Preserving the Family Legacy

The estate tax “repeal” doesn’t eliminate the need for succession planning.

TO HELP FAMILY BUSINESS OWNERS BUILD A LEGACY, CPAs need to help family members develop a plan to transfer the business to the next generation while minimizing estate, gift and income taxes. Although the 2001 tax act eliminates estate taxes in 2010, there is no guarantee the repeal will be permanent.

USING THE INSTALLMENT SALE STRATEGY, the senior family member sells the business to a younger member for a fixed series of payments at least one of which is received in a future tax year. The senior member recognizes a gain each year he or she receives payments. As long as the purchase price is fair and the note bears a reasonable rate of interest, there are no gift tax consequences.

WITH A SELF-CANCELING INSTALLMENT NOTE (SCIN), the junior family member promises to make periodic payments until the senior member receives the sale price or dies, whichever occurs first. To compensate the senior member for the risk he or she will die before receiving full payment, the SCIN includes a risk premium in the form of a higher purchase price or interest rate.

CPAs CAN ALSO RECOMMEND THE SENIOR FAMILY member sell the business via a private annuity in exchange for the junior member’s unsecured promise to make payments for the duration of the senior’s life. This kind of transaction includes elements of both a sale and an annuity and is taxed accordingly.

WITH A GRANTOR RETAINED ANNUITY TRUST , the senior member transfers the business to a trust and retains an income interest for a specified number of years. When the trust term ends, the business passes to the junior member. This strategy gives the senior member an income stream while he or she continues to control the business.

LEE G. KNIGHT, PhD, is professor of accountancy at the Calloway School of Business and Accountancy, Wake Forest University, Winston-Salem, North Carolina. Her e-mail address is . RAY A. KNIGHT, CPA/PFS, JD, is a principal with Ernst & Young LLP in Charlotte, North Carolina. His e-mail address is .
uilding a family business into a legacy demands that families plan for succession. A business owner’s key objective in developing such a plan is to transfer the greatest amount of wealth to the next generation at the least possible tax cost. In addition to minimizing estate, gift and income taxes, the transfer also must provide the senior family member, who may lack sufficient resources other than the family business, with adequate sales proceeds or a lifetime income stream to continue to live comfortably.

All in the Family

In the United States, 90%
of companies are family-owned.

Source: UMass Family Business Center, .

The estate-tax-repeal provisions included in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) may lead some clients to believe they no longer need to plan for the transfer of a family business. As CPAs realize, however, those who dismiss estate planning because of the act are reading the headlines only—not the fine print. Exhibit 1 shows the so-called estate tax repeal doesn’t take effect until 2010 and continues thereafter only if Congress votes to override EGTRRA’s sunset provisions.
Exhibit 1: Transfer Tax Rates and Exemption Amounts Under EGTRAA
Calendar year Death transfer exemptions for estate and generation skipping transfer (GST) taxes Highest estate, gift and GST tax rates
2002 $1 million for estate tax; $1.06 million indexed from 2001 for GST tax 50% (surtax repealed)
2003 $1 million for estate tax; $1.06 million indexed from 2001 for GST tax 49%
2004 $1.5 million 48%
2005 $1.5 million 47%
2006 $2 million 46%
2007 $2 million 45%
2008 $2 million 45%
2009 $3.5 million 45%
2010 N/A (estate and GST taxes repealed) Gift tax remains, equal to top individual income tax rate of 35%
2011 $1 million for estate tax; $1.06 million indexed from 2001 for GST tax 55%, plus 5% surtax on certain estates over $10 million

The result is that complete estate tax repeal is a remote and short-lived possibility. Thus, CPAs need to warn clients of the danger of adopting a “wait until repeal” policy. Minimizing the estate and gift tax cost of passing the family business to the next generation continues to warrant active planning. This article highlights four strategies that are capable of helping a family business minimize transfer tax costs as well as meet the needs of the senior family member:

Installment sale.
Self-canceling installment note.
Private annuity.
Grantor retained annuity trust.

Each of these strategies has advantages and disadvantages that CPAs can explain to clients trying to develop succession plans. With the dim prospects for estate tax repeal, these techniques are little changed and remain viable ways to preserve the family legacy.


