Todd’s client was the founder and sole owner of a manufacturing firm in the
Midwest. His product was very popular,
but he did not have the financial resources to expand the company to reach its
full potential. The client entered into
a deal with an investment banking firm to start positioning the company for a
public offering. As a result of that
deal, the investment banking firm owned a 52% equity interest in the company,
and he retained a 48% equity interest in the company
Frost Brown Todd
met with the client and his wife shortly after the deal with the investment
banking firm was finalized. The client
knew that the company would likely go public within the next two years, and
wanted to start some estate planning, anticipating a significant increase in
their wealth. This was somewhat unique,
in that many business owners will not think of the estate planning aspects
until after a sale or public offering is completed, when the wealth shifting
opportunities are not as significant.
wanted to be sure they would have sufficient financial resources for the rest
of their lives, but they also did not want to “spoil” their three children, all
of whom were minors at the time. They
also had a significant interest in charitable causes.
that our client consider an installment sale of a portion of his equity in the
company to an irrevocable “grantor” trust, which would be consummated well in
advance of the public offering. We
explained the aspects of this Irrevocable Trust:
- The assets of the Irrevocable Trust would be sheltered from
estate taxation at the deaths of our client and his wife. In order to assure that the assets would also
be shielded from estate taxation for multiple generations, we retained the
services of a corporate trustee in a state which would permit the Irrevocable
Trust to continue for multiple generations.1
- We included certain features in the Irrevocable Trust
which would cause the income generated by trust assets to be taxed on the client’s
individual income tax return, rather than being taxed to the Irrevocable
Trust. This was important so that the
client would not have to recognize capital gain when he would sell the stock in
the company to the Irrevocable Trust.
- The trust assets would be sheltered from the claims of
creditors of the client, his wife and the children and grandchildren.
- The trust assets would be shielded from the claims of a
divorcing spouse of a child or grandchild.
Like most couples, they were almost more interested in this feature than
the significant future estate tax savings!
After the client and his wife indicated that they liked
the concept, we built a spreadsheet to assist them in understanding how the
cash flow would work with this technique, and to decide how much of the
client’s remaining equity in the company should be sold to the Irrevocable
Trust. After examining many different
scenarios, they ultimately decided that they wished to transfer 20% of their
48% equity interest in the company to the Irrevocable Trust, and they would
retain the other 28% of their 48% equity interest.
We started with drafting the Irrevocable Trust. The client and his wife agreed that we should
have separate shares for each of the three children, because we didn’t want the
children to have to agree (or disagree) in the future on the investment of
trust assets, the rate of spending, and similar issues.
- We included features which would allow the children to become
trustees of their own separate trusts at appropriate future ages.
- We detailed where assets would pass if no grandchildren were
- We included a provision which would allow a child to include his or
her spouse as a beneficiary at the child’s death if the child so desired,
but guaranteeing that the assets for the spouse would return to the family
upon the spouse’s death or remarriage.2
- We included provisions which would allow appropriate advisors to
change the terms of the “Irrevocable” Trust in the future, as family
circumstances, financial circumstances and tax laws change.3
- We included provisions which would permit the trustee to acquire the
stock of the company, even if the trust assets consisted almost entirely
of that one asset. We also
permitted to trustee to acquire non-traditional investment assets in the
future, including closely held businesses, artwork and vacation
We hired an appraiser to determine the value of the 20%
interest in the company that the client was going to sell to the Irrevocable
Trust. Taking into account the fact
that this was a minority interest in the company and was not liquid, the
appraiser determined that the value of that 20% interest was $4,000,000. Knowing that the IRS likes to see at least
10% equity in these transactions, we decided to have the client and his wife
make an initial “seed” gift of cash to the Irrevocable Trust of $600,000. We instructed the accountant to file gift
tax returns for them, using $300,000 of each of their lifetime gift tax credits
to shield the gift from gift taxation.
We also had the accountant allocate $300,000 of each of their generation
skipping exemptions to this gift, which would protect the trust assets from
estate taxation and gift taxation for multiple generations.
The next step was the sale of the 20% interest in the company
by the client to the Irrevocable Trust at a price of $4,000,000. The Irrevocable Trust paid him a down payment
of $500,000, and delivered to him its promissory note in the amount of
$3,500,000 requiring equal annual payments of principal and interest4
over a nine year period. The repayment
of that note was secured with a pledge of the stock by the Irrevocable Trust in
favor of the client. The Irrevocable
Trust also had $600,000 of equity from which the client could satisfy his
claims if the Irrevocable Trust defaulted on the note. All of this made the transaction
“commercially reasonable.” At the same
time, the client’s cash reserves were only depleted by the $100,000 cash which
remained in the Irrevocable Trust after he received the down payment.5
The company went public more than a year after we completed the
sale transaction. After the company went
public, the Irrevocable Trust was subject to a two year holding period for the
stock. To everyone’s delight, during
that two year period, the 20% stock position (which was diluted in the public
offering) rose in value from the appraised value of $4,000,000 to over
$35,000,000. After the two year holding
period expired, the Irrevocable Trust began liquidating its position in the
company, and some of the proceeds were used to repay the principal and interest
on the promissory note.6
After the Note was paid and the client and his wife had a chance
to review the results of the transaction, they grew concerned with their
children having too large an inheritance.
They were very concerned that their children not be exposed to too much
wealth, and that they have the incentive to work and be contributing members of
society. The client and his wife also
had some very significant charitable interests.
Four years after we completed the transaction, the client and his wife
created a family charitable foundation and requested that the trustee of the
Irrevocable Trust use its discretion as trustee to transfer $10,000,000 of its
assets to the charitable foundation.
This left about $21,000,000 in the Irrevocable Trust, and they felt that
$7,000,000 for each of their children was enough for their children for the
rest of their lives. Knowing that those
funds would pass free of estate taxation to their grandchildren at their
children’s deaths, the client and his wife also changed their other estate
planning documents to provide that the assets which they retained
(approximately $40,000,000) would also pass to the charitable foundation at the
death of the survivor of the client and his wife, free of estate taxation.
- Each child has a separate trust with
$7,000,000 which will grow through the years, providing cash flow to the child
for the rest of the child’s lifetime.
At the child’s death, that child’s separate trust will pass to that
child’s children free of estate taxation.
The trust also protects the child from lawsuits, creditor claims and
divorce during the child’s lifetime.
- The client and his wife have $40,000,000
that they fully control for the rest of their lives.
- At the death of the survivor of the client
and his wife, the family foundation will be fully funded with $50,000,000, and
the children will run that foundation for the rest of their lives.
- What is the estate tax bill for this family? Zero!
The key to making this
work effectively was early action by the client and his wife in getting us
involved. If they had waited to
implement this until after the company had gone public (or until after a letter
of intent had been signed in a private sale of their company), the tax savings
would have been far less.
 The state where the client and his wife live had a
traditional “rule against perpetuities” at the time, which would not permit the
trust to continue for multiple generations.
This is not a problem for residents of Ohio, Kentucky and many other
Some clients like this feature and we include it, and other clients do not like
this feature, and we exclude it.
3 None of the client, his wife or their
children could hold this power.
4 Interest is determined in accordance
with IRS tables. As an example, for a
nine year note with annual payments in September 2011, the interest rate is
5 This $100,000 cash reserve in the Irrevocable Trust was intended to
assure that cash would be available to meet the interest obligation on the note
in year 1 and to pay trustee fees.
6 The Note could have been kept in place, with the
Irrevocable Trust meeting its payment obligations over the nine year term of
the Note, but the client and his wife decided to prepay the entire balance due.