A charitable remainder trust is a powerful technique to reduce the tax burden on the sale of a family business.
Recently a good friend, whom we’ll call John, called to discuss the sale of his family business, SmithCo. John is now 65-years old and he and his wife, Betty, the sole shareholders of SmithCo, are looking for an exit strategy. They expect to sell SmithCo for $12,000,000. Because John and Betty have little basis in SmithCo, their accountant has estimated their federal income tax liability from the sale will be $2,856,000 (using a 20% federal capital gains tax rate and the 3.8% net investment income tax rate).
John and Betty are good examples that the greatest wealth transfer in history is occurring as the Baby Boom generation ages. Many Boomer business owners are confronting the need to create an exit strategy. Possible exit strategies include:
- A sale to family members or key employees;
- A sale to an employee stock ownership plan (ESOP);
- A sale to a competitor;
- An initial public offering (IPO); or
- A merger with a competitor or other third-party.
Whether the transaction is a sale, IPO, or merger, converting company stock to cash creates a tax bite. Regardless of the strategy chosen, a charitable remainder trust (CRT) can reduce or eliminate the tax bite on the sale of a business, create a current charitable income tax deduction, provide a business owner with income for life, and fund a significant charitable gift at death.
So, how do you successfully sell a family business using a CRT? Here’s a roadmap:
- Perform a suitability analysis. Assess whether the business entity form and operation, and the structure of the proposed sale transaction (g., asset sale versus stock sale) are compatible with the use of a CRT.
- Design the CRT. Define the CRT’s type, trustee, beneficiaries, payout rate, and duration.
- Draft and execute the CRT agreement. Hire an attorney to draft a trust agreement consistent with the design.
- Determine the amount of company stock to transfer to the CRT. The proper amount of stock to transfer is primarily a function of the business owner’s (a) net worth, (b) tax avoidance goal, (c) optimal charitable income tax deduction, and (d) need for income from the CRT (as opposed to other sources).
- Transfer the company stock on the records of the corporation. This step establishes the date of transfer to the CRT for income tax deduction purposes, for part-year beneficiary distribution calculations, and for appraisal purposes. See Part 2 for more details on the importance of not entering into a sale agreement prior to this step.
- Sell the company stock. Once the transfer to the CRT is complete, the trustee of the CRT may negotiate and enter into a binding agreement to sell the company stock.
- Obtain a qualified appraisal of the stock contributed. To claim an income tax deduction for a gift of company stock, the business owner must substantiate the value of the transferred stock by obtaining an appraisal that meets the strict definition of a “qualified appraisal.”
- Ensure ongoing compliance. Hire a competent administrator to ensure compliance with the unique requirements of a CRT.
- Sit on the beach and collect income checks.
The moral of the story: a CRT plan can be a powerful component of a comprehensive business exit strategy. However, maximizing the benefits obtained from using a CRT requires specialized knowledge and skill in the design, drafting, investment, and administration of the CRT.
So what happened to John and Betty?
You might be wondering what John and Betty did. Based on our discussions, they transferred 20% of SmithCo ($2,400,000 of undiscounted value) to a CRT. Had they sold the stock without the benefit of the CRT, the tax on this 20% interest would have been $571,000. To substantiate their charitable gift for income tax purposes, John and Betty engaged a qualified appraiser to value their gift, including a discount for a minority interest. Based on an appraised value of $1,900,000, their ages, and the CRT’s payout rate, John and Betty received a current income tax deduction of $640,000 for their future gift to their favored charity. Further, John and Betty elected to receive an income stream from their CRT based on a 5% payout rate; which means that their annualized first year distribution was $95,000.
In Part 2 of this two-part series, we will explore key suitability considerations and common hazards encountered when using a CRT to sell a business.
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