Optimal Timing?

During the last twenty years, there have been a number of times during which the owners of closely held business entities have been encouraged – “urged” might be a better word, at least in some cases – by many advisers to take advantage of what may be described as “adverse” economic circumstances to do some gift and estate planning.

A sluggish economy, one with slow or no growth, is usually the catalyst. This is invariably accompanied – or caused? – by dropping consumer confidence which, in a service-based economy such as ours, only makes matters worse. The stock market will reflect[i] this less-than-positive outlook and, as the market declines, so will the value of most people’s retirement funds. The Fed will drop rates to encourage spending by businesses and consumers in the hope of limiting and hopefully reversing the effects. Government may “start” spending more in order to spark economic activity.

Where is the silver lining in all of this? “It’s the perfect environment,” many might say to a business owner, “to do some estate tax planning.” Why is that? “Because the value of your business has likely declined.”

To these folks, I say, “Slow down, don’t move too fast.”[ii]

The Goal of E-Tax Planning

The goal of estate tax planning, of course, is to transfer from members of a family’s older generation to members of its younger generation – without incurring a gift tax liability[iii] – those assets which now have a relatively low value – whether as a result of a downturn in the business, in its industry, in the economic generally, or otherwise – but which are reasonably expected to appreciate in value over time.

In theory, that is one way in which a gift tax or estate tax plan may be implemented – it is somewhat analogous to the adage about “buying low and selling high.”[iv]

For example, Parent owns an established business that may take off in a couple of years because of anticipated regulatory changes in its industry, or Parent may have recently started a business that is developing a new technology that promises to one day change the way widgets[v] are manufactured, or Parent’s business may be confident of eventually obtaining Federal approval for a new drug it is developing. In the hope of sharing with their children some portion of the future value of this business, Parent may decide to make a gift of some equity in the business to a trust for the benefit of the children.[vi] Because the value of this equity interest is relatively low as compared to what Parent reasonably believes are its prospects, such a gift makes sense.[vii] Their transfer of an equity interest to a child will not consume a large part of Parent’s federal exemption amount. What’s more, the transfer to a child or to a trust for their benefit removes the interest from Parent’s gross estate for purposes of the Federal estate tax; it also removes the future growth in the value of the interest from their estate.

That’s the underlying theory.


It is a basic precept of estate planning that Parent should not dispose of any interest in their business that they are not comfortable giving up[viii] – whether for business or personal reasons – regardless of how much such a transfer may ultimately save in gift and estate taxes. It may not be the smartest decision from a tax planning perspective, but it is Parent’s property.

Do you recall the end of 2012? The Federal unified exemption amount, which was set at $5.12 million per person, was scheduled to revert on January 1, 2013, to its 2002 level of $1 million per person.[ix] Many business owners panicked at the thought of losing the opportunity to pass at least a portion of the value of their business to their children on a tax-sheltered basis.

What did they do in the face of this pending calamity? They made gifts before the clock struck 12:00 am on January 1, 2013. On that day, however, Congress passed the American Taxpayer Relief Act,[x] which President Obama signed into law on January 2, 2013, with retroactive effect.

On January 3, 2013, many of those business owners who had rushed to make gifts in December 2012 called their attorneys to see how they could rescind their 2012 transfers. “You’ll have to buy it back,” they were told,[xi] or “your kids will have to gift it back to you.” I can tell you, no one wanted to hear that.[xii]

In the case of those who made their gifts into a grantor trust with respect to which they retained a power of substitution,[xiii] the resulting income tax liability of such a repurchase was avoided. In those other cases . . . Oh well.

The “Recalcitrant” Parent

In some instances, Parent may be reluctant to part with any of their voting power in the business, though this may be easily addressed by providing for voting and nonvoting equity interests,[xiv] with only the latter being gifted.

In addition, a well-drafted shareholders’ or partnership/operating agreement can go a long way in securing Parent’s control over the business.

Parent’s Economics

In other instances, Parent may be loath to give up any of the economic benefits, including the right to distributions, associated with their ownership of the business.

