The low interest rate of recent years has created a potentially favourable environment for owners of family businesses to transfer ownership to the next generation by reducing transfer and interest costs, but reviewing the history of the federal interest rate indicates that the rate may be set to climb soon.
Parents wanting to pass on the torch, or even just increase their heirs’ investment in the family business have a few options to transfer stock to their children while mitigating transfer costs.
Transferring ownership as a gift to the next generation requires planning. One way to gift an asset without generally incurring gifting costs is by creating a grantor retained annuity trust (GRAT), which typically allows the owner to transfer the asset to the trust and take an annuity income in exchange for a few years. A GRAT allows the transfer to take place without the seller having to pay gift taxes (assuming the GRAT is zeroed out). Zeroing out the GRAT requires the owner to take back the value that was transferred into the GRAT along with an amount equal to the assumed rate of growth on those assets, which is based on the rates provided under Internal Revenue Code section 7520 (the “7520 rate”).
This “7520 rate” calculates the rate for a certain month as 120% of the applicable federal mid-term rate and rounded to the nearest two-tenths of one percent. As mentioned in the introduction, these rates are at historical lows.
Once the 7520 rate is calculated, this is then compared to what the assuming the growth of the business is currently yielding, and if all is favourable can exceed this assumed rate of growth, then the excess can be transferred, then the transfer can happen without incurring any a gifting gift taxes at all. This can be an effective is a very successful way of transferring to transfer the business on to the next generation, but depends greatly on low interest rates in order to be effective. Once interest rates go up, such a system will no longer appear as attractive.
Certain business owners may prefer not to simply give control of the business to their children, and may choose instead to sell shares to family members who are active in the business, in order to promote a sense of worth and earned ownership.
The current low interest rates allow for favourable intra-family sales, meaning that owners may be able to mitigate transfer costs to secure ownership into the next generation.
Owners wanting to bring the next generation into the family business may consider taking advantage of the current low interest rates by setting up a fixed-interest loan to their child set over a period of more than nine years. This would allow the child to continue to benefit from the current interest rate, even if it rises in the future.
As long as the business has sufficient cash flow, the child receiving this loan should be able to pay back the annual interest accrued, as well as benefit from the growth of the business.But as stated previously, interest rates may be rising soon, to it may be time to begin thinking about succession planning before interest rates.