Under the installment sale strategy, the senior family member (the business owner) sells his or her business to a younger family member for an interest-bearing promissory note requiring a series of fixed payments, at least one of which will be received in a future tax year. The installment method detailed in IRC section 453 automatically applies to this type of transfer unless the senior member elects out of it or it is a transaction section 453 specifically prohibits.

Income tax consequences. The tax gain the senior family member recognizes each year is the gross profit portion of the installment payments he or she receives during the year.

Example. Charles Canada owns a family business with a tax basis of $200,000 and a fair market value of $1 million. Charles sells the business to his daughter, Julia, in a transaction eligible for installment reporting. Charles receives $100,000 cash immediately and a promissory note that will pay him $90,000 (plus interest at the current market rate) at the beginning of each of the next 10 tax years. Under the installment method, Charles recognizes $80,000 of the gain immediately in the first year (80% gross profit rate ($800,000 total gain $1,000,000 selling price) times the $100,000 cash he received). Charles recognizes the remaining $720,000 gain ($800,000 total gain – $80,000 recognized immediately) over the 10-year payment period—at the rate of $72,000 per year (80% gross profit rate times $90,000 annual payment).

The senior family member also includes the interest he or she receives each year in taxable income (or must impute interest if required to do so by the original issue discount rules of IRC sections 1271 to 1275 or by the imputed interest rules of IRC section 483 as discussed later).

Sections 453(A)(b)(1) and (2) require the senior family member to pay interest on a portion of the income tax deferred if the sales price of the business exceeds $150,000 and he or she, at the end of the year of sale, holds more than $5 million of installment notes arising during the year. This interest, calculated at the IRC section 6621(a)(2) underpayment rate for the last month of the year, is nondeductible personal interest to the senior family member.

Using note as collateral. The senior family member cannot accelerate cash collection on the installment sale—even if the cash comes from another source—without accelerating gain recognition. Section 453 requires the seller to treat the proceeds of a loan collateralized by the installment note as a payment on the note. This means CPAs should warn clients to avoid using the promissory note for collateral on a bank loan or suffer the tax consequences.

Resale of business. The senior family member must recognize all previously unrecognized gain if the junior family member qualifies as a related person and resells the transferred business within two years of the original installment sale. The term “related person” includes two categories of likely recipients of a family business—children and grandchildren—but if the intent of the transfer is to preserve the family legacy, selling the business is not an option for these recipients, particularly within the first two years.

Disposition of installment obligation. Selling, exchanging or otherwise disposing of the installment note also accelerates gain recognition. Transferring the note to a trustee, however, is not a disposition if the income of the trust is taxable to the senior family member under the grantor trust rules. Thus, for estate planning purposes, CPAs can recommend the senior family member transfer the promissory note to a revocable trust without triggering gain recognition.

If the junior family member cannot make the installment payments, the senior may be tempted to cancel the installment note. Cancellation of an installment note, however, is considered a disposition in a transaction other than a sale or exchange. Upon cancellation, the senior family member recognizes a gain equal to the difference between his or her basis in the note (unrecovered tax basis) and its fair market value (the present value of the remaining installment payments) immediately before cancellation. If the junior family member qualifies as a related person under section 453 (a child or grandchild of the senior family member), the fair market value deemed received cannot be less than the face amount of the canceled note.

Security interests and escrow account. The senior family member’s retention of a security interest in the business does not constitute a payment nor does it otherwise accelerate recognition of the gain inherent in the installment payments. Funds the buyer deposits into an escrow account for future distribution to the seller, however, are considered payments unless the senior member’s right to receive them is subject to a substantial restriction. An alternative to using an escrow account CPAs can recommend that will not accelerate gain recognition but will provide some security to the senior family member is to have the buyer secure the note with a standby letter of credit from a financial institution. This arrangement keeps the senior family member from relying exclusively on the junior family member for payment.

Gift tax effects. The senior family member will not have to pay gift tax on the installment sale if the transfer is for full and adequate consideration. However, if the fair value of the installment note is less than the fair value of the business, the difference is a taxable gift under IRC section 2512.

