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To Eliminate Estate and Gift Taxes, Feel the Freeze!

Posted on: January 1st, 2018

A 60-year-old business owner who has done well financially wants to take care of his children and grandchildren. He knows that he will sell his business one day—and he detests taxes.

His solution: He freezes the value of his business by gifting some of his company stock to a trust and selling more of it to that same trust for a promissory note, for a grand total of $5 million.

Result: The value of his firm grows by 10 percent annually for the next nine years, at which point he sells. But the $5 million in company stock in the trust—along with all the appreciation on that stock over nine years and all future appreciation in the trust assets after that—remains outside of the owner’s estate and not subject to estate taxes when the assets get passed on to the kids and grandkids.

Get familiar with the basics of freezing trusts

Certain estate planning tools and strategies, such as this type of irrevocable trust—which we often refer to as a freezing trust—can effectively transfer assets such as privately held business interests to the next generation in highly tax-efficient ways. Freezing trusts can be especially powerful if you use assets that you believe will significantly appreciate over time—such as your business.

By using this trust, you can reacquire trust assets for cash or other assets. You are responsible for paying income taxes on the income generated by the assets in the trust, but the expectation is that the interests in the business that are now inside the trust will appreciate rapidly.

Check out these scenarios to see how a freezing trust can have a massive impact on entrepreneurs’ and investors’ wealth.

Scenario #1: The entrepreneur with selling on his mind

A business owner expects to sell his company in about five years. The company is currently valued at $30 million. It is doing quite well, growing at about 15 percent each year for the last half-dozen years, and the owner can conservatively assume continued 15 percent annual growth over the next five years.

On the advice of his team of professionals, the owner decides to freeze half the company and transfer the value to his grandchildren. He does so as follows:

  • He makes what is referred to as a seed gift of $1.5 million to the trust.
  • He sells $13.5 million to the trust for a promissory note with a government-set interest rate of 1.95 percent annually.
  • When the stock in the company is sold to the trust, no income taxes or capital gains taxes are owed.

Important: The terms of the promissory note are very flexible and can be structured in multiple ways. Some business owners prefer straight amortization, while others choose paying only the interest with a balloon payment when the note matures. In this case the business owner chooses to pay only the interest, a little over $250,000 annually.

The value of the company shares transferred to the trust is set on the date the transfer occurs. After that date, any appreciation escapes transfer taxes. And growth above the promissory note’s interest rate is transferred to heirs with no gift or estate taxes.

When the business owner sells the company six years later, the shares have appreciated to over $28 million. Upon the sale, the $13.5 million of principal repaid to the business owner to pay off the debt.

Result: Nearly $19 million was transferred to the trust, potentially saving the family over $7.5 million of estate taxes.

Scenario #2: The real estate investor

A real estate investor owns a real estate portfolio in a limited liability company that is valued at $100 million and is expected to grow by 12 percent annually. The investor wants to transfer wealth to her family but also keep the investment in the family.

Working with a team of professionals, the investor decides to freeze 25 percent of the LLC (worth $25 million) and transfer the value in trust to her children. 

Because the LLC interest is a minority interest and there is a lack of marketability for such an asset, a discount factor of 30 percent is applied to it—so the limited liability company interest is valued at just $17.5 million.

The investor makes a 10 percent seed gift of $1.75 million to the trust and sells the remaining $15.75 million to the trust for a promissory note with a ten-year term at a rate of 2.58 percent annually. When she sells the interest in the LLC to the trust, she owes no income taxes or capital gains taxes. Additionally, the gift and GST taxes are absorbed by $1.75 million of her $5.5 million lifetime exclusion.

The value of the minority interest in the LLC transferred to the trust is set on the date of the transfer. Any rate of growth over the promissory note’s interest rate will be transferred to her children, with no gift or estate taxes due when she dies. Also, the depreciation deduction for the properties flows to the real estate investor and, in the early years, shelters all the trust income from income tax.

At the end of the ten-year term, the discounted LLC assets held by the trust are worth $42.5 million, while the underlying properties are worth more than $55 million. After the $15.75 million note is paid, nearly $40 million of underlying value is transferred to a multigenerational creditor-protected trust for the children. The lifetime exemption of the grantor is reduced by $1.75 million. Only credit, not dollars, is used to achieve this result, which enables the investor to avoid $16 million in potential transfer taxes at the end of ten years. If the assets continue to grow, more wealth will avoid getting caught in the gift, estate and GST tax net.

Why so few entrepreneurs embrace the deep freeze

Despite these and other types of results, this freezing trust is all but ignored. Only about 1 in 10 successful business owners has used such a trust to freeze the value of the business (see Exhibit 3).

Perhaps there are many reasons this estate tax mitigation strategy is not commonly implemented. In our experience, however, the biggest reason is the limited expertise of many of the financial professionals who work with today’s accomplished entrepreneurs. 

Consider this: In a study of 803 financial advisors, only half of them (or the specialists they consult with) are knowledgeable about freezing trusts (see Exhibit 4). Even more telling: Only about 8 percent of them have implemented the strategy for a client.

If you expect to one day sell your company—be it to outsiders or family—you want to work with financial advisors and other professionals who are knowledgeable, skilled and experienced in helping successful business owners like you mitigate taxes.

Bottom-line implications

It may make sense to consider freezing the value of your company if all the following are true:

  1. You anticipate selling your company sometime in the future.
  2. You expect it to appreciate in value.
  3. You want your wealth to benefit your heirs.
  4. You want to avoid paying gift and estate taxes.

Freezing will enable your inheritors to have more money, because they will receive the appreciation in your company without having to pay gift or estate taxes.

Although this can be a very powerful way to mitigate certain taxes, problems can easily arise if you rely on professionals who are not adept in these solutions. As shown above, hardly any we surveyed have actually helped clients freeze the value of their businesses. That suggests a general lack of experience that should give you pause.

Our recommendation: If you think this strategy may help you achieve your goals, contact your financial or legal professional to explore whether freezing the value of your business could be the right move for you, your company and your heirs.

This report was prepared by, and is reprinted with permission from, VFO Inner Circle.  AES Nation, LLC is the creator and publisher of VFO Inner Circle reports.

Disclosure: The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra IS or Kestra AS. The material is for informational purposes only. It represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. It is not guaranteed by Kestra IS or Kestra AS for accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS.

Fusion Wealth Management is not affiliated with Kestra IS or Kestra AS. https://www.kestrafinancial.com/disclosures

VFO Inner Circle Special Report
By Russ Alan Prince and John J. Bowen Jr.
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