1. Transferring Wealth toChildren:A Primer for Business OwnersWhite PaperBusiness owners struggling with the issue ofthree questions: passing wealth to children would do well to1. How much wealth do you want? revisit their original exit objectives, namely, How 2. How much wealth do you want the kids much money do you wish to have after the saleto have? of your business?Using that pieceof3. What tools minimize the Estate and Gift information as a starting point, you can thenTaxconsequences of transferring move to the issue of How much wealth shouldwealth? the children have? How much is too much?To illustrate how one fictional business Oncethosequestions areanswered,theowner answered these questions, lets look at business owner can then design a transferthe case of George Delveccio, a composite of a mechanism that will pass the wealth to thenumber of successful business-owning clients. children with minimal tax impact.George opened ourmeeting almostThese, then, are the three subjects of thisapologetically. I knew Id waited too long to White Paper.begin gifting part of the company to my kids1. Fixing the owners financial objectiveswhen I met with my CPA. She told me that thebefore considering a wealth transfer; company could be worth as much as $12 million2. Determining the amount of wealth to be to a third party. I had no idea! Since I dont needtransferred (and determining how much that much, I want to transfer at least half theis too much); and valueat a lower valuation of coursebefore3. Designing a wealth transfer strategy thatany possible sale. My CPA suggested giftingkeeps the IRS from becoming the small amounts of stock using my $12,000largest beneficiary of your hard-earned annual exclusion and perhaps part of my lifetimecash. gift exemption. She believes that additionalstrategies might allow me to increase theThese three subjects can be framed as amount of my gift without paying gift taxes so2007 Business Enterprise Institute, Inc. rev 01/08

2. she suggested that I meet with an experienced three basic issues (already mentioned above) estate planning or tax attorney. that must be resolved for successful Wealth Georges attorney pointed out that the use of Preservation Planning to occur. the $12,000 annual gift exclusion and the early use of the $1 million lifetime gift exemption wereISSUE ONE sound ideas, but, used alone, could not facilitateHow Much Wealth Do You Want? the transfer of a significant amount of wealth to The primary decision every business owner his children. Even combining Georges and his makes when transferring wealth to children is wifes annual exclusion amounts with their full not how to accomplish the transfer, (thats the lifetime gift exemptions, the transfer to the kidsestate planners job) but how much wealth to would amount to less than $2,024,000. transfer to the children. Answering that question The deficiency of this plan was further requires that you first revisit your own exit accentuated when George was asked what he objective; namely, how much wealth you wish to thought the future held for his business. In hishave after you exit your business. The amount words, The skys the limit. This was tellingof wealth owners wish to leave their children given Georges occupationhe owned an air usually (but not always) depends on how much freight expediter business. He strongly believedthe owners wish to keep after they exit their that the companys cash flow would continue tobusiness. As a general rule, we discourage grow, from its current $12.5 million, by at least parents from making significant gifts to children 25 percent per year for the next three years. until their own financial security is assured. Only And thats what worries me. Given howafter the parents needs are met do we ask how much more valuable my business will be in a much is enoughor too muchfor the kids. few years, wont it be even more difficult to The first step in the Seven Step Exit transfer wealth to the kids? What I need to knowPlanning Process is for owners to determine is how I can give my kids as much as possible their objectives. Owners who fail to do so are without paying any taxes.rarely able to leave their businesses in style. Believe it or not, this was exactly whatThe three retirement objectives that every owner Georges attorney was hoping to hear. The must fix are best phrased as questions: attorney explained, The more rapidly your 1. How much longer do I want to work in business is growing in value...the more cash it the business? spins off...the easier it is to give wealth away 2. What is the annual after-tax income I and give it away quicklywith little or no gift tax want(in todaysdollars) during consequences. retirement? But George, like many owners, was paying 3. Who do I want to transfer the business too much attention to the wrong issue.The to? attorney suggested that George focus on the As you can see, answering the second2007 Business Enterprise Institute, Inc.rev 01/08 3. question establishes personal financial goals but their spouses) access to wealth. This is true it also provides the takeoff point for how much regardless of the amount of wealth the parent money the owner can afford to leave to children.wishes to transfer. Lets look at the steps in a Many owners draw upon the expertise of theirtypical access/control scenario. financial planner or insurance advisor to work through thesequestions.Typically, these CONTROLLING ACCESS TO WEALTH advisors run through a number of what if Step One. First, the parents form a limited scenarios using different variables. The goal isliability company (LLC)orfamily limited to determine how much money you will need partnership (FLP) in which the parents own both from the sale of your business. the operating interest (or general partnership ISSUE TWO interest) and the limited partnership interests. How Much Wealth Do You Want the Kids to Limited partners have no ability to compel a Have? distribution, to compel a liquidation of the For many successful business owners, thepartnership (or LLC), or to vote. In short, limited question of how to leave as much money as partners enjoy few rights and have no control. possible to children begs the more important question.Giventhe huge (and perhapsStep Two. Childrens trusts are created for unexpected) financial success of the business,the benefit of each child. The trusts will the real question is how much money