Example. John Jackson sells a business with a fair market value of $1.2 million to his son, Eric, for $400,000 cash and an installment note with a value of $600,000. Because the total consideration received is less than the fair market value of the business, the $200,000 difference constitutes a gift for federal gift tax purposes.

Unreasonably low interest rate. Limiting the amount of interest the younger-generation family member pays is a common objective in structuring an intrafamily installment sale. However this practice may create a differential subject to gift tax. The original issue discount (OID) rules of sections 1271 to 1275 and the imputed interest rules of section 483 place restrictions on setting unreasonably low interest rates in installment sale transactions. The OID rules apply to the intrafamily installment sale unless the

Transferred business is a farm and the sales price is $1 million or less.

Total consideration (principal and interest) received for the business is $250,000 or less (multiple transactions may be aggregated for purposes of the $250,000 test).

Under the OID rules, the installment note must bear interest at the applicable short-term, midterm or long-term federal rate in effect under section 1274(d) or the seller will be deemed to have made a gift equal to the difference between the present value of the note based on the prevailing market rate of interest under section 1274 and its present value based on the stated rate of interest (if any).

The section 483 imputed interest rules cover installment sales of a family business not subject to the OID rules unless the sales price is $3,000 or less. Like the OID rules, section 483 imputes interest based on the applicable federal rate under section 1274(d). These minimum interest requirements for installment sales may cause serious cash flow problems for the junior family member. Therefore, CPAs need to help families carefully project the sources of cash available to the junior member to regularly service the installment debt obligation.

Estate tax implications. The installment sale removes the family business and future appreciation from the senior family member’s gross estate, while providing the younger-generation family member the business he or she would have inherited later—but at no transfer tax cost. However, if the note has an outstanding balance at the date of death, the senior member’s gross estate includes the fair market value of the installment note at the date of death or the alternate valuation date. The gross estate also includes principal and interest payments the senior family member received but did not spend or transfer by gift before dying.

If the junior family member makes the required payments, the installment sale will improve the liquidity of the senior member’s gross estate by removing illiquid assets and replacing them with cash and a promissory note. This strategy also will contribute to the senior member’s objective of having income to live comfortably.

Consequences to junior family member. The buyer’s basis in the business equals the principal portion of the purchase price. Thus, he or she receives a step-up in basis that would not have been possible if the senior family member had transferred the business by gift. The junior family member may deduct the interest paid or accrued on the installment note unless otherwise disallowed by the IRC (for example, investment interest is subject to deductibility limits under IRC section 163(d)(5)).


Using the self-canceling installment note (SCIN) strategy, the senior family member sells the business in exchange for the junior family member’s promise to make periodic payments until the senior member receives the sales price or dies, whichever occurs first. The SCIN, therefore, is a contingent payment installment sale. The contingency is that the seller’s death will occur before the note matures.

To compensate the senior family member for the risk of the note’s cancellation, the SCIN includes a “risk premium” reflected in a higher sales price (the principal balance due on the note) or a higher interest rate. The IRS, in general counsel memorandum 39503, says the period for receiving the sales price of the business must be less than the senior family member’s life expectancy to avoid private annuity treatment.

Income tax consequences. If the SCIN transaction qualifies for installment sale treatment, the senior family member can report the gain—calculated assuming receipt of the maximum sales price—over the period he or she receives payments. In calculating interest under the OID or the imputed interest rules, the senior assumes payments will be accelerated to the earliest possible date the agreement allows. Each payment represents a return of basis, capital gain and interest income.

Another acceleration of gain event. The events triggering gain recognition under the installment sales method—resale of the business within two years if the junior family member is a related party, using the note as collateral for a loan, disposing of the note and paying funds into an escrow account—apply equally to a SCIN. But the SCIN adds another gain acceleration caveat: the death of the senior family member before all payments are received. As established in Frane , 998 F.2d 567 (8th Cir. 1993), this gain is reported as income in respect of a decedent on the estate’s income tax return.

The Future of the Estate Tax Repeal
“If it is not repealed again for 2011, a ‘death bubble year’ will be created in 2010. Let’s hope that this potential scenario does not create too great an incentive for the murder of wealthy elderly people near the end of 2010.”

