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John Doe

John Doe. Business Succession Planning Case Study – Sale of Non-voting stock interest to Grantor Type Dynasty Trust. Step #1 – Recapitalize the S Corporation. Create Voting and Non-voting common shares, issued on a pro-rata basis to existing shareholder. Current capital stock ownership.

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John Doe

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  1. John Doe Business Succession Planning Case Study – Sale of Non-voting stock interest to Grantor Type Dynasty Trust

  2. Step #1 – Recapitalize the S Corporation Create Voting and Non-voting common shares, issued on a pro-rata basis to existing shareholder

  3. Current capital stock ownership S Corporation Assumed FMV: $10,000,000 John owns 1,000 voting shares (100% of outstanding shares)

  4. 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)

  5. S Corporation Assumed FMV = $10,000,000 • 10 voting shares $ 120,000 • 990 non-voting shares $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)

  6. Step #2 – Create the Dynasty Trust

  7. 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.

  8. “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

  9. Step #3 – Gift of “Seed Capital” to Dynasty Trust

  10. 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”

  11. Step #4 – John sell’s his 990 non-voting shares to the Trust for aninstallment note

  12. Appraised Fair Market Value of 990 Non-voting shares = $5,940,000 S Corporation 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) John’s shares: 10 voting 990 non-voting Dynasty Trust (“Grantor Trust”) $600,000 cash from gift 990 shares from purchase (99% shareholder) John receives: $447,197 annual note payments every year for 20 years $5,940,000 note owed to John

  13. Resulting S Corporation Ownership

  14. 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)

  15. Effects of “Grantor Trust” status

  16. 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

  17. Income Tax Effect of Sale of Stock • John’s sale of S Corporation stock to the Dynasty Trust is treated as a “non-recognition” 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

  18. Illustration of “Pass Through” of Dynasty Trust Income

  19. Allocation of assumed “K-1” income pro-rata to all shareholders, based on share ownership percentages S Corporation Assume $500,000 net income John owns 10 shares (1%) $5,000 K-1 income Dynasty Trust (“Grantor Trust”) Because the Dynasty Trust is structured as a “Grantor Trust” for income tax purposes . . . . $600,000 cash 990 shares (99%) $495,000 K-1 income John must pay the income tax attributable to the S Corporation income that is allocated to the Dynasty Trust!

  20. 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!

  21. So how does the Dynasty Trust make the required Note payments to John?

  22. 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)

  23. Allocation of assumed pro-rata distribution of $500,000 to shareholders, based on share ownership percentages S Corporation Assume $500,000 net income John owns 10 shares (1%) $5,000 distribution Dynasty Trust (“Grantor Trust”) $600,000 cash 990 shares (99%) $495,000 distribution

  24. 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: $447,197 Less $447,197 payment to John $647,803 cash balance

  25. 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 Possible Annual Exclusion gifts of up to $13,000 annually to children and others $327,917 available for John for his lifestyle support or gifting

  26. 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?

  27. 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!!

  28. 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

  29. 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

  30. If John either consumes or gifts ($13,000 annual exclusion gifts) the net after tax note payments that he receives from the Trust . . . .

  31. 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

  32. 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)

  33. 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

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