The implementation of advanced planning strategies to: (1) reduce or eliminate capital gains tax; (2) reduce future estate tax; and (3) increase asset protection from creditors and lawsuits should be on every founder, owner, and investor’s mind. All strategies revolve around time and the amount of equity ownership an employee or investor has in the company. The most relied upon considerations to keep in mind while envisioning planning strategies— to save money on taxes in the long-run are:
- What stage is the company in its life cycle?
- What is the value of your shares?
- What are your current and future wants and needs?
What is QSBS?
Qualified Small Business Stock (QSBS) provides for up to a 100% exclusion of Capital Gains taxes. The QSBS regulations are located in Internal Revenue Code (IRC) Section 1202 and include criteria for both the corporation to qualify as a Qualified Small Business and criteria for the investor to determine how much of their gain may be eligible for tax exclusion.
What is a Grantor Retained Annuity Trust?
A grantor retained annuity trust (GRAT) is a financial tool used in estate planning to reduce taxes on substantial monetary transfers to family members. An irrevocable trust is established for a specific term—or amount of time—under these plans. When a trust is founded, the person who establishes it pays a tax. Then the assets are deposited in the trust, and an annual annuity is paid out. When the trust ends, the assets are distributed to the recipient tax-free.
Although they are set up for a specific amount of time, trust makers have the ability to pass down a substantial amount of wealth to future generations with minimal or no tax liabilities.
Benefits of a GRAT
This technique allows the founder to reduce their estate tax liability by distributing wealth beyond their estate, especially without having to pay gift taxes or use a lifetime gift exemption. It’s particularly useful when a situation occurs and a person’s lifetime gift tax exemption has been exhausted. This is an effective method for minimizing a founder’s tax exposure—whether gift or estate—for future significant “unicorn”/rapid growth stakes.
The creator (grantor) of the GRAT transfers assets to the GRAT and receives a stream of annuity payments in return. These annuity payments are calculated using the IRS 7520 rate, which is now quite low. After all of the annuity payments have been made back to the founder, there will be an excess remaining amount in the GRAT, only if the assets deposited into the trust increase faster than the IRS 7520 rate.
This excess amount will be the money that is exempt from the founder’s estate and can eventually be transferred to beneficiaries or kept in the trust estate tax-free. This remaining sum can grow to be multiples of the original contribution value over time. If you have some company stock that you believe will appreciate in value, transferring those shares to a GRAT and allowing the appreciation to occur within the trust might be highly beneficial.
You can transmit all of the additional gift and estate tax-free from your estate to your beneficiaries this way. Furthermore, because the GRAT is set up as a grantor trust, the founder can pay the trust’s taxes, making this method even more effective.
One thing to keep in mind is that for the method to work, the grantor must endure the entire term length of the trust. The strategy cannot withstand death of the grantor prior to the end of the term, in which case part or all of the assets stay in the estate as if a GRAT was never formed.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.