John Doe
Business Succession Planning Case
Study –
Sale of Non-voting stock interest to
Grantor Type Dynasty Trust
1
Step #1 – Recapitalize the S
Corporation
Create Voting and Non-voting
common shares, issued on a prorata basis to existing shareholder
2
Current capital stock ownership
S Corporation
Assumed FMV:
$10,000,000
John owns 1,000 voting shares
(100% of outstanding shares)
3
After assumed re-issue of voting and
non-voting stock
S Corporation
Assumed FMV:
$10,000,000
John owns 1,000 shares:
- 10 voting shares (1.0% of outstanding share)
- 990 non-voting shares (99.0% of outstanding shares)
4
S Corporation
Assumed FMV =
$10,000,000
- 10 voting shares
- 990 non-voting shares
$ 120,000
$5,940,000
Assume non-voting shares have an appraised value of:
$6,000 per share
(reflects assumed 40% “lack of control” and
“lack of marketability” discount)
Assume voting shares have an appraised value of:
$12,000 per share
(reflects assumed 20% control premium)
5
Step #2 – Create the
Dynasty Trust
6
Trust Creation and Establishment
John creates the Trust
Doe Family
Irrevocable Trust
Trustee:
John’s son(?)
The Trust is structured as a “Grantor Trust” as to John.
As a result of this structure . . . . .
all Trust income is deemed to be the income of John.
7
“Exempt Trust” status
• If John allocates portions of his available
Generation Skipping Tax Exclusion to the Trust
as lifetime gifts are made to the Trust by John
• The Doe Family Irrevocable Trust will have
maintained a “Zero Inclusion Ratio” for
Generation Skipping Tax purposes
• THIS IS A HUGE BENEFIT TO THE TRUST
BENEFICIARIES!!
– Trust assets are not includible in trust beneficiaries
gross estates for federal estate tax purposes
8
Step #3 – Gift of “Seed
Capital” to Dynasty Trust
9
John makes a gift
of $600,000 cash
to the Trust
Doe Family
Irrevocable Trust
$600,000
cash
The gift of $600,000 is a taxable gift that must be reported on a Federal Gift
Tax return (IRS Form 709) to be filed by John to report gifts made by
him during the calendar year of the gift
No gift tax will be due – instead, $600,000 of John’s $1,000,000
lifetime Gift Tax Exclusion will be used to shelter the taxable gift from taxation
John will also allocate $600,000 of his $3,500,000 Generation Skipping
Tax Exclusion to this gift so that the Trust will maintain a “zero inclusion
ratio”, i.e. will remain a “GST Exempt Trust”
10
Step #4 – John sell’s his 990
non-voting shares to the
Trust for an installment note
11
S Corporation
John’s shares:
10 voting
990 non-voting
Appraised Fair Market Value of 990
Non-voting shares
= $5,940,000
John sells his 990 non-voting shares to the
Dynasty Trust
for a 20 year installment note, payable annually
(4.26% Long Term AFR rate)
Dynasty Trust
(“Grantor Trust”)
$600,000 cash from gift
John receives:
$447,197 annual
note payments
every year for
20 years
990 shares from
purchase
(99% shareholder)
$5,940,000 note owed
to John
12
Resulting S Corporation
Ownership
13
S Corporation
John owns:
10 voting shares
(100% of vote)
(1% of entity equity)
Dynasty Trust
(“Grantor Trust”)
$600,000 cash
990 non-voting shares
(no vote, 99% entity equity)
14
Effects of “Grantor Trust” status
15
Income Tax Reporting
• John is deemed to be the “owner” of
the Dynasty Trust for purposes of
reporting the income of the Dynasty
Trust
– Dynasty Trust does not file a 1041 – instead,
an “information return” is filed, with Dynasty
Trust income tax information reported to John
as the Dynasty Trust’s deemed owner (for
income tax), for reporting on his personal
income tax return (1040) for the applicable tax
year
16
Income Tax Effect of Sale of Stock
• John’s sale of S Corporation stock to
the Dynasty Trust is treated as a “nonrecognition” event (a sale “by John to
himself”)
– NO gain is recognized on the sale of stock
– NO interest income is recognized on the
installment note payments to John
– The Dynasty Trust does not receive a
deduction for interest payments made
17
Illustration of “Pass Through”
of Dynasty Trust Income
18
S Corporation
Assume $500,000
net income
Allocation of assumed “K-1”
income pro-rata to all
shareholders, based on share
ownership percentages
John owns
10 shares
(1%)
$5,000
K-1 income
Because the Dynasty Trust is
structured as a “Grantor Trust”
for income tax purposes . . . .