—Accounting Professor Robert H. Michaelsen writing in Tax Notes and quoted in The Wall Street Journal, August 8, 2001.

“The legislation would have to survive five Congresses and possibly as many as three presidents.”

—Sanford J. Schlesinger, wills and estates department, Kaye Scholer LLP, New York, quoted in The Wall Street Journal, May 25, 2001.

Consequences to junior family member. Like the installment sale strategy, the SCIN allows the junior family member to get a stepped-up basis even if the senior family member dies prematurely. Likewise, the child or grandchild can deduct the interest paid or accrued on the installment note unless the IRC says otherwise.

The risk premium itself also may provide tax advantages to the junior family member. If the premium is reflected through a higher interest rate, the interest deductions available to the junior family member will be higher. Alternatively, if the parties are willing to assign a higher sales price to the SCIN to reflect the risk premium, the junior family member may acquire the optimum supportable basis in the individual assets of the business, thus maximizing depreciation. The increased basis also will reduce the gain the new owner reports on a subsequent disposition of the property.

Gift tax effects. If the value of the self-canceling note the seller receives from the junior family member is less than the fair market value of the business, the difference is a taxable gift under section 2512. The parties usually can avoid this treatment if the values they rely on are reasonably accurate and they apply special care in ensuring the risk premium the buyer pays for the cancellation feature is realistic. If the parties use the IRS life expectancy tables, which reflect an increasing risk premium as the seller’s age and the term of the note increase, to determine the risk premium, this usually satisfies the special care standard. In situations where death is imminent, however, the tables don’t apply (revenue ruling 80-80, (1980-1 CB 194)), and the IRS will judge the reasonableness of the risk premium by considering the amount of the down payment, the length of the contract and the seller’s actual health.

Estate tax implications. If properly structured, the value of the canceled obligation under the SCIN will not be included in the senior’s estate for federal estate tax purposes. This treatment assumes the entire note, including the self-cancellation feature, resulted from bargaining between parties in equal positions and the buyer paid an adequate premium for the feature.

As with the regular installment sale, the senior family member’s estate includes SCIN payments (principal and interest) received but unspent at death. The longer the senior member lives, the more funds he or she will accumulate. If the senior lives for an extended period of time, the regular installment sale strategy will provide better estate tax results because the annual payments will not include a risk premium. Unfortunately, clients must decide which strategy to use at the time of the transfer. CPAs should warn clients that later events (premature death, living longer than expected) might change the outcome of a particular strategy.


Using the private annuity strategy in IRC section 72, the senior family member sells the business in exchange for the junior family member’s unsecured promise to make periodic payments for the duration of the senior’s life. The transaction is characterized as a private annuity because the junior family member is not in the business of entering into annuity contracts commercially.

A private annuity fits literally within the definition of an installment sale (a disposition of property where at least one payment is received after the close of the tax year of disposal) and may be structured like a SCIN (the periodic payments continue until a specified monetary amount is reached or the senior family member dies, whichever occurs first). The legislative, judicial and administrative history of the two strategies, however, indicates the tax law does not treat them the same way. Section 72 governs private annuities and section 453 governs installment sales. To distinguish the two strategies, the IRS, in general counsel memorandum 39503, established the bright-line test referred to earlier:

If the specified monetary amount can be received during the seller’s life expectancy, determined under table I of Treasury regulations section 1.72-9, the transfer is a SCIN.

If the specified monetary amount cannot be received during the seller’s life expectancy, then the transfer is a private annuity.

Income tax consequences. The IRS spells out its position on the income tax treatment of private annuities in revenue ruling 69-74 (1969-1 CB 43). Recognizing that a private annuity contains elements of both a sale and an annuity, it requires the seller to allocate each annuity payment between a capital amount (further broken down between a recovery of basis and capital gain) and an annuity amount (taxed as ordinary income). To accomplish this allocation, the senior family member must follow a three-step process (see example in exhibit 2).
Exhibit 2: Income Taxation of Private Annuities—An Example
Facts: Bill Newsome, age 64, transfers the family business ($1.5 million adjusted tax basis and $4 million fair market value) to his daughter, Jill, for a lifetime annuity of $433,920 and an expected return of $9,025,536 ($433,920 annual payment times the 20.8 year remaining life prescribed in table V, Treasury regulations section 1.72-9). The present value of the annuity, as determined under the estate and gift tax tables, is $4 million, the same as the fair market value of the business.