In many cases, the “lost” cash flow may be addressed, in part, by structuring the transfer to the kids as one in which Parent retains an interest in the transferred property,[xv] or as one that is made in exchange for consideration.[xvi]

This has two beneficial consequences: the amount of the gift is reduced by the amount of the consideration to be received by Parent, and it provides Parent with a flow of funds. One potentially adverse result is that the transfer may be treated as a sale for income tax purposes which may cause Parent to have a taxable gain.


For example, Parent may contribute some of their equity in the business to an irrevocable trust,[xvii] but will retain the right to be paid an annuity (basically, a fixed amount) from the trust every year, for a specified number of years[xviii] – a grantor retained annuity trust, or GRAT.[xix] When the term of Parent’s retained annuity interest ends, the property remaining in the trust will either remain in trust for the benefit of Parent’s children, or the trust may liquidate, with the property passing to the children as the beneficiaries of the remainder interest.

The trust is typically drafted so that the annuity amount payable to Parent is based upon a percentage of the value of the property as of the day the property was transferred by Parent to the trust.[xx] Once the annuity amount has been determined, Parent may calculate the amount of the gift arising from their transfer to the trust – i.e., the present value of the remainder interest, which is determined as of the date of the transfer to the trust using an interest rate prescribed by the IRS.[xxi]

In addition, the GRAT is typically drafted so as to be treated, for purposes of the income tax, as a so-called “grantor trust” – in general, a trust with respect to which the grantor has retained an interest such that the grantor will continue to be treated as the owner of the income and assets of the trust.[xxii] Because a taxpayer cannot sell property to themselves, and because the grantor is treated as owning the trust property, any transfers of property and payments of cash between Parent and the grantor trust will be disregarded for income tax purposes.[xxiii]


Alternatively, Parent may sell some of their equity interest in the business to a grantor trust[xxiv] in exchange for a promissory note with a face amount equal to the value of such equity interest. The loan should bear interest at least equal to the applicable federal rate (“AFR”), as determined by the IRS.[xxv] This interest may be payable on a current basis,[xxvi] with a balloon payment of principal when the note matures.[xxvii] Hopefully, the equity “sold” to the trust will have appreciated enough by then so that the trust may satisfy its obligation under the note by returning some of the equity to Parent. In this way, Parent avoids making a taxable gift while also avoiding taxable gain on the sale.

If there is little gain inherent in the equity interest to be transferred, Parent may choose to sell the property outright to child or to a non-grantor trust in exchange for a note bearing interest at the AFR.[xxviii]

The Federal transfer tax gambit in the case of a GRAT is that the equity interest transferred by Parent will appreciate, or will produce income, at a rate that is greater than the AFR – i.e., the interest rate that the IRS requires to be applied in determining the value of the gift in the case of the GRAT. If such appreciation or income levels are realized, then the excess will remain in the trust at the end of the term of Parent’s retained annuity interest. Thus, in a low interest rate environment like the one in which we now find ourselves, the GRAT may prove effective in removing value from Parent’s future estate.

In the case of an installment sale, the AFR represents the minimum rate of interest that the IRS requires be charged under the notes in order to avoid an imputed gift of any foregone interest.

Does Gifting Make Sense?

However, under the economic circumstances assumed herein, including the reduced value of the business – which likely stems in no small part from a not-insignificant drop in its revenues – one may question the wisdom, let alone the need, for Parent to transfer any of their equity interest in the business to, or for the benefit of, their child for the purpose of reducing Parent’s potential estate tax exposure.

As a result of the Tax Cuts and Jobs Act,[xxix] every individual has a combined Federal gift/estate tax exemption of $11.58 million;[xxx] in the case of married persons (especially a couple that takes advantage of “portability”), the exemption is $23.16 million per couple. Thus, an individual may, by a combination of lifetime and testamentary dispositions, transfer property with an aggregate fair market value of $11.58 million without incurring Federal gift or estate taxes. Where such property consists of interests in an ongoing, closely held business for which there is no ready market, the valuation of such interests will reflect their lack of liquidity.