should theeventually own the limited partnership interests. children receive and how much is too much? As A child will be entitled to receive distributions George put it, I want to give the kids enoughfrom the trust based on guidelines, parameters money to do anything, but not enough to doand restrictions that the parents prescribe in nothing. A noble sentiment, to be sure, but oneeach trust document. difficult to executeat least without carefulThese restrictions can be of several different planning. In Georges case, he preferred histypes. children receive nothing to the prospect of Perhaps the most common restriction limits creating trust babies.a childs right to gain access to funds held in When owners wrestle with this question, it isthe trust. Typically distributions are made good to remember that children need not receiveover a series of ages, for example one-third money outright. Rarely are large amounts ofof the trust principal at age 30, one third at wealth transferred to children freely or outright.age 40, and balance of the trust principal at Instead, access to wealth is restricted throughage 50. The intent is that as children reach the use of family limited partnerships (or limitedthese ages, they will be sufficiently mature liability companies) and the use of trusts. Theseto handle the assets. Further, if a child tools are primarily designed to reflect themishandles an early distribution, he will parents desire to restrict their childrens (andlearn from his mistakes and will not repeat2007 Business Enterprise Institute, Inc. rev 01/08 4. them with later distributions. At least thatschilds othersources ofincome are the idea. depleted. This type of a trust is commonly Tying trust distributions to children to thecalled a Dynasty Trustor generation childs achievement of written standardsskipping trust since any assets remaining in contained in the trust is increasingly popular. this type of a trust after a childs death These standards can take many different usually pass, tax free, to that childs forms.children. Parents may base trust distributions on The variety of restrictions parents can a childs earned income. For example, ifplace upon a childs right to receive money is a child earns $60,000 annually in her limited only by imagination and any decision employment, she would be entitled toupon the degree of restriction. Keep in mind, receive an equal amount or some other however,thatsomeoneknown asthe percentage from the trust.Trusteeneeds to interpret, administer, invest, Distributions may be tied to the childsand make distributions accordingtothe activities. For example, a parent may provisions of the trust. wish to distribute money to children whoYour choice of trustee is at least as engage in (what the parent believes toimportant as the trust design. The constraints of be) socially useful activities: teacher in athis White Paper prevent a full discussion of public school, an artist, a writer, an Exit desirable trustee characteristics and attributes. Planning Advisor. However, consider the following questions: Some parents require a child to enter What degree of discretion do you wish to into a premarital agreement beforegive the Trustee to make distributions to the receiving any distributions from the trust. children? Parentsmayforbid childrenfrom How long does the trust last? receiving any distributions they would What is the value of the trust assets? otherwise be entitled to if convicted of a What type of asset is in the trust? If an crime or addictedto anillegal operating business interest is to be owned substance. by the trust, the choice of Trustee may well Many parents create safety nets for their be different than if the trust is comprised of children by giving children access to most of investment assets. the wealth during their lifetimes (in the form Should the trustee be a family member? of outright or periodic distributions) but Who will be entitled to remove the Trustee retaining some portion in trust for the child and for what, if any, reason? for the duration of the childs life. This retained money is to be used only if all of a Step Three. After determining the restrictions2007 Business Enterprise Institute, Inc.rev 01/08 5. they want in place, the parents transfer the foundations or give money to other charitable limitedpartnershipinterests or non-votingorganizations. interests into each childs trust. At this point the Heres the net result. parent is making a gift of the value of the limited The children receive what the parents interest to the child.want them toreceiveduringtheUnfortunately, parents with large estatesparents lifetimes; often abandon the planning process at this stage The parents enjoy 100 percent of the because they believe they can only transfer theirwealth remaining as long as either combined lifetime gift exemptions (roughly $2parent survives; million)to theirchildren without incurring After both parents die their wealth immediate tax consequences. As demonstratedtransfers to a charity of their choice in Issue Three, however, parents are often ablesuch as their own private foundation. to transfer as much wealth to children as theyAnd last, but not least, desire. Once again, the toughest issue for The IRS gets nothing. For many parents parents to address is: How much, when, andand business owners this is an estate under what conditions should kids receive theplan design worthy of close scrutiny. For dough?George Delveccio, a man with strongcharitable interests, this was the estate Planning Can Benefit Charity As Wellplan design that he chose to implement. Thereisoneadditional planning consideration that should be mentioned here.ISSUE THREE Under current estate tax law one spouse canWhat Tools Minimize the Estate and Gift Tax leave assets at his/her death to the other spouseConsequences of Transferring Wealth? without estate tax consequences. For mostThe key to transferring large amounts of estates, taxes are assessed only at the death ofwealth was discussed 2000 years ago by the the surviving spouse. If, during their lifetimes,patron saint of estate planning attorneys, parents are able to give their children (and otherArchimedes. Regarding leverage he observed, heirs) as much wealth as they wish the childrenGive me a place to stand and I will move the to receive, it is then possible to design an estateearth. Using leverage to move the earth or to plan that