Income tax consequences to Bill Newsome

Step 1

The exclusion ratio is 16.620% ($1.5 million investment in the contract $9,025,536 expected return). Thus, Bill excludes $72,118 of each annuity payment ($433,920 payment X 16.620%) from income until he recovers the entire basis in 20.8 years.

Step 2

The capital gain portion of each annuity payment is 27.699% ($2.5 million total capital gain ($4 million present value of annuity minus $1.5 million adjusted tax basis) $9,025,536 expected return). Thus, Bill pays capital gains tax on $120,192 of each annuity payment ($433,920 payment 3 27.699%) or ($2.5 million total capital gain 20.8 year remaining life) for the duration of his life.

Step 3

Bill pays ordinary income taxes on the remainder of each annuity payment, $241,610 ($433,920 2 $72,118 excluded portion 2 $120,192 capital gain portion) or ($433,920 X 55.681%).

If Bill lives longer than his life expectancy of 20.8 years, he pays ordinary income taxes on both the excluded portion and the capital gain portion of each payment for the duration of his life.


Total payment $ 433,920
Excluded portion (72,118)
Capital gains portion (120,192)
Ordinary income tax portion $ 241,610

Step 1. Calculate the percentage of each annuity payment excluded from income until the senior member recovers his or her basis in the business. This percentage, referred to as the “exclusion ratio, is calculated by dividing the senior’s investment in the contract (adjusted basis in the business) by the total expected return (annual payment multiplied by the senior’s life expectancy determined using the tables in regulations section 1.72-9). The dollar amount excluded is simply the exclusion ratio times the annuity payment.

Step 2. Calculate the percentage of each payment taxed as a capital gain by dividing the total gain by the expected return or by multiplying the ratio of the capital gain to the expected return times the annuity payment. The total capital gain is the difference between the senior’s adjusted basis in the business and the present value of the annuity (using the estate and gift tax tables IRC section 7520 requires). The dollar amount of capital gain is simply the capital gain percentage times the annuity payment or the total capital gain divided by the senior’s remaining life expectancy. Thus, the senior pays capital gain taxes on the capital gain portion of each payment for the duration of his or her life; thereafter, the gain portion is taxed at ordinary income rates.

Step 3. Calculate the portion of each payment taxed as ordinary income for the duration of the senior’s life by subtracting the excluded portion and the capital gain portion.

The senior family member who secures the annuity usually will be taxed immediately on the gain (see Estate of Bell v. Commissioner, 60 TC 469 (1973) and 212 Corporation v. Commissioner, 70 TC 788 (1978)). Moreover, if the junior family member can’t make the annuity payments, the senior member may not benefit from writing off the remainder of his or her basis. If the loss is deemed a capital rather than an ordinary loss, as the Tax Court held in Mcingvale v. Commissioner, TC Memo, 1990-340, aff’d, 936 F2d 833 (5th Cir. 1991), the senior member must have capital gains against which to offset the capital loss to benefit from the writeoff. Thus, if the private annuity is to be a viable strategy for transferring a family business, the junior family member’s ability to make the payments should be certain.

An advantage of the private annuity over the SCIN is that canceling the obligation does not trigger gain recognition. (General counsel memorandum 39503.) However, it will be difficult for the senior member to cancel the obligation without gift tax consequences. Based on private letter ruling 9513001, the IRS will argue that cancellation indicates the senior member never expected to receive or enforce the annuity payments. Thus, the annuity was not a bona fide business transaction. CPAs should warn clients that the income tax benefits of canceling the obligation will pale in comparison to the gift tax obligation if the IRS successfully enforces this challenge.

