For the last several years, advisors have had low interest rates to help them tax efficiently transfer family business interests to the next generation. Whether gifting or selling the business to the owner’s children, low interest rates translate into low transfer tax costs. But time may be running out. I was reviewing a recent history of interest rates and realized we need to get the word out to business owners – act now while there’s still time.
If you have ever wondered why the heirs of Sam Walton show up as perennial winners of the wealthiest Americans moniker, it’s because the creators of Wal-Mart did great estate planning while they were alive. One of the techniques the Walton planning team used continues to be effective today, particularly in this low interest rate environment.
A grantor retained annuity trust (GRAT) is a technique where a person can gift an asset and take an annuity income back for a period of years. Wealthy business owners often use this technique as a way to get business ownership to the next generation without incurring gift or estate taxes. The leverage is that the government is forced to use conservative interest rates in calculating the annuity value of the gift (referred to as the “7520 rate”). If the assumed 7520 rate is 2.4% and the business is yielding 10%, the significant arbitrage in rates leads to business values that can be transferred to the next generation gift tax-free. In the Walton’s case, after a protracted battle with the IRS in which the government claimed a $4.5 million tax assessment, millions of dollars of Wal-Mart stock value were transferred at effectively a zero value for federal transfer tax purposes. And, that was at a time when the 7520 rate was more than twice the current rate.
The GRAT continues to be an effective tax planning tool for appreciating assets, such as profitable family businesses. You don’t have to be a Walton to make this work. My concern, however, is that the leverage lessens as interest rates rise. The less the difference between the 7520 rate and the actual return on the business asset, the less the tax advantage. Below are this year’s 7520 rates. The trend is obvious:
Most family business owners I talk with prefer to see their children who are active in the business as “successor owners” rather than “heirs”. Instead of being silver-spooned beneficiaries of a lucky last name, owners want their children to share in their entrepreneurial spirit and take the business to the next level. The current low interest rate environment makes this dream financially possible for many family businesses, by allowing for very inexpensive terms with intra-family sales. With proper planning, an owner can sell a business interest to a child at a low interest rate that remains fixed, even as interest rates rise. The government has a table (Applicable Federal Rate or “AFR”) that sets the floor at which a low loan rate won’t be deemed a gift from the parent. Let’s look at an example (recognizing there are tax and legal steps that must be completed to make this work):
A business owner sells a $1 million dollar non-voting business interest to her son for a down payment and a fixed interest loan. The loan terms are interest-only at 3.5% annually, for a 20 year period with a balloon payment at the end. No points or closing costs are assessed.
This allows for tremendous planning. Even though this is a very low fixed rate, because the rate is no lower than the current AFR (the long-term AFR applies to a loan with a term of over 9 years), the government shouldn’t challenge the low interest as a disguised gift. Assuming the business is making a profit, the son may be receiving enough cash flow to pay both the annual interest charge to his mother and set aside money for the balloon payment. This can be done through a sinking fund, the purchase of cash value life insurance or other techniques for accumulating capital. The mother is happy because she is transferring a non-controlling business interest to her son in such a way that he is motivated to see their family business prosper. Any excess profits from his $1 million stake in the business inure to him. The same challenge as with gifting presents itself here. Interest rates are rising. Below is this year’s history of long-term AFR rates: The time to act is now!