How Estate Freeze Trusts Work


An estate freeze trust can help them keep all of their eggs in the proverbial basket.
An estate freeze trust can help them keep all of their eggs in the proverbial basket.
Chris Hondros/Getty Images

It's a story as old as theater itself. A cloud of doom descends upon a family farm. The landowner has just died, leaving behind all kinds of financial messiness. Enter the evil tax baron who swoops down on the unsuspecting relatives and demands payment of back taxes. Of course, the heirs are either unaware of their rights or unable to pay and, thus, forfeit the homestead that has been in their family for centuries.

Fortunately, life does not imitate art in every aspect. In the event of a death of a family member, or a senior owner of a family business or farm, an Estate Freeze Trust (EFT) can establish a plan for minimizing taxes and prevent surviving children from assuming an overwhelming tax burden. It also provides the family with a tangible what if contingency in the form of a succession plan. A succession plan is simply the continuation of a family business by the next generation of family members after the senior member dies or retires.

An Estate Freeze Trust is an integral part of an estate plan that helps minimize taxes on the future appreciation of certain assets. For example, if a family business holds a stock long-term and it appreciates even 6 percent each year, the tax liability to the surviving heirs could be astronomical.

Simply put, the reason for creating an Estate Freeze Trust is to shield tax liability (the amount of tax an individual or company owes) and keep family businesses in the family.

To find out how wills and trusts work with EFTs and how EFTs can reduce tax liability, check out the next page.

Types of Estate Freeze Trusts

President Bush listens to Steve Preston, administrator of the Small Business Administration, speak about National Small Business Week on April 23, 2008. National Small Business Week is a good time to organize a healthy succession plan.
President Bush listens to Steve Preston, administrator of the Small Business Administration, speak about National Small Business Week on April 23, 2008. National Small Business Week is a good time to organize a healthy succession plan.
Saul Loeb/AFP/Getty Images

In 1990, the United States Internal Revenue Service repealed the complex tax code IRC Sec.2036(c) and added a provision known as Chapter 14 to the estate, gift and generation-skipping sections of the IRS tax code. Chapter 14 applies to the preserving or transferring of control in a family business.

In the past -- before Chapter 14 -- EFTs allowed family business owners to exchange most of their common stock (with voting rights) for preferred stock (with no voting rights) and give or sell any remaining shares to their families. The business owner could then retire and live off the dividends (payments) from the preferred stocks. The trust liberated members of the next generation from the heavy tax liability, freeing them carry on the family business.

Family-owned businesses incur a higher gift and estate tax rate than other businesses. Without careful planning, some companies may still have to liquidate assets in order to pay taxes. It's a good idea to talk to a professional.

If you decide to use an estate freeze trust to protect your family business, there are many different ones out there depending on what you need.

  • You might create an annuity to give your beneficiaries an income stream but shield them from gift taxes.
  • In a Grantor Retained Annuity Trust, you give your property to a trust that provides income to you (as an annuity) while you're alive. Your annuity is based on the value of the property when you create the trust; your beneficiaries profit when the property appreciates.
  • You can give property to beneficiaries, but couple it with an annuity or a unitrust -- which entitles the beneficiary to payments over time and thereby reduces the gift's current tax liability.
  • In installment sales, your beneficiaries essentially buy their inheritance over time. This may be appropriate if you expect the property to appreciate greatly (for example, if the property is company stock).
  • In installment sales to Intentionally Defective Grantor Trusts (IDGTs), you pay your beneficiaries' income taxes. Be aware that an IDGT may open you to heightened IRS scrutiny.

Hopefully one of these plans will help you save your family business in order for you to turn it over to your heirs. Of course, as with any matters of finance, it's best to speak with a professional to get advice to best suit your needs. In the meantime, see the links on the next page to get more information on estate freeze trusts and other financial topics.

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More Great Links

Sources

  • Breed, Richard P. "New Chapter 14 Rules Affect Buy-Sell Agreements." FindLaw.com. 1999. http://library.findlaw.com/1999/Aug/1/126131.html
  • Fiala, David M. "Business succession planning: a new ball game." The National Public Accountant, 19910801. August 1, 1991. http://www.allbusiness.com/marketing-advertising/marketing-promotions/252421-1.html
  • Keiser, Laurence. "Thaw on estate freezes: the repeal of Section 2036(c) (Internal Revenue Code)." The CPA Journal. April 1991. http://www.nysscpa.org/cpajournal/old/10691643.htm
  • Mintz, Robert J. "Estate Freeze Trust." Asset Protection Law Center. 1996-2003. http://www.rjmintz.com/estate-freeze-trust.html
  • Rosen, Jan M. "Tax Watch; Family Business In a Legal Tangle." The New York Times. October 2, 1989…http://query.nytimes.com/gst/fullpage.html?res=950DE7DA1239F931A35753C1A96F948260&sec=&spon=
  • Sloan, Stephen R. "Ten Strategies for Reducing Estate Tax." Vancott Magazine. 2007. http://www.vancott.com/news/articles/104
  • Wiggin and Dana. "Estate Freeze Techniques." Wiggin and Dana Publications. Winter 2000, Vol. 2, no. 4. 2000 http://www.wiggin.com/pubs/advisories_template.asp?ID=1354157212000