Consequences to junior family member. Revenue ruling 55-119 spells out the IRS position on the basis of the property to the purchaser. For depreciation purposes, the ruling says the purchaser’s basis before the seller dies is the present value of prospective payments, using the stipulated life expectancy tables. The purchaser adds any payments exceeding this value to the basis as they are made. At the seller’s death, the purchaser’s basis in the property equals the total annuity payments made.

Unlike with installment payments where interest may be deductible, the junior family member cannot deduct any part of the annuity payments. This rule runs counter to the senior member’s treating part of each payment as ordinary income—in effect, interest—but is well established in case law (see Bell v. Commissioner, 76 TC 232 (1981), aff’d, 668 F.2d 448 (8th Cir. 1982); Dix v. Commissioner, 46 TC 796 (1966), aff’d, 392 F.2d 313 (4th Cir. 1968)). Thus, the junior family member treats each payment as entirely principal—an increase in basis. However, this provision also means the junior member must be able to make the annuity payments without a tax deduction.

Gift tax effects. No gift tax arises with the private annuity strategy if the fair value of the family business is roughly equivalent to the annuity’s present value. If the fair value of the business exceeds the present value of the annuity, however, revenue ruling 69-74 requires the senior to treat the excess as a gift to the junior. Likewise, if the annuity’s present value exceeds the fair value of the business, revenue ruling 69-74 requires the junior family member to treat the excess as a gift to the senior member. Either party may use the annual gift tax exclusion to reduce the taxable gift.

Estate tax implications. The major tax benefit of a private annuity is that the business will not be part of the senior family member’s gross estate. Additionally, since payments end at the senior member’s death, no income in respect of a decedent exists. However, as with the regular installment sale and the SCIN, the senior’s estate will include annuity payments received but not expended as of the date of death.


Using the grantor retained annuity trust (GRAT) strategy, CPAs can advise the senior family member (the grantor) to transfer the business to an irrevocable trust, retaining an income interest for a specified number of years. When the trust term ends, the business passes to the junior family member (the remainder beneficiary). Thus, a GRAT gives the senior member an income stream from the business for a period of years while he or she continues to control it.

Income tax consequences. For income tax purposes, IRC section 677 considers the GRAT a grantor trust and thus continues to treat the senior member as owner of the property transferred to the trust. Accordingly, he or she recognizes no gain when placing the business into the trust and reports no income upon receipt of the annuity payments. Instead, the senior member pays taxes on all income the trust earns.

The parties may structure the trust so that in a given tax year the excess of tax paid on trust income over the annuity payment is distributed to the grantor. The IRS hinted in letter ruling 9444033 that it considers the tax the grantor paid on trust income a gift to the remainder beneficiary. The IRS, however, provides no legal support for its position and the senior family member can argue that excess income in one year will not necessarily be passed (gifted) to the junior family member. The trust may need this excess to pay the annuity in a year where income is less than the required annuity payment. Also, since the senior member recognizes no gain on transferring the business to the trust, it’s only logical the junior family member receives the business with a carryover basis. Thus, provided the senior prevails in this situation, a GRAT offers the benefit of an indirect gift to the junior family member without gift tax.

Gift tax effects. While the senior has no taxable gain upon transferring the business into trust, a taxable gift arises at this point. The value for gift tax purposes is the difference between the fair value of the business and the present value of the retained annuity payments. The annuity discount period is the shorter of the annuity term and the senior member’s expected life. The discount rate, established in section 7520, is 120% of the federal midterm rate for the month the senior puts the business in trust.

Because contributing the business to the GRAT is a future interest, the contribution is not eligible for the $10,000 annual gift tax exclusion. Thus, the entire value is subject to gift tax. However, CPAs know the tax can be reduced to a nominal amount by minimizing the gift value—accomplished through some combination of extending the term of the trust, establishing the GRAT at a younger age and increasing the size of the annuity. These actions will raise the present value of the retained annuity payments, thus decreasing the value of the gift. By minimizing the gift tax paid, little will be lost if the senior member dies in 2010, the one-year window for no estate tax under EGTRRA.

