© Julius H. Giarmarco, Esq KEEPING THE FAMILY BUSINESS IN THE FAMILY Prepared by: Julius H. Giarmarco, Esq. Cox, Hodgman & Giarmarco, P.C. 101 W. Big Beaver Road, 10th Floor Troy, MI (248)

© Julius H. Giarmarco, Esq CIRCULAR 230 DISCLAIMER THESE MATERIALS ARE NOT INTENDED OR WRITTEN BY THE AUTHOR TO BE USED, AND THEY CANNOT BE USED BY YOU (OR ANY OTHER TAXPAYER) FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON YOU (OR ANY OTHER TAXPAYER) UNDER THE INTERNAL REVENUE CODE OF 1986, AS AMENDED.

© Julius H. Giarmarco, Esq Techniques to be Discussed 1.Grantor Retained Annuity Trusts 2.Grantor Trusts 3.Private Annuities 4.Self-Canceling Installment Notes 5.Valuation Discounts

© Julius H. Giarmarco, Esq Grantor Retained Annuity Trust Typical Features 1.Grantor transfers income producing assets (i.e., S corporation stock, FLP/FLLC interests) to an irrevocable trust f/b/o children. 2.Grantor retains the right to a fixed annuity payment for a set term of years. 3.At end of term, the assets remaining in the GRAT pass to the remainder beneficiaries (the children). 4.If grantor dies before the set term, the assets in the GRAT revert back to his/her estate.

© Julius H. Giarmarco, Esq Grantor Retained Annuity Trust Typical Features 5.The risk of inclusion can be “insured” against with life insurance on the grantor’s life. 6.The gift tax value is the FMV of the assets transferred to the GRAT, less the present value of the annuity interest and the value of the reversion. 7.The grantor is taxed on all income and realized gains on trust assets even if these amounts are greater than the annuity payment. 8.All income and appreciation in excess of that required to pay the annuity accumulate for the benefit of the remaindermen.

© Julius H. Giarmarco, Esq IRC §7520 Rate5% Grantor’s Age60 Term of Trust10 Annual Growth of Principal5% Pre-discounted FMV$3,000,000 Income Earned by Trust (8% x $3M = $240K)8% Discounted FMV$2,000,000 Percentage Payout (12% x $2M = $240K)12% Payment PeriodAnnual Annual Annuity Payout$240,000 Value of Grantor’s Retained Interest$1,727,208 Taxable Gift Value of Residual Interest in Trust$272,792 Grantor Retained Annuity Trust

© Julius H. Giarmarco, Esq Beginning5%8% AnnualAnnual YearPrincipalGrowthIncomePaymentRemainder 1$3,000,000$150,000$246,000$240,000$3,156,000 5$3,758,783$187,939$308,220$240,000$4,014,942 10$5,425,367$271,268$444,880$240,000$5,901,516 Summary$3,000,000$2,008,150 $3,293,366$2,400,000$5,901,516 Grantor Retained Annuity Trust Economic Schedule

© Julius H. Giarmarco, Esq During Life  FMV of S Corporation = $5,000,000  Dividend Distributions = 10% / year  Corporation’s Growth Rate = 3% / year  Donor’s Life Expectancy = 20 years At Death  FMV of S Corporation = $ 9,031,000  Estate Tax (45%) = $ 4,063,950  Children’s Inheritance= $ 4,967,050 Intentionally Defective Irrevocable Trust (“IDIT”) Do Nothing

© Julius H. Giarmarco, Esq IDIT Recapitalization 1.Recapitalize the S Corporation  Donor owns 10%, voting shares  Donor owns 90%, non-voting shares 2.Obtain a qualified appraisal substantiating a valuation discount for the non-voting shares ranging from 10% to 40%

© Julius H. Giarmarco, Esq S Corporation No DiscountWith 35% Discount 10%$500,000$500,000 voting 90%$4,500,000$2,925,000 Non- voting Donor Retains 100% Voting Control Donor Transfers 90% of Corporation’s value out of his/her estate IDIT Obtain Appraisal

© Julius H. Giarmarco, Esq IDIT Fund Trust 1.Establish Intentionally Defective Irrevocable Trust (“IDIT”)  Power of substitution - IRC §675(4)(c)  Power to borrow without security - IRC §675(3)  Power in non-adverse party to add charitable beneficiaries – IRC §674(b)(5) 2.Gift 10% of shares (all non-voting) to IDIT using $325,000 of gift tax exemption  This “seed” money avoids potential estate inclusion under IRC §2036  Can allocate GST exemption to IDIT

© Julius H. Giarmarco, Esq IDIT Fund Trust 3.Sell 80% of shares (all non-voting) to IDIT  Promissory Note with term of 20 years  Interest payments only (annually) with balloon payment at end of 20 years  IRS assumed interest rate is 5.5% (long-term AFR)  No capital gains tax, and grantor not taxed separately on interest payments 4.Alternatives to an installment note  Private annuity  Self-canceling installment note (“SCIN”)