In light of the foregoing, many business owners may ask “why give up any interest in the business?” The owner may feel that they need complete ownership – and whatever economic benefits they can derive or extract from such ownership – until the business stabilizes and starts to recover. Until then, they may not want to risk giving up any of its value or cash flow, especially if they feel they may need to sell the business down the road in order to fund their retirement because their IRA or other retirement accounts have taken a beating.

2026 or 2021?

As if a near economic disaster isn’t enough, enter the scheduled sunset of the increased gift/estate tax exemption amount. Specifically, for gifts made and for decedents dying after 2025, the exemption amount will revert to its pre-2018 levels; basically, it will be cut in half.

“But, Lou, you realize that we’re only in 2020, right?”

There is a more imminent threat to the higher exemption amount than the 2025 sunset: the November 2020 presidential election. The Democrats already control the House of Representatives – will they retain it? They need to win only three or four seats (depending on who wins the vice presidency) to take the Senate. What if they also win the White House?

Given the tenor and clear message of the Democratic primary contests, a reduction in the gift/estate tax exemption amount and an increase in the maximum gift/estate tax rate[xxxi] should be expected in 2021 in the event the Democrats do well this November.[xxxii]

What’s more, it is no longer only a question of principle or fairness or redistribution of wealth – the government must somehow come up with a way to pay for the $2.2 trillion economic stimulus package enacted on March 27, 2020,[xxxiii] and these Federal transfer taxes are fair game. In other words, the taxpayers at whom these taxes are targeted would be fortunate if we reverted to pre-TCJA law.

Scylla and Charybdis[xxxiv]

What to do?

Dispose of as much of the business as possible while the exemption amount is still high? Utilize GRATs and sales to grantor trusts to preserve some of the cash flow from the business to the owner? Retain only enough of an interest in the business so as to enable one’s estate to qualify for installment reporting of the estate tax attributable to the business?[xxxv] Hold on to the business, and purchase additional life insurance in an irrevocable trust?

All of the above? Probably.

Unfortunately, there’s a lot to think about here, but not a lot of time to plan.

[I] And reinforce? I have always viewed the stock market as a reactive element in the chemistry of the economy. You add information to the pot, and “it” responds based on some mix of perceived short-term and long-term self-interest. I’m sure that others view it differently.

[ii] Remember “The 59th Street Bridge Song”? Have you wondered whether we should now be calling it the “Ed Koch Queensboro Bridge Song”? I don’t think S&G would approve. “Slow down, you move too fast.”

[iii] New York no longer imposes a gift tax, though it will pull back into a decedent’s taxable estate any taxable gifts made by a resident decedent during the three-year period ending with the decedent’s date of death. NY Tax Law Sec. 954(a)(3). This claw-back provision applies to decedents dying before January 1, 2026. Would anyone be surprised to see it extended? Nope.

[iv] The gift and estate taxes are sometimes referred to as “transfer taxes.”

[v] No, this is not some item from Harry Potter, like a horcrux or a golden snitch. It is much more practical than such childish imaginings. For attorneys, a widget is a smallish, fictional device that is manufactured by a hypothetical business that can’t seem to catch a break. This poor widget manufacturer is forever involved, it seems, in some form of litigation, whether based on a commercial or other tort, a breach of contract, a misplaced peppercorn, etc.

[vi] Lots of good reasons for a trust. Keeping the property out of the kids’ hands will help to keep it out of the hands of their spouses and creditors, and will make it financially more difficult for the kids to engage in harmful behavior, like gambling or substance abuse.

[vii] Especially when one considers the valuation methodology for a going concern. Add to that the fact that the gift may consist of a minority interest which is not easily transferable, and the valuation may be quite favorable from a gift tax perspective.

[viii] In the words of many planners, it should be “disposable.”

[ix] The “sunset” of EGTRRA’s estate and gift tax provisions (P.L. 107-16), as extended and modified by the 2010 Extension Act (P.L. 111-312).

In addition, portability of a predeceasing spouse’s unused exemption amount would have been eliminated, and the tax rate would have increased to 55 percent. Oy.

[x] P.L. 112-240.

