Grantor Trusts: A Path to Employee Ownership

by Christopher Michael

Originally published in the October 12, 2015 issue of Tax Notes (149:2); reprinted in the 2016 edition of the New York University Review of Employee Benefits and Executive Compensation

This article outlines a method of transferring ownership of a company to employees. The specific technique used is the intentionally defective grantor trust (IDGT), a common estate-planning tool. Since 1985 the IDGT has been a reliable method for transferring assets to family members without incurring capital gains, gift, or estate taxes. IDGTs may also be applied to employee ownership. IDGTs offer the following advantages vis-à-vis traditional employee stock ownership plans: (1) perpetual employee ownership; (2) suitability for corporations and limited liability companies; (3) reduced transaction costs; (4) exemption (not deferral) of federal and state capital gains tax; (5) no repurchase liability; (6) the advantage of not necessarily being covered by ERISA; (7) no 30 percent floor for stock transactions; and (8) the opportunity to sell the company at a premium. Finally, vis-à-vis democratic ESOPs (DESOPs), the IDGT offers the following advantages: (1) democratic employee voting of registration-type securities; (2) industry-specific selection of probationary period; and (3) inclusion of seller, seller’s family, and 25 percent shareholders.

The essential structure of an IDGT business transfer is as follows: The grantor creates a grantor-owned trust, ‘‘sells’’ its stock to the trust, and takes a loan note from the trust. In 1985, the IRS ruled that type of transaction is not a taxable event: A single taxpayer cannot sell property to itself.1 No capital gain is recognized. No gift is recognized. And interest on the note is not recognized.

To achieve that outcome, the trust document must attribute ownership to the grantor. This is done in one of several ways that are pertinent to employee ownership:

1. any person has the right to add beneficiaries2 designated to receive the corpus;3

2. a non-adverse trustee has the right to apply trust income to the payment of life insurance premiums for the grantor or grantor’s spouse;4

3. the trust’s corporate shares are controlled by anyone acting in a nonfiduciary capacity, for example, current part- and full-time employees;5 or

4. the grantor retains6 a reversionary interest in the corpus.7

Any of those techniques will shift recognition of all tax attributes of the trust to the grantor’s personal income tax return. In doing so, the transfer will be viewed as a nontaxable event and will have all the benefits described above.

However, the method would be lacking, if the grantor remained liable for the trust’s taxes. To this end, the trust document might include a nonmandatory provision that allows the trustee to reimburse the grantor for any trust-related personal income tax. These reimbursements would have no tax consequences. Alternatively, the trust document could include a mandatory provision that requires annual tax reimbursement — however, such a provision would cause the full value of the trust’s assets to be included in the grantor’s estate.8 Finally, the trust should terminate grantor status after payment of the note is complete to avoid any future personal income tax liability to the grantor, and in the case of a mandatory tax reimbursement clause, to remove the trust’s assets from the grantor’s estate.9

Regarding the sale price, the IRS must view the sale as commercially reasonable to avoid gift tax. A qualified professional should perform a valuation of the company stock. Of course, a valuation for the purpose of an IDGT is not subject to the same requirements as an ESOP valuation. An IDGT valuation permits some flexibility and, depending on the nature of the transaction, may warrant a premium.

The promissory note itself is traditionally structured as an installment sale with interest-only payments and a balloon payment at the expiration of the term.10 No arbitrary limits exist on the term of years, and the interest rate should be equal to or greater than the minimum applicable federal rate at the time of the sale.11 The trust document should be drafted to allow the trustee to prepay without penalty.12 And again, the transaction may warrant a premium interest rate.

To qualify the transaction as a sale, the trust is typically funded by a gift of 10 percent of the stock.13 In that way, the trust has enough equity for the loan to appear commercially viable. At the same time, the gift allows the trust to make a cash down payment on the sale.14 In capitalizing the trust, the grantor will likely use up a portion of its lifetime gift tax exemption. If the 10 percent gift exceeds the lifetime exemption, gift tax will be imposed on the balance. Although the gift is a loss, as is the impact on the grantor’s lifetime gift tax exemption, the net benefits are plain in comparison with the capital gains rate. For example, in New York City the total federal, state, and local capital gains taxes are approximately 33 percent. Thus, the grantor nets 23 percent of the total ‘‘sale’’ price, even after making the 10 percent ‘‘gift’’ to the trust. Also, any ‘‘loss’’ may be counterbalanced by a premium on the sale price and interest rate.15 As an alternative to the 10 percent gift, a not-for-profit or government beneficiary may guarantee the promissory note.16

Some ambiguity exists regarding the tax consequences of the grantor’s death before completion of payment on the note. Any unpaid balance on the promissory note is included in the grantor’s estate. However, it is unclear to what extent any gain on the underlying assets would be realized in the grantor’s estate.17 Thus, it is ideal to plan for the note to expire before the grantor’s death. That can be accomplished through a timely installment schedule or a self-canceling note.

