Perpetuation Tools of Gifting of Stock & GRATs

For family businesses, the key is to understand everyone’s needs and expectations and then design a plan well in advance of the transfer of ownership. Two great ways to “leave your business” are gifting and the GRAT.

Gifting Amount

In 2022, an individual could possibly give up to $16,000 (up from $15,000 where it was stuck since 2018) to someone in a year and generally not have to deal with the IRS about it. However, if more than $16,000 in cash or assets is given (for example, stocks, land, a new car) in a year to any one person, a gift tax return must be filed.

Lifetime Gift Tax Exclusion Works

The official estate and gift tax exemption climbs to $12.06 million per individual for 2022 deaths, up from $11.7 million in 2021, according to new Internal Revenue Service inflation-adjusted numbers.

“Think about buckets or cups,” says Christopher Picciurro, a certified public accountant and co-founder of accounting and advisory firm Integrated Financial Group in Michigan. Any excess “spills over” into the lifetime exclusion bucket.

For example, if you give your brother $50,000 this year, you’ll use up your $16,000 annual exclusion. The bad news is that you’ll need to file a gift tax return, but the good news is that you probably won’t pay a gift tax. Why? Because the extra $35,000 ($50,000 – $15,000) simply counts against your lifetime exclusion. Next year, if you give your brother another $50,000, the same thing happens: you use up your annual exclusion and whittle away another portion of your lifetime exclusion.

The gift tax return keeps track of that lifetime exemption. So if a person doesn’t gift anything during their life, then they have their whole lifetime exemption to use against your estate when you die.

If one is lucky enough and generous enough to use up their exclusions, they may indeed have to pay the gift tax. The rates range from 18% to 40%, and the giver generally pays the tax. There are, of course, exceptions and special rules for calculating the tax, so see the instructions to IRS Form 709 for all the details.

Which States Have Estate Taxes?

Several states and the District of Columbia have an estate tax. Many have lower asset thresholds than the federal government. Each state’s exclusion amount should be looked up.

If one lives in a state with an estate tax, the good news is that (generally speaking) the estate tax bill is subtracted from the value of the taxable estate before calculating what is owed to the IRS.

Gifting to Transfer the Agency Business

Gifting could be a good approach to transfer ownership if the value of the business is the bulk of the estate and it falls below the $12.06 million combined total limit (husband and wife) or the $6.03 million limit per person. There can be no taxes with this approach.

The downside is when an owner would still like to receive some money from the business after the transfer of ownership. If the owner continues to work after gifting the stock, then they can receive a salary. However, for tax purposes, defining any transfer of money becomes a problem after the owner is no longer involved with the business.

Another issue with the gifting of the stock is that the owner’s tax basis for the stock is transferred to the new owners after it is gifted. This means there is no step-up in basis for the new owners to the current value the agency. When the new owner sells the business, their capital gains taxes are calculated from the difference between previous owner’s original basis amount and the value of the stock when sold. The capital gains taxes are just deferred until the new owners sell the their stock further down the road.

Gifting Options

If the owner still wants to receive money from the business after they transfer ownership, one approach is to not gift 100% of the stock. Instead, the owner can gift 51% (or more) of the stock. This allows the new owner to get control of the business, but it also allows the original owner the opportunity to receive dividends.

The agency needs to be structured to let the profits drop to the bottom line, so that dividends are paid to the shareholders. Keep in mind that this is not the most tax-efficient way to pull money out of the business, since there will be both corporate and personal taxes on the dividends paid.

However, if the original owner retains some fraction of the stock and keeps it until their death, the beneficiary will then receive a step-up in tax basis for that portion of the retained stock. This could help offset some of the taxes paid when the business issued the dividends.

Planning also needs to happen if there are multiple beneficiaries for the estate and the business is gifted to only a portion of them. First, it is important to designate who receives the stock. Next, the other beneficiaries that were not gifted the stock should have an equivalent value of the estate designated for them.

GRAT to Transfer the Business

GRAT stands for Grantor Retained Annuity Trust (GRAT) and is also an excellent tool that is used as a perpetuation vehicle between owners and key employees or family members.

A GRAT is an irrevocable trust to which the Grantor transfers assets while retaining an annuity or unitrust payment for a set period of time. GRATS are used by wealthy individuals and startup founders to minimize tax liabilities.

At the end of the payment period, which must be a minimum of five years, the assets in the trust pass to the trust beneficiaries. To determine the impact on the federal estate tax exemption, the value of the retained annuity is subtracted from the value of the property transferred to the trust (i.e., a share of the business). If set up properly, the retained annuity is zero, so there is no impact on the estate tax exemption.

First, a valuation is done of the firm. Then, one or more GRATS are set up to transfer the stock.

Annuity payments are determined by the value of the stock in the GRAT and the payment period, often five to 10 years. The payments are deductible to the corporation and are capital gains to the recipient. Assets are placed under the trust and then an annuity is paid out every year. When the trust expires, the beneficiary receives the assets tax-free. If the Grantor dies before the payment period ends, then the tax benefits are lost for the stock in any active GRAT. There are a number of idiosyncrasies about establishing a GRAT so it is best to use an attorney that specializes in this tool.

Summary

Gifting the business is a great way to transfer the ownership of a business. Based on the circumstance, there are options to change the tax burden and/or have the owner receive some money from the business. In some cases the GRAT may be a preferred vehicle to gifting, especially if the estate is large. Working with a CPA and a qualified attorney will provide the owners the answers they need to use one of these two vehicles properly.