Estate tax implications. The major benefit of a GRAT hinges on whether the senior family member can exclude the trust property from his or her estate. If the senior member survives the annuity term, the family will realize this benefit. The rationale for this exclusion is that the remainder interest passed to the beneficiaries when the grantor created the trust. Thus, the actual transfer of the property at the GRAT’s termination is a nonevent for transfer tax purposes. If the family business can generate a return in excess of the rate used to value the retained annuity payments (120% of the federal midterm rate), the excess will pass to the junior family member free of estate and gift taxation. Upon termination of the GRAT, the property is entirely vested in the beneficiaries; the grantor no longer holds any rights to it.

If the senior family member dies before the annuity term expires, his or her taxable estate will include all or a portion of the trust property. Inclusion in the estate obviously is not the intended result, but the senior member is no worse off than if he or she had not used the GRAT strategy. Because the senior receives credit on the estate tax return for the gift tax already paid (unless death occurs in 2010 and current EGTRRA provisions remain intact), the only cost is the time value of money on the lost use of any gift tax paid.

How much of the trust is included in the senior member’s estate is an unsettled issue. Revenue ruling 82-105 (1982-1 CB 133) indicates that under IRC section 2036(a)(1) the amount to include is the corpus necessary to produce the retained annuity. In letter rulings 9345035 and 9451056, the IRS contends that under section 2039 the entire trust corpus should be part of the estate. Including any amount, however, will undermine the primary objective of excluding the trust property from the senior member’s estate. To deal with this issue, CPAs should advise clients to select an annuity term the senior family member is likely to survive. The shorter term will enhance the family’s chances of realizing the estate tax benefits of the GRAT and won’t necessarily increase the value of the gift.
Exhibit 3: Strategies for Transferring the Family Business
Facts: Paul Baker owns 100% of the stock of a family corporation. Paul’s son, Jim, started working in the business when he graduated from college 15 years ago. At age 65, Paul is in excellent health, but feels it is time to transfer the business to Jim. The tax basis of the stock is $500,000; its current worth is estimated at $5 million. Paul needs and wants an income stream for his continued financial support from the transfer strategy.
Additional Assumptions:
Federal estate tax rate 50%
Federal estate tax exemption $1 million
State estate tax rate 6%
Marginal income tax rate 44%
Capital gain tax rate 28%
Tax rate on income in respect of a decedent   44%
Prior taxable gifts   0
Annuity payout   10%
Term of installment note   20 years
Current IRC section 7520 rate   5.6%
Interest on note   9%
Appreciation rate of business   10%
Rate of income earned by asset   6%
Pretax return on cash   5%
Present value discount rate   3%
Stock sold by beneficiary   No
Trust term   10 years
Payment taken in property   Yes
Loan interest rate   9%
Interest deductible by the buyer   Yes
SCIN present value discount rate for risk premium calculation   3%
Type of installment note and SCIN   Self-amortizing

If Paul dies at age 85—20 years after transferring the family corporation to Jim—and both parties pay all taxes due and payable during and at the end of this 20-year period, the comparative value of the assets Paul receives is as follows:

Transfer strategy Present value of assets
Do-nothing $12,535,611
Installment sale 21,908,400
SCIN 21,934,836
Private annuity 17,143,026
GRAT 19,326,707


For clients to truly appreciate the impact these strategies can have on their finances, CPAs need to provide them with a written quantitative analysis of the benefits. Exhibit 3, above, uses proprietary software to compare the financial impact of the four strategies for the hypothetical client situation described in the exhibit. It also includes a fifth, “do-nothing” strategy (that is, pay the transfer taxes at death) for comparative purposes. Clearly, any of the four strategies discussed in this article benefits the family transfer described in exhibit 3. With the numbers to back up the verbal comparisons of the strategies, most families will be motivated to start succession planning of some kind to lessen the transfer tax impact.


Estate planning, including planning for the transfer of the family business, would be a dead issue if Congress had opted for immediate repeal of the estate tax. The delayed implementation of the estate tax changes, combined with the unlikelihood of its ever being repealed, however, keeps succession planning in the marketing strategies of CPAs trying to find ways to add value to their client relationships. Family business owners commonly look to their CPAs for tax-efficient ways to transfer their businesses to the next generation. Practitioners can use the four strategies discussed in this article as a foundation for providing these services.


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