Pair a Trust and an Installment Sale to Pass on Your Business

For many people, a family business is a significant source of wealth, so passing it on to the next generation in a tax-efficient manner is an important estate planning goal. One of the simplest and most effective strategies available is an installment sale to an intentionally defective grantor trust (IDGT).

So long as the business generates sufficient cash flow to make the installment payments, a sale to an IDGT allows you to transfer the  business free of capital gains and gift taxes. In addition, the business is removed from your estate, so that any future appreciation in value goes to your heirs estate-tax free.

A Powerful Combination

A straight installment sale for fair market value allows you to transfer the business to your children or other family members gift-tax free. Although this means the buyers will have to come up with the funds to make the installment payments, you have the flexibility to design a payment schedule that meets your family’s needs.

For example, you can structure payments to fluctuate over time to match expected cash flows from the business. Or you can provide for interest-only payments for a specified term, followed by a balloon payment of principal.

Future appreciation in the business’s value is protected against estate taxes, but you’re subject to income taxes on the portion of each installment payment you receive that represents capital gains or interest. This is where an IDGT comes into play.

An IDGT is an irrevocable trust that, with careful planning, is treated as a grantor trust for income tax purposes even though transfers to the trust are considered “complete” for gift and estate tax purposes. This is accomplished by retaining certain powers for yourself — such as the right to borrow funds from the trust without adequate security — that cause the trust to be a grantor trust without drawing the trust assets back into your estate.

The grantor trust rules provide two important benefits: First, any tax on trust income is paid by you, rather than by the trust, effectively providing your beneficiaries with tax-free gifts. Second, because the trust is considered your alter ego for income tax purposes, an installment sale to the trust is like a sale to yourself, so you’re not liable for capital gains taxes or other income taxes on the installment payments you receive.

For a summary of the benefits and risks involved with this strategy, see the list below of “Pros and cons of selling to an IDGT.”

The Pros and Cons Of Selling to an IDGT

An installment sale of a business to an intentionally defective grantor trust (IDGT) offers many benefits, including the following:

  • Selling to a trust rather than to your beneficiaries outright allows you to retain some control over the business.
  • Because you’re selling to a grantor trust, there’s no sale for income tax purposes.
  • The current value of the business, as well as all future appreciation, is removed from your taxable estate.
  • As grantor, you pay the taxes on trust income, resulting in additional tax-free gifts to your beneficiaries.
  • Unlike a grantor retained annuity trust (GRAT), if you die during the trust term the business probably will not be pulled back into your taxable estate (though the present value of any unpaid installments would be included in your estate).

This strategy isn’t without its risks, however, including:

A lack of precedent – Unlike GRATs and certain other strategies, there’s relatively little guidance on sales to IDGTs. Even though this technique is popular, its estate planning benefits aren’t guaranteed. For example, there’s some uncertainty about the tax consequences if you die during the trust term.

The possible elimination of the “no sale” rule – Although IRS rulings confirm that there’s no taxable gain when a grantor makes an installment sale to a grantor trust, the agency has criticized this rule in the past and there’s no guarantee it won’t revisit its position in the future.

Planning Considerations

As previously noted, an IDGT must be drafted carefully to ensure that it will be treated as a grantor trust for income tax purposes but that the sale to the trust will be considered a completed transfer for gift and estate tax purposes.

In addition, the transaction must be structured to avoid an IRS challenge on grounds that it’s a disguised gift. The first step is to ensure that the trust has sufficient assets so an installment sale of the business in exchange for a promissory note would be considered commercially reasonable.

Usually, this involves investing some “seed money” in the trust — which likely will be subject to gift tax. There’s no bright-line rule about how much seed money will suffice, but typically it’s at least 10% of the business’s value.

Care should also be taken in drafting the installment note. Although there’s some flexibility in designing the payment schedule, it’s important to provide for a reasonable rate of interest and other commercially reasonable terms to ensure that the note is deemed to represent a legitimate debt.

Review Your Options

This is just one example of the many available estate planning strategies for transferring a family business to the next generation. The federal gift tax exemption is expected to rise to $13.61 million for 2024 (up from $12.92 million in 2023), so there’s an opportunity to make substantial gifts of business interests to your heirs tax free. Other options include grantor retained annuity trusts, self-canceling installment notes, family limited partnerships and family limited liability companies. The right strategy for you depends on your particular business, financial and tax circumstances.

Cpoyright 2023

This article appeared in Walz Group’s December 11, 2023 issue of The Bottom Line e-newsletter, produced by TopLine Content Marketing. This content is for informational purposes only.