John must pay the income tax attributable
to the S Corporation income that is
allocated to the Dynasty Trust!
Dynasty Trust
(“Grantor Trust”)
$600,000 cash
990 shares (99%)
$495,000
K-1 income
19
But that is what John was doing prior
to the sale of his non-voting shares
to the Dynasty Trust!
In other words, John is paying
the same income tax . . . .
before and after the sale of
stock!
20
So how does the Dynasty Trust
make the required Note
payments to John?
21
Assume S Corporation distributes
its assumed $500,000 net
income to its shareholders
Dynasty Trust will receive a
distribution of $495,000
($500,000 x 99% = $495,000)
22
S Corporation
Assume $500,000
net income
Allocation of assumed pro-rata
distribution of $500,000 to
shareholders, based on share
ownership percentages
John owns
10 shares
(1%)
$5,000 distribution
Dynasty Trust
(“Grantor Trust”)
$600,000 cash
990 shares (99%)
$495,000 distribution
23
Trustee of the Dynasty Trust
uses the cash distribution from S Corporation
together with the cash
that was gifted to the Trust
to make the note payment to John
Dynasty Trust
(“Grantor Trust”)
$600,000 cash + $495,000 cash =
$1,095,000 cash
Annual note payment
to John:
Less $447,197 payment to John
$447,197
$647,803 cash balance
24
John pays
income tax on 100% of the net
income of S Corporation
($500,000 in this example)
$125,000 at 25% assumed effective income tax rate
Cash flow John has
received:
$5,000 distribution and
$447,197 note payment =
$452,917
Less $125,000 income tax
$327,917
available for John
for his lifestyle support
or gifting
Possible Annual
Exclusion gifts of
up to $13,000 annually
to children and others
25
Results after year one:
Dynasty Trust
990 shares S Corporation stock
Cash accumulation: $647,803
Year end note balance:
$5,745,847
What to do with the cash accumulation?
26
The Trustee of the Dynasty Trust could use the net cash to:
- Invest and save (income taxes on earnings are taxed to
John)
- Distribute to Trust beneficiaries – GIFT TAX FREE
- Use to buy life insurance on John’s life!!
27
• Dynasty trust could be structured so that upon John’s
death
– the non-voting shares are allocated to a GST exempt separate
trust share for his son
– life insurance proceeds received by the Trust at John’s death are
allocated to GST Exempt separate trust shares for the other two
children
• John’s revocable trust could leave the 10 voting shares
(1%) to his son at his death
• Leaves Son’s GST Exempt Trust owning the S
Corporation, and the other children’s GST Exempt Trust
shares owning cash
• John’s wife will continue to receive remaining note
payments for her support
28
• John may reduce his salary from S
Corporation, as he won’t need this cash
flow
– This saves payroll tax and leaves more cash
in S Corporation for operations, etc.
– Pay John enough salary to continue to qualify
him for health insurance plan coverage
29
If John either consumes or gifts
($13,000 annual exclusion gifts) the
net after tax note payments that he
receives from the Trust . . . .
30
There is no asset “build-up”
inside of John’s gross estate, and
at John’s death, only the then
unpaid balance of the note is
included in John’s gross estate
31
Estate Tax Results
• John has removed $10,600,000 of appreciating assets
from his gross estate that at his death would be subject
to estate tax at 45% (current estate tax rate)
• John has received an asset (the self amortizing Note)
that is:
– DISCOUNTED
– FROZEN (will not appreciate in value)
– DEPRECIATING (the Note principal will decrease in value over
the 20 year Note term)
• If John does not accumulate the Note payments, then at
the end of the Note term –
– John will have totally removed the $10,600,000 (plus
all future appreciation on this amount) from his gross
estate WITHOUT MAKING A TAXABLE GIFT (other
than the initial $600,000 “seed capital” gift)
32
• Trust assets are in a Generation Skipping
Tax Exempt Trust with asset protection
features
– Trust assets are not included in the children’s
(or grandchildren’s) gross estates at their
deaths
33
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