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 an Intentionally Defective Grantor Trust?
An intentionally defective grantor trust (IDGT) permits a trustor to separate income tax treatment from inheritance tax treatment on certain trust assets. This trust is set up with a “built-in” incentive that allows the grantor to keep making payments on income taxes concerning certain trust assets, even though those assets have been transferred from the individual. This strategy works because income tax laws do not acknowledge that those assets have been isolated.
Because the grantor is responsible for paying taxes on all trust income on a yearly basis, the assets in the trust can grow tax-free, avoiding gift taxation for the grantor’s beneficiaries. As a result, it’s a way to avoid paying estate taxes. This type of trust is especially useful when the trust beneficiaries are children or grandchildren, and the grantor has paid income tax on the increasing assets that they will inherit.
What are the benefits of an IDGT?
Comparable to the GRAT, it allows the founder to transfer wealth beyond their estate to reduce their estate tax liability; however, there are some major differences between these two trusts. One of the differences is that the grantor must “seed” the trust by contributing 10% of the asset worth to be transferred; this method necessitates the use of a gift tax or lifetime gift exemption.
The trust buys the remaining 90% of the value to be transferred in exchange for a promissory note. This purchase is not taxable in terms of income tax or QSBS. The key advantages are that the grantor moves assets into the trust and receives an interest-only note instead of annuity payments, which demand greater payments. However, because it is an interest-only loan, the payments are much smaller.
Another significant difference is that the IDGT is more flexible than the GRAT and can skip generations. The IDGT is a better choice than the GRAT if the intention is to minimize generation-skipping transfer tax (GSTT). This is because assets are measured for GSTT purposes when they are donated to the trust before appreciation, rather than after appreciation for a GRAT.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.