avoiding estate taxation of a small business is not so simple that business owners can just download forms off the internet and expect to generate good results. The estate plan must be tailored to fit the client’s unique circumstances. Nevertheless, an oversimplified example of one technique (sale to a grantor trust) will be given for illustration.  Please note, however, that I consider this technique to be too risky to employ, given that another essentially economically equivalent technique is available which is much safer, but harder to understand.  Further, the example is not realistic because I would convert the corporation to an LLC, retaining the S election, before taking further steps.

Suppose Mr. Client owns 100% of the stock of an S corporation producing $1 million per year in net income and that such business is valued at five times earnings, or $5 million.

The first step would be to focus on discounting the value of the stock. A discount for lack of marketability is available. In addition, Mr. Client can declare a tax-free nonvoting common stock dividend of, say, 99 to 1. Such nonvoting stock would be eligible for a minority discount due to its lack of control. The combination of discounts could be expected to be, say, 40%. That means the value of the stock would be, say, $3 million, comprised of voting common stock worth, say, $200,000 and nonvoting common stock worth, say, $2.8 million.

The second step would be for Mr. Client to declare that he is holding, say, $400,000 of the nonvoting common stock as trustee (thus keeping control of the gifted stock) of an irrevocable trust for the benefit of someone else (e.g., his wife.)  This stock transfer gives the trust sufficient value to support the next step. The "downside" of the gift is that it would be a taxable gift.  On the other hand, the gift would not generate an out of pocket tax liability because of the $1 million gift tax exemption equivalent.  Aggressive use so-called "Crummey" letters to take advantage of the $13,000 annual exclusions from taxable gifts could substantially reduce the amount of the exemption equivalent used up via the gift, while nevertheless keeping the stock in the trust.

The third step would be for Mr. Client to sell the remaining nonvoting common stock to the trust in exchange for a $2.4 million, 5% interest only, 10 year note. The sale would not be taxable because the trust would be considered to be a "defective grantor trust" for federal income tax purposes. This means Mr. Client would be considered as the owner of the trust assets, liabilities, income and expenses for income tax purposes, but not for estate and gift tax purposes. Since the trust has no separate income tax existence apart from Mr. Client, the sale is a sale to himself, a nonevent.

At this point Mr. Client’s financial statement would show the note and the voting stock, but not the nonvoting stock. The nonvoting stock would not be exposed to estate taxation, regardless of its future value (assuming he lives three years).  The trust and the corporation would nevertheless be available to make or guarantee loans, etc. to Mr. Client (although a (tax-free) fee would have to be paid for a guarantee.)

Over the three years following issuance of the $2.4 million note, the corporation would distribute, say, $2.8 million to the trust and the trust would pay off the note. During the three years the trust took to pay off the note Mr. Client would have received essentially the same money he otherwise would have received as the sole stockholder and he would have paid, say, $1.2 million in income taxes, leaving him with the same $1.8 million he would have had if he had continued to own the stock. But Mr. Client would not be entitled to any further payments from the trust nor from the corporation, other than compensation for his services.

Since the trust would be a grantor trust, Mr. Client would continue to be liable for the future income taxes generated by the business to the extent the income is attributable to the S corporation stock held by the trust. This is so even though he does not get distributions to pay the tax. This "phantom tax" liability can be thought of as a tax-free gift to the trust, dissipating his remaining exposure to the estate tax.

If the phantom income tax liability gets too large, Mr. Client can distribute trust moneys to his wife if needed to pay the tax. If his wife dies, Mr. Client can terminate the grantor trust status and thus have the trust and trust beneficiaries bear their own income tax liabilities. (Additional flexibility can be achieved through the use of powers of appointment.)

©2010 Steven M. Chamberlain. All rights reserved. Republication with attribution is permitted.