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A GRAT-ful Planning Opportunity with ESOP Replacement Property

May 2007

Use of an Employee Stock Ownership Plan (ESOP) is a common planning vehicle for many business owners who wish to effectuate a business continuation plan in an effective and tax-efficient manner.  The business owner is able to defer capital gains on the sale of his or her stock if the ESOP owns at least 30% of the company stock and the owner reinvests the proceeds in other U.S. operating companies ("replacement property") within twelve months after the sale.  This technique is oftentimes referred to as an ESOP rollover, and there are numerous restrictions imposed by the Internal Revenue Service regarding any transfer or disposition of the replacement properties.  A transfer or disposition of the replacement property will usually trigger gain recognition.     

If the business owner holds onto the replacement properties acquired in an ESOP rollover until death, his or her estate will receive a basis adjustment on the property to its then fair market values, and his or her beneficiaries will avoid any income tax on the deferred gain.  However, the full value of the replacement properties will be includible in the business owner's estate for federal estate tax purposes.

In order to minimize those expected federal estate taxes, the business owner may wish to consider one or more planning options, provided that such option does not unnecessarily trigger gain recognition.  One common planning option to consider is a grantor retained annuity trust (GRAT). 

GRAT Basics:

A GRAT is an irrevocable trust in which you as grantor retain a right to receive fixed payments payable at least annually for a set number of years.  During this term, the trust pays you income.  At the end of the trust term, the assets will be owned by the trust beneficiaries (i.e., your children) and will not be included in your estate when you die. If you should die before the term ends, the trust assets will be includible in your estate for estate tax purposes as if no special planning occurred. 

Accordingly, to reduce transfer tax consequences in growing estates by having future appreciation accumulate outside of the estate for federal estate tax purposes, many taxpayers create GRATs. 

For example, assume a 56 year-old taxpayer creates a 10-year GRAT for the benefit of his children and funds it with $1,000,000 worth of securities. If the taxpayer receives approximately $133,305 as an annuity payment each year during the 10-year term, the trust assets will be worth approximately $977,812 at the end of the trust term (assuming the trust assets grow 6.5% per year and earn 6.5% per year in dividends). 

Under the applicable Internal Revenue Service tables, the value of the taxpayer's gift to the trust is generally the fair market value of the assets transferred less the taxpayer's retained annuity interest for the 10-year term, as reduced to present value.  By structuring the annuity interest in a certain manner, the taxpayer's gift for federal gift tax purposes may be quite nominal or nearly $0. For instance, the expected gift tax owed by our hypothetical taxpayer is $1 (assuming the applicable Internal Revenue Service interest rate at the creation of the GRAT is 5.6%). 

Transfer of ESOP Replacement Property to and from a GRAT:

Recently, in Private Letter Ruling 200709011, the Internal Revenue Service concluded that a transfer of replacement property acquired in an ESOP rollover transaction to and from a GRAT will not trigger gain if the transferor is treated as the owner of the trust for federal income tax purposes.  Specifically, the Internal Revenue Service found:

  • The transfer of the replacement property to the GRAT will not be a disposition of the replacement property.
  • The exercise of the taxpayer's power held during the GRAT term in a non-fiduciary capacity to substitute cash or other replacement property of at least equivalent value will not be a disposition of the replacement property.
  • The transfer of the replacement property to the trust beneficiaries pursuant to the terms of the trust will not result in a recapture of gain deferred in the ESOP rollover transaction.
  • If the taxpayer dies while the GRAT is still in existence, an interim or final annuity payment in the form of replacement property made to his or her successor in interest will not result in a recapture of gain deferred in the ESOP rollover transaction.

However, capital gains taxes will be payable when the replacement property is sold within the trust.

Thus, a taxpayer who has completed an ESOP rollover and acquired replacement property as a result of that transaction may consider creating a GRAT as a way to transfer wealth to the next generation with relatively little or no gift tax costs.

However, caution must be exercised in creating and funding a GRAT with replacement property.  Any taxpayer interested in this technique should consult his or her tax advisor.

This communication is provided as a general informational service to clients and friends of Pedersen & Houpt. It should not be construed as and does not constitute legal advice on any specific matter, nor does this message create an attorney-client relationship. This material may be considered Attorney Advertising in some states. Please note that any prior results discussed in this material do not guarantee similar outcomes.

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