[xi] After all, in order for a gift to be effective for estate and gift tax purposes, it has to be a completed transfer. Reg. Sec. 25.2511-2.

Many clients asked why they had to pay to recover the gifted property. “After all,” several of them said, “my kids have no idea I even established a trust for them.” Oy, again.

[xii] And I am certain that many engaged in “self-help” at that point.

[xiii] IRC Sec. 675(4).

[xiv] In the certificate of incorporation in the case of a corporation; in general, in the operating agreement, in the case of a partnership/LLC.

[xv] Instead of an outright gift.

[xvi] A partial gift.

[xvii] With an “understanding” trustee. It also helps if Parent has the right to remove a trustee and, within certain limits, to appoint another.

[xviii] The “term” of Parent’s retained annuity interest in the trust.

[xix] IRC Sec. 2702; Reg. Sec. 25.2702-3. The GRAT will typically rely upon receiving distributions from the property contributed to the trust in order to make the annuity payments. For this reason, where the GRAT is funded with an interest in a closely held business organized as a partnership/LLC or as an S corporation – i.e., a pass-through that is not itself taxable – more cash will be left for the trust with which to make the necessary distributions.

[xx] In the event the IRS were to ever successfully challenge the reported value for the property, the annuity amounts would likewise be adjusted, thereby reducing what otherwise would have been the increased value of the gifted remainder interest. Reg. Sec. 25.2702-3(b)(2).

[xxi] IRC Sec. 7520. Specifically, 120% of the short-term AFR under Sec. 1274.

[xxii] Under the grantor trust rules. See IRC Sec. 671 – 679. The deemed owner will continue to be taxed on the income and gains recognized by the trust. If the owner-grantor can afford bearing this income tax liability, the trust may grow without being reduced for taxes. What’s more, the grantor’s payment of the income tax is not treated as a gift by the grantor for purposes of the gift tax.

[xxiii] Rev. Rul. 85-13.

[xxiv] So as to avoid adverse income tax consequences; i.e., taxable gain from the sale.

[xxv] IRC Sec. 1274. If a lower rate were charged, the foregone interest would be treated as a taxable gift by Parent.

[xxvi] The note has to be respected as such for purposes of the gift tax. The payment of such interest is not taxable to the grantor-owner. They cannot pay interest to themselves.

[xxvii] An installment sale. On the death of Parent, the trust ceases to be treated as a grantor trust, and the sale in exchange for a note is completed for purposes of the income tax. A balloon payment is often used because if Parent dies while the note remains outstanding, their estate may be able to claim a step-up in basis for the equity interest “sold” and thereby avoid any gain recognition. Of course, the note is included in Parent’s gross estate for purposes of the estate tax.

[xxviii] If the value of the equity interest was less than Parent’s adjusted basis for the interest – i.e., a sale would result in the realization of a loss – Parent may want to reconsider selling the interest to a family member; that’s because IRC Sec. 267 disallows (suspends, really) the recognition of loss arising from a sale or exchange between certain related persons.

[xxix] P.L. 115-97 (the “TCJA”). Effective for gifts made and decedents dying after 2017.

[xxx] IRC Sec. 2010(c)(3) and (c)(4); Sec. 2505. This is in addition to the annual gift exclusion amount of $15,000. IRC Sec. 2503.

[xxxi] The current maximum rate is 40 percent.

[xxxii] In addition, one should expect a Democratic assault on the discounts commonly taken when valuing interests in a closely held business for purposes of the gift and estate taxes.

[xxxiii] The Coronavirus Aid, Relief and Economic Security Act.

[xxxiv] No, not the line from Wrapped Around My Finger by The Police. Rather, the mythical monsters that were thought to inhabit opposite sides of the Straits of Messina and who preyed on passing sailors. They figured prominently in Homer’s Odyssey. Given the severity of the choices described here, we may want to throw in a Cyclops for good measure.

[xxxv] IRC Sec. 6166. https://www.taxlawforchb.com/2020/03/recapitalizing-debt-to-defer-payment-of-the-estate-tax-good-idea/