Donor Paying IDIT’s income taxes is equivalent of tax-free gift Donor retains control as 10% voting shareholder Donor receives $193,000 annually (from interest payment and dividends on the 10% voting shares) Donor pays income taxes of $210,000 ($500,000 x 42%) - for annual short fall of $17,000 IDIT / Dynasty Trust $500,000 FMV $4,000,000 FMV IDIT earns 10% on $4,500,000 = $450,000/ year IDIT pays interest only for 20 years of $143,000 annually ($2,600,000 x 5.5%) Donor gifts 10% of S Corp stock (10% x $5,000,000 = $500,000 less 35% discount = $325,000) Donor sells 80% of S Corp stock (80% x $5,000,000 = $4,000,000 less 35% discount = $2,600,000) IDIT’s Cash Flow $450,000 ($143,000) $307,000 IDIT

© Julius H. Giarmarco, Esq IDIT Cash Flow $450,000 ($143,000) $307,000 IDIT Cash Flow $450,000 ($143,000) $307,000 Excess cash flow could be used for reinvestment, purchase of real estate, and/or purchase of life insurance. IDIT

© Julius H. Giarmarco, Esq Grantor Gifts S Corp Stock $500,000 Sale to IDIT Illustration Grantor Sells S Corp Stock $4,000,000 Taxable Gift $325,000 IDIT Issues Note $2,600,000 Discounted Face Principal & Interest $5,460,000 Value of IDIT in 20 Years $18,419,940

© Julius H. Giarmarco, Esq  Annuity may not be secured.  Each payment is divided into capital gain ($58,065), interest income ($44,953), and a nontaxable recovery of basis ($6,452). Assumes the Section 7520 Rate is 5%.  Child cannot deduct any part of payments.  When parent dies, payments terminate.  Calculation assumes a 16 year life expectancy.  Standard valuation tables may be used if annuitant has at least a 50% probability of living one year. If the annuitant survives for at least 18 months, the 50% test is presumed to have been met. Regs § § (b)(3) and (b)(3). Parent (Age 70) Annual Payout of $109,469 Child Sale of $1M of S Corporation Stock (with basis of $100K) Private Annuity

© Julius H. Giarmarco, Esq Self Canceling Installment Note (“SCIN”)  Instead of a standard installment note, the sale can be paid with a SCIN. In Estate of Costanza, the Sixth Circuit, in a case arising out of Michigan, recognized a SCIN as a bona fide transaction.  A SCIN is an installment note that by it’s terms is extinguished at the death of the seller.  With a SCIN, nothing is included in the seller’s gross estate (similar to a private annuity).

© Julius H. Giarmarco, Esq Self Canceling Installment Note (“SCIN”)  The purchaser must pay a “risk” premium to the seller as consideration for the cancellation feature. However, there is no statutory or regulatory guidance as to how the risk premium should be calculated.  Apparently, the premium can be reflected as an increase in the sales price, or as an increase in the interest rate.

© Julius H. Giarmarco, Esq Self Canceling Installment Note (“SCIN”) IRC §7520 Rate5.00% FMV of Property$2,600,000 Cost Basis$1,000,000 Initial Down Payment$0 Age60 Term of Note10 years Type of NoteInterest Only AFR5.50% Payment PeriodAnnual

© Julius H. Giarmarco, Esq Self Canceling Installment Note (“SCIN”) Risk Premium PrincipalInterest Mortality Risk Premium (Principal)$263,567N/A Total Sale Price$2,863,567$2,600,000 Principal Amount of Note$2,863,567$2,600,000 Mortality Risk Premium (Interest)N/A1.2790% Total Interest Rate5.5000%6.7790%

© Julius H. Giarmarco, Esq IRS Support for IDITs 1.Rev. Rul  There is no capital gain on sales between a grantor and a grantor trust. 2.Rev. Rul  The payment of income taxes by the grantor on behalf of a grantor trust does not constitute a gift to the trust’s beneficiaries.  If an independent trustee has the discretionary power to reimburse the grantor for income taxes, this does not cause the trust to be taxed in the grantor’s estate under IRC Sec. 2036(a)(1). 3.Karmazin vs. Commissioner  This gift tax audit, which was settled out of court, treated a sale to a grantor trust as a bona fide sale.  Trust was funded with 10% seed money.

© Julius H. Giarmarco, Esq  Assumed discount rate is AFR  Only note is included in grantor’s estate  Can allocate GST exemption  End loading with balloon payment IDIT vs.  Assumed discount rate is IRC §7520 rate  All trust assets included in grantor’s estate  Cannot allocate GST exemption because of ETIP rules  Annuity cannot exceed 120% of prior year’s annuity GRAT

© Julius H. Giarmarco, Esq IDIT  Cannot reduce gift to zero because of seed money  Unintended gift may be minimized with a “formula” gift  Potential capital gain if grantor dies while note is outstanding  Non-statutory technique vs. GRAT  Can reduce gift to zero with Walton GRAT  Unintended gift is minimized if annuity is a percentage of FMV  No capital gain if grantor dies during the term  Statutory technique

© Julius H. Giarmarco, Esq “When I go, I plan on taking at least two of my estate-tax lawyers with me.”

© Julius H. Giarmarco, Esq The End. Thank You!