gives the balance of the wealth at themove your wealth is the key to achieving first parents death to the surviving parent. Whennoteworthy results. As we have discussed, each the surviving parent dies, his/her loved onesU.S. resident can give away, during lifetime, $1 (yes, your children!) will have received all of themillion as well as $12,000 annually. wealth the parents wanted them to receive andIn Georges case, his CPA (also a Certified the balance of the estate can be transferred toValuation Analyst) valued the business at $9 charity. Somefamiliesestablishprivatemillion, a conservative but supportable valuation.2007 Business Enterprise Institute, Inc. rev 01/08 6. The companys stock was recapitalized into determined number of years. At the end of this voting and non-voting stock. Based on currenttime period, which is established when the trust Tax Court case law, the CPA could justifyis created (usually two to ten years) any stock discounting the value of non-voting stock (or aremaining in the trust is transferred to the gift of a minority interest of the voting stock). In children. A gift is made when the stock is her opinion, the minority discount was 35transferred into the GRAT. The amount of the percent of the full fair market value of the stock.gift is the value of the asset transferred minus Thus, she reduced the size of the earth by 35the present value of the annuity which the owner percent, and Archimedes was well on his way to will continue to receive. To calculate this present leveraging the use of the Delveccios lifetime value the IRS requires the use of its federal exemption amount.midterm interest rate (currently about five Even with the 35 percent discount, however,percent). The owner acts as the Trustee (the a gift of 50 percent of the company (now person in charge of the management of the trust reduced to approximately $3 million in value)assets, in this case the stock of the company). would exhaust Georges and his wife, Eunices, Using George as an example, he transfers combined lifetime gift exemption amounts of $1 his nonvoting stock, valued at $3 million, into his million each as well as cause the payment of a GRAT. The amount of the gift is determined gift tax of approximately $400,000.when the GRAT is funded. For Delveccio, weLike every other business owner, George designed a GRAT, funded it with $3 million of was not particularly keen on paying a tax of stock and required a $1 million annual payment $400,000. So he didnt. And he still gave away for four years. Recall that the $1 million 50 percent of the company to his children. Hedistribution amount is the amount of dividend did so by using the biggest lever in Archimedes distribution the company normally made with arsenalthe biggest lever in the Wealth respect to one-half of the stock. Consequently, Preservation Transfer Game: a GRATaall of the stock originally transferred to the GRAT Grantor Retained Annuity Trust.will still be there after four years. How GRATs Work.The IRS, however, must assume that a $3 After first obtaining a professional valuation million asset will produce only $150,000 of of his company George created a GRAT. Adistributions/growth a year.(It bases that GRAT is an irrevocable trust into which theassumption on its current five percent Federal business owner transfers his stock. George mid-term interest rate.) Consequently, to design transferred all of his non-voting stock--which the GRAT to generate an annuity payment of $1 represented 50 percent of the overall ownershipmillion per yearmeansthatthe GRAT interest in the company. theoretically distributesusing the IRS's interest The GRAT must make a fixed payment assumptionsroughly $850,000 of the GRATs (annuity) to George each year for a pre- principal (the nonvoting stock) in the first year of2007 Business Enterprise Institute, Inc.rev 01/08 7. the GRAT. In each of the ensuing three years, million and $12 million to his children in even more principal will be distributed to satisfyfour years without using his lifetime the annual annuity payment until (theoretically)exemption. the principal of the GRAT is exhausted. As you 2. He continued to receive all of the can see, if the IRSs five percent assumption isincome from the company during that correct, all of the GRAT assets must be four-year period. distributed to satisfy the annual $1 million 3. At the termination of the trust (four annuity payment.years) the trust asset, consisting of non-Of course, if Georges company maintains voting stock, was transferred to trusts its capacity to pay its regular distribution of $1for Georges children. These trusts were million with respect to 50 percent of the stock, allin turn established by George when the of the stock will remain in the GRAT after theGRAT was created and contained his four-year GRAT term.wishes regarding when, and if, the For gifting purposes, however, George ischildren were to receive money from entitled to use the IRSs interest assumption.those trusts. This results in nothing being left in the GRAT, and therefore no gift was made at the time the Epilogue GRAT was created. In Georges situation, whenThe assets in George Delveccios estate did the GRAT terminates four years hence, theindeed continue to grow. He was able to transfer remaining stock (in this case ALL) is transferredwealth equal to $3 million to each child in trust. to the children without further gift consequences. After the business was sold, he and his wife, The children receive one-half of the company atEunice, were able to invest $5 million, far more no gift tax cost.than required to maintain their relatively simple The key to making a GRAT work well is to lifestyle. In fact, George and Eunice have made have an asset which appreciates in value and/ortentative plans to establish a foundation and produces income (or grows in value) in excessgive additional wealth during their lifetimes to the of the Federal mid-term interest rate. Mostcharities of their choice. successful businesses easily exceed this IRS- mandated threshold. This is especially true when we design the gifting to take advantage of the additional leverage in the form of using a minority discount on the original transfer of the business interest to the GRAT. Lets summarize what George did: 1. He transferred one-half of a businesswith a fair market value of between $9 2007 Business Enterprise Institute, Inc. rev 01/08