Tangentially, a grantor retained annuity trust (GRAT) could also fulfill many of the basic elements of this transaction. GRATs are similar vehicles to IDGTs, and some care should be taken to select the appropriate structure.18 A full discussion is not possible here, but in short, GRATs serve to eliminate capital gains, gift, and estate taxes. In lieu of a promissory note, the GRAT grantor receives an annuity for lifetime or a term of years. In many cases, an initial transfer to the GRAT can avoid the gift tax implications of the IDGT capitalization. GRATs are advantaged inasmuch as they are statutory creations, whereas IDGTs evolved through IRS rulings and case law. However, GRATs are more regimented in their payout timeline. Also, if the grantor dies before the term’s expiration, part or all of the GRAT assets pass back to the estate.

A. Impacts on Employee Ownership

The ESOP is a powerful tool for employee ownership, and several ESOP benefits are not offered by the IDGT, including a tax-favored approach to capitalization and federal tax-exempt retained earnings for S corporation ESOPs. Additional advantages include a tax deferral available to employees and the possibility of a future deferral through a rollover to an IRA or other plan. Perhaps most importantly, the ESOP is a long-tested and reliable mechanism for employee successions. In contrast, the IDGT employee succession faces uncertain treatment by the IRS and the Department of Labor. The IDGT is more narrowly tailored to individual owners and does not provide a vehicle for capitalization to companies.

Another key difference is that the ESOP offers a regimented set of employee benefits, while the IDGT is a transitional mechanism that can lead to a wide variety of employee succession configurations. The grantor, trustee, and employees will likely maintain varying levels of control over the IDGT and the interest held by the IDGT throughout the transition period.19 However, after the loan note is finished, grantor trust status is ‘‘toggled off’’ — and the full spectrum of employee control and profit-sharing options is available for implementation. Thus, this article refers to both the transitional ‘‘intentionally defective grantor trust’’ and the resulting forms of employee ownership. This article emphasizes particular approaches to employee ownership that minimize the tax impact on grantor and employees, reduce regulatory and transactional costs, enhance sale price, maintain the plan’s perpetuity, and maximize the dignity of employees. The following lists several potential advantages of this broader IDGT employee ownership strategy — relative to ESOPs — for individual sellers.

1. Perpetuity. A planner may not always be able to guarantee an ESOP’s perpetuity because a company may choose to cease distribution of shares into the ESOP plan. This might relate to a change in management; the ESOP trustee in a minority ESOPowned company not having sufficient control; or the trustee of a majority ESOP-owned company, acting in accordance with his fiduciary duty, being reluctant to purchase additional company stock. However, while companies are not required to distribute additional shares to ESOPs, they are required to repurchase shares upon the exit of company workers. This can and does lead to an ever-diminishing percentage of ESOP ownership, with some companies ultimately closing their ESOP plans.

The IDGT functions differently. All of the trust shares may be held in the beneficial interest of the employees. Without any repurchase obligation or corresponding need for new distributions of shares, the trust offers a perpetual vehicle for employee ownership. Of course, the owners are free to transfer additional shares to the IDGT, but once transferred, those shares may remain in the trust. While shares could be distributed from the trust to company workers, that practice is not generally recommended without additional provisions to guarantee the perpetuity of employee ownership within the target company, for example, nontransferability of shares, mandatory redemption upon termination of employment, and trust veto rights over major shareholder decisions.

Of course, some states limit the perpetuity of trusts. However, that can be circumvented by creating the trust in a ‘‘Tier 1’’ state, such as South Dakota or Delaware.20 An out-of-state trust may be maintained at a low cost by hiring a trustee in the foreign state. Alternatively, many states allow for perpetual employee trusts.21 When the client intends to provide for democratic employee voting, it is likely possible to characterize the trust as having an educational purpose and, thus, to qualify as a charitable trust and as exempt from the rule against perpetuities in any state.22

Finally, the trust should include non-employees as beneficiaries. When the designated beneficiaries are limited to employees, the trust is susceptible to challenge. As a countermeasure, the trust document should be designed to preserve the principal for a charitable beneficiary, for example, a not-for-profit organization that operates to support employee ownership. That way, the employees have no motivation to terminate the trust and liquidate the company.23 Moreover, the policy preserves the company’s wealth in the case of dissolution and for reinvestment in efforts to build and sustain employee ownership.

2. Applicability to LLCs and S corporations. The ESOP plan is applicable only to C or S corporations, and the ‘‘1042 rollover’’ is restricted to C corporations. The IDGT capital gains exemption may be used with C or S corporations, LLCs, and unincorporated partnerships. In the latter cases, the grantor transfers a percentage of his membership or partnership interest to the IDGT in lieu of stock. Note, as well, that S corporation and LLC trusts will benefit from state tax-exempt retained earnings when the business is located in trust-friendly states such as Alaska, Florida, Nevada, South Dakota, and Wyoming.24 When the trust beneficiaries are out of state, for example, in the case of charitable beneficiaries, this list expands to include Delaware, New Hampshire, Ohio, and Tennessee.

3. Reduced transaction costs. The IDGT is expected to significantly reduce transaction costs. Similar to an ESOP, the setup fees will include a valuation and legal fees. However, the IDGT does not require ongoing maintenance costs in the form of annual valuations or plan administration that complies with Department of Labor guidelines. Beyond the initial transfer, it is recommended that company stock remain inside the trust. Stock is not transferred into individual employee accounts. Finally, the trust is not coupled with any repurchase liability. An exiting employee has no claim on any company stock or stock-related compensation. In turn, due to the lower administration requirements of the trust, annual trustee costs should be lower on average than ESOP trustee costs.

4. Exemption from federal and state capital gains tax. The ESOP ‘‘1042 rollover’’ allows an owner to defer capital gains tax by reinvesting sale proceeds in domestic securities.25 No capital gains tax is due if the seller defers until death. Alternatively, an IDGT sale receives an outright exemption of capital gains tax that is immediate and available in the seller’s lifetime. The 1042 rollover is limited to federal capital gains tax.26 IDGT tax treatment is identical at federal, state, and local levels. Accordingly, the capital gains exemption is complete. Again, an IDGT sale is viewed as a nontaxable event by the IRS.

5. No repurchase liability. ESOP and IDGT employee successions share a common interest in the dignity of employees as essential stakeholders and valued participants in the life of the company. At a technical level, ESOPs are structured as retirement plans: Shares are allocated to employee accounts and repurchased upon termination of employment. In contrast, the IDGT is not coupled with any repurchase liability.

Rather, IDGTs offer a flexible vehicle for employee ownership — and need not be tied to retirement.

As more traditional vehicles for employee ownership, that is, employee control and profit sharing, a range of options are available in lieu of the ‘‘share allocation and repurchase’’ ESOP benefit. For example, current part- and full-time workers could direct the trustee in voting on shareholder issues and electing board members. Trust income could be distributed directly as cash payments to current part- and full-time workers. Or, for majority trustowned companies, the trustee might vote for employee bonuses that effectively function as profit shares.27 Funds might be directed toward enhancing the work environment or increasing the number of pre-tax employee benefits, for example, new technology or subsidized transportation.

6. Not necessarily covered by ERISA. The IDGT is not itself a statutory mechanism subject to ERISA. Generally, the types of benefits proposed here do not correspond to the employee benefit plans regulated by ERISA, for example, those relating to sickness, unemployment, retirement, and legal services.28 One major exception involves situations in which trust income is distributed to employees. That arrangement would likely involve distributions to retirement-age employees, which would qualify as an ERISA-type benefit.29 However, the IDGT is a creation of the selling owner or owners and not an employer or an ‘‘employee organization’’ — which is a necessary condition for ERISA coverage.30 Thus, IDGT employee trusts are not likely to be regulated by the Department of Labor.31 That said, some attention from Labor should be expected. However, the potential for Labor involvement could be significantly reduced when beneficiaries are limited to a single charitable organization or class of charitable organizations. In the latter scenario, employee ownership might be a function of direct control over company shares — and the corresponding ability to regulate salaries and benefits — rather than an indirect beneficial interest in company shares.32 Also, to the extent that employees are permitted to directly vote company shares as nonfiduciaries, trustees’ responsibilities are limited. Likewise, without employee beneficiaries, trustees face fewer potential plaintiffs. In all of the above, trustee fees and valuation costs should be adjusted to reflect any diminished potential for regulation and litigation.

7. No 30 percent floor for stock transactions. To gain the benefit of a 1042 rollover tax deferral, a seller must transfer at least 30 percent of the company stock to the ESOP. A sale to an IDGT does not require any minimum transfer of interest and can be accomplished at any percentage interest of the target company.

8. Premium sale price. Valuation for an IDGT sale is not regulated by Department of Labor guidelines. Thus, IDGT sale prices are not subject to ESOP repurchase liability or lack of marketability discounts.33 Also, IDGT valuations may receive the benefits of a control premium and a strategic price.34 Control premiums alone can yield 20 to 30 percent above market price.35 In combination, those factors are likely to result in a significant advantage to the grantor, in terms of sale price, over an ESOP. Also, whereas Labor is most concerned with the overvaluation of company stock in ESOP sales, the IRS is more likely to be concerned with undervaluation of an IDGT sale. This is because IDGTs are traditionally used to avoid gift tax in family business succession planning. As long as the sale price is commercially reasonable, the IRS should not be unduly concerned by the valuation accorded to an IDGT sale.

B. Impacts on Democratic Employee Ownership

Although ESOPs are infrequently used as a mechanism for democratic employee voting on shareholder issues (one person, one vote), the law provides for that client goal. That said, the DESOP faces a few obstacles that may be more easily managed in an IDGT employee succession. Several potential advantages of the IDGT employee ownership strategy relative to DESOPs are listed below.

1. Democratic voting. The law mandates direct share voting of publicly traded securities that are included within an ESOP plan.36 In theory, that requirement could be circumvented by a shareholders agreement under which DESOP participants agree to vote their shares in accordance with the outcome of an employee vote. Although that strategy would work — and should be considered by ESOP companies moving in a more democratic direction — an IDGT succession is less cumbersome. It would not require the additional step of a shareholders agreement or vetting potential employees based on their willingness to sign the agreement.

ESOP