1. Transferring Wealth to
Children:
A Primer for Business Owners
White Paper
Business owners struggling with the issue of three questions:
passing wealth to children would do well to 1. How much wealth do you want?
revisit their original exit objectives, namely, “How 2. How much wealth do you want the kids
much money do you wish to have after the sale to have?
of your business?” Using that piece of
3. What tools minimize the Estate and Gift
information as a starting point, you can then
Tax consequences of transferring
move to the issue of “How much wealth should
wealth?
the children have? How much is too much?”
To illustrate how one fictional business
Once those questions are answered, the
owner answered these questions, let’s look at
business owner can then design a transfer
the case of George Delveccio, a composite of a
mechanism that will pass the wealth to the
number of successful business-owning clients.
children with minimal tax impact.
George opened our meeting almost
These, then, are the three subjects of this
apologetically. “I knew I’d waited too long to
White Paper.
begin gifting part of the company to my kids
1. Fixing the owner’s financial objectives when I met with my CPA. She told me that the
before considering a wealth transfer; company could be worth as much as $12 million
2. Determining the amount of wealth to be to a third party. I had no idea! Since I don’t need
transferred (and determining how much that much, I want to transfer at least half the
is too much); and value—at a lower valuation of course—before
3. Designing a wealth transfer strategy that any possible sale. My CPA suggested gifting
keeps the IRS from becoming the small amounts of stock using my $12,000
largest beneficiary of your hard-earned annual exclusion and perhaps part of my lifetime
cash. gift exemption. She believes that additional
strategies might allow me to increase the
These three subjects can be framed as amount of my gift without paying gift taxes so
©2007 Business Enterprise Institute, Inc.
rev 01/08

2. she suggested that I meet with an experienced three basic issues (already mentioned above)
estate planning or tax attorney.” that must be resolved for successful Wealth
George’s attorney pointed out that the use of Preservation Planning to occur.
the $12,000 annual gift exclusion and the early
use of the $1 million lifetime gift exemption were ISSUE ONE
sound ideas, but, used alone, could not facilitate How Much Wealth Do You Want?
the transfer of a significant amount of wealth to The primary decision every business owner
his children. Even combining George’s and his makes when transferring wealth to children is
wife’s annual exclusion amounts with their full not how to accomplish the transfer, (that’s the
lifetime gift exemptions, the transfer to the kids estate planner’s job) but how much wealth to
would amount to less than $2,024,000. transfer to the children. Answering that question
The deficiency of this plan was further requires that you first revisit your own exit
accentuated when George was asked what he objective; namely, how much wealth you wish to
thought the future held for his business. In his have after you exit your business. The amount
words, “The sky’s the limit.” This was telling of wealth owners wish to leave their children
given George’s occupation—he owned an air usually (but not always) depends on how much
freight expediter business. He strongly believed the owners wish to keep after they exit their
that the company’s cash flow would continue to business. As a general rule, we discourage
grow, from its current $12.5 million, by at least parents from making significant gifts to children
25 percent per year for the next three years. until their own financial security is assured. Only
“And that’s what worries me. Given how after the parents’ needs are met do we ask how
much more valuable my business will be in a much is enough—or too much—for the kids.
few years, won’t it be even more difficult to The first step in the Seven Step Exit
transfer wealth to the kids? What I need to know Planning Process™ is for owners to determine
is how I can give my kids as much as possible their objectives. Owners who fail to do so are
without paying any taxes.” rarely able to leave their businesses in style.
Believe it or not, this was exactly what The three retirement objectives that every owner
George’s attorney was hoping to hear. The must fix are best phrased as questions:
attorney explained, “The more rapidly your
1. How much longer do I want to work in
business is growing in value...the more cash it
the business?
spins off...the easier it is to give wealth away
2. What is the annual after-tax income I
and give it away quickly—with little or no gift tax
want (in today’s dollars) during
consequences.”
retirement?
But George, like many owners, was paying
3. Who do I want to transfer the business
too much attention to the wrong issue. The
to?
attorney suggested that George focus on the
As you can see, answering the second
©2007 Business Enterprise Institute, Inc.
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3. question establishes personal financial goals but their spouse’s) access to wealth. This is true
it also provides the takeoff point for how much regardless of the amount of wealth the parent
money the owner can afford to leave to children. wishes to transfer. Let’s look at the steps in a
Many owners draw upon the expertise of their typical “access/control” scenario.
financial planner or insurance advisor to work
through these questions. Typically, these CONTROLLING ACCESS TO WEALTH
advisors run through a number of “what if” Step One. First, the parents form a limited
scenarios using different variables. The goal is liability company (LLC) or family limited
to determine how much money you will need partnership (FLP) in which the parents own both
from the sale of your business. the operating interest (or general partnership
ISSUE TWO interest) and the limited partnership interests.
How Much Wealth Do You Want the Kids to Limited partners have no ability to compel a
Have? distribution, to compel a liquidation of the
For many successful business owners, the partnership (or LLC), or to vote. In short, limited
question of how to leave as much money as partners enjoy few rights and have no control.
possible to children begs the more important
question. Given the huge (and perhaps Step Two. Children’s trusts are created for
unexpected) financial success of the business, the benefit of each child. The trusts will
the real question is how much money should the eventually own the limited partnership interests.
children receive and how much is too much? As A child will be entitled to receive distributions
George put it, “I want to give the kids enough from the trust based on guidelines, parameters
money to do anything, but not enough to do and restrictions that the parents prescribe in
nothing.” A noble sentiment, to be sure, but one each trust document.
difficult to execute—at least without careful These restrictions can be of several different
planning. In George’s case, he preferred his types.
children receive nothing to the prospect of
• Perhaps the most common restriction limits
creating “trust babies.”
a child’s right to gain access to funds held in
When owners wrestle with this question, it is
the trust. Typically distributions are made
good to remember that children need not receive
over a series of ages, for example one-third
money outright. Rarely are large amounts of
of the trust principal at age 30, one third at
wealth transferred to children freely or outright.
age 40, and balance of the trust principal at
Instead, access to wealth is restricted through
age 50. The intent is that as children reach
the use of family limited partnerships (or limited
these ages, they will be sufficiently mature
liability companies) and the use of trusts. These
to handle the assets. Further, if a child
tools are primarily designed to reflect the
mishandles an early distribution, he will
parents’ desire to restrict their children’s (and
learn from his mistakes and will not repeat
©2007 Business Enterprise Institute, Inc.
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4. them with later distributions. At least that’s child’s other sources of income are
the idea. depleted. This type of a trust is commonly
• Tying trust distributions to children to the called a “Dynasty Trust”—or generation
child’s achievement of written standards skipping trust since any assets remaining in
contained in the trust is increasingly popular. this type of a trust after a child’s death
These standards can take many different usually pass, tax free, to that child’s
forms. children.
• Parents may base trust distributions on The variety of restrictions parents can
a child’s earned income. For example, if place upon a child’s right to receive money is
a child earns $60,000 annually in her limited only by imagination and any decision
employment, she would be entitled to upon the degree of restriction. Keep in mind,
receive an equal amount or some other however, that someone—known as the
percentage from the trust. Trustee—needs to interpret, administer, invest,
• Distributions may be tied to the child’s and make distributions according to the
activities. For example, a parent may provisions of the trust.
wish to distribute money to children who Your choice of trustee is at least as
engage in (what the parent believes to important as the trust design. The constraints of
be) socially useful activities: teacher in a this White Paper prevent a full discussion of
public school, an artist, a writer, an Exit desirable trustee characteristics and attributes.
Planning Advisor. However, consider the following questions:
• Some parents require a child to enter • What degree of discretion do you wish to
into a premarital agreement before give the Trustee to make distributions to the
receiving any distributions from the trust. children?
• Parents may forbid children from • How long does the trust last?
receiving any distributions they would • What is the value of the trust assets?
otherwise be entitled to if convicted of a
• What type of asset is in the trust? If an
crime or addicted to an illegal
operating business interest is to be owned
substance.
by the trust, the choice of Trustee may well
• Many parents create “safety nets” for their be different than if the trust is comprised of
children by giving children access to most of investment assets.
the wealth during their lifetimes (in the form • Should the trustee be a family member?
of outright or periodic distributions) but • Who will be entitled to remove the Trustee
retaining some portion in trust for the child and for what, if any, reason?
for the duration of the child’s life. This
retained money is to be used only if all of a Step Three. After determining the restrictions
©2007 Business Enterprise Institute, Inc.
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5. they want in place, the parents transfer the foundations or give money to other charitable
limited partnership interests or non-voting organizations.
interests into each child’s trust. At this point the Here’s the net result.
parent is making a gift of the value of the limited
• The children receive what the parents
interest to the child.
want them to receive—during the
Unfortunately, parents with large estates
parents’ lifetimes;
often abandon the planning process at this stage
• The parents enjoy 100 percent of the
because they believe they can only transfer their
wealth remaining as long as either
combined lifetime gift exemptions (roughly $2
parent survives;
million) to their children without incurring
• After both parents die their wealth
immediate tax consequences. As demonstrated
transfers to a charity of their choice—
in Issue Three, however, parents are often able
such as their own private foundation.
to transfer as much wealth to children as they
And last, but not least,
desire. Once again, the toughest issue for
• The IRS gets nothing. For many parents
parents to address is: How much, when, and
and business owners this is an estate
under what conditions should kids receive the
plan design worthy of close scrutiny. For
dough?
George Delveccio, a man with strong
charitable interests, this was the estate
Planning Can Benefit Charity As Well
plan design that he chose to implement.
There is one additional planning
consideration that should be mentioned here.
ISSUE THREE
Under current estate tax law one spouse can
What Tools Minimize the Estate and Gift Tax
leave assets at his/her death to the other spouse
Consequences of Transferring Wealth?
without estate tax consequences. For most
The key to transferring large amounts of
estates, taxes are assessed only at the death of
wealth was discussed 2000 years ago by the
the surviving spouse. If, during their lifetimes,
patron saint of estate planning attorneys,
parents are able to give their children (and other
Archimedes. Regarding leverage he observed,
heirs) as much wealth as they wish the children
“Give me a place to stand and I will move the
to receive, it is then possible to design an estate
earth.” Using leverage to move the earth or to
plan that gives the balance of the wealth at the
move your wealth is the key to achieving
first parent’s death to the surviving parent. When
noteworthy results. As we have discussed, each
the surviving parent dies, his/her loved ones
U.S. resident can give away, during lifetime, $1
(yes, your children!) will have received all of the
million as well as $12,000 annually.
wealth the parents wanted them to receive and
In George’s case, his CPA (also a Certified
the balance of the estate can be transferred to
Valuation Analyst) valued the business at $9
charity. Some families establish private
million, a conservative but supportable valuation.
©2007 Business Enterprise Institute, Inc.
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6. The company’s stock was recapitalized into determined number of years. At the end of this
voting and non-voting stock. Based on current time period, which is established when the trust
Tax Court case law, the CPA could justify is created (usually two to ten years) any stock
discounting the value of non-voting stock (or a remaining in the trust is transferred to the
gift of a minority interest of the voting stock). In children. A gift is made when the stock is
her opinion, the minority discount was 35 transferred into the GRAT. The amount of the
percent of the full fair market value of the stock. gift is the value of the asset transferred minus
Thus, she reduced the size of the “earth” by 35 the present value of the annuity which the owner
percent, and Archimedes was well on his way to will continue to receive. To calculate this present
leveraging the use of the Delveccio’s lifetime value the IRS requires the use of its federal
exemption amount. midterm interest rate (currently about five
Even with the 35 percent discount, however, percent). The owner acts as the Trustee (the
a gift of 50 percent of the company (now person in charge of the management of the trust
reduced to approximately $3 million in value) assets, in this case the stock of the company).
would exhaust George’s and his wife, Eunice’s, Using George as an example, he transfers
combined lifetime gift exemption amounts of $1 his nonvoting stock, valued at $3 million, into his
million each as well as cause the payment of a GRAT. The amount of the gift is determined
gift tax of approximately $400,000. when the GRAT is funded. For Delveccio, we
Like every other business owner, George designed a GRAT, funded it with $3 million of
was not particularly keen on paying a tax of stock and required a $1 million annual payment
$400,000. So he didn’t. And he still gave away for four years. Recall that the $1 million
50 percent of the company to his children. He distribution amount is the amount of dividend
did so by using the biggest lever in Archimedes’ distribution the company normally made with
arsenal—the biggest lever in the “Wealth respect to one-half of the stock. Consequently,
Preservation Transfer Game”: a “GRAT”—a all of the stock originally transferred to the GRAT
Grantor Retained Annuity Trust. will still be there after four years.
How GRATs Work. The IRS, however, must assume that a $3
After first obtaining a professional valuation million asset will produce only $150,000 of
of his company George created a GRAT. A distributions/growth a year. (It bases that
GRAT is an irrevocable trust into which the assumption on its current five percent Federal
business owner transfers his stock. George mid-term interest rate.) Consequently, to design
transferred all of his non-voting stock--which the GRAT to generate an annuity payment of $1
represented 50 percent of the overall ownership million per year means that the GRAT
interest in the company. theoretically distributes—using the IRS's interest
The GRAT must make a fixed payment assumptions—roughly $850,000 of the GRAT’s
(annuity) to George each year for a pre- principal (the nonvoting stock) in the first year of
©2007 Business Enterprise Institute, Inc.
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7. the GRAT. In each of the ensuing three years, million and $12 million to his children in
even more principal will be distributed to satisfy four years without using his lifetime
the annual annuity payment until (theoretically) exemption.
the principal of the GRAT is exhausted. As you 2. He continued to receive all of the
can see, if the IRS’s five percent assumption is income from the company during that
correct, all of the GRAT assets must be four-year period.
distributed to satisfy the annual $1 million 3. At the termination of the trust (four
annuity payment. years) the trust asset, consisting of non-
Of course, if George’s company maintains voting stock, was transferred to trusts
its capacity to pay its regular distribution of $1 for George’s children. These trusts were
million with respect to 50 percent of the stock, all in turn established by George when the
of the stock will remain in the GRAT after the GRAT was created and contained his
four-year GRAT term. wishes regarding when, and if, the
For gifting purposes, however, George is children were to receive money from
entitled to use the IRS’s interest assumption. those trusts.
This results in nothing being left in the GRAT,
and therefore no gift was made at the time the Epilogue
GRAT was created. In George’s situation, when The assets in George Delveccio’s estate did
the GRAT terminates four years hence, the indeed continue to grow. He was able to transfer
remaining stock (in this case ALL) is transferred wealth equal to $3 million to each child in trust.
to the children without further gift consequences. After the business was sold, he and his wife,
The children receive one-half of the company at Eunice, were able to invest $5 million, far more
no gift tax cost. than required to maintain their relatively simple
The key to making a GRAT work well is to lifestyle. In fact, George and Eunice have made
have an asset which appreciates in value and/or tentative plans to establish a foundation and
produces income (or grows in value) in excess give additional wealth during their lifetimes to the
of the Federal mid-term interest rate. Most charities of their choice.
successful businesses easily exceed this IRS-
mandated threshold. This is especially true
when we design the gifting to take advantage of
the additional leverage in the form of using a
minority discount on the original transfer of the
business interest to the GRAT.
Let’s summarize what George did:
1. He transferred one-half of a business
with a fair market value of between $9
©2007 Business Enterprise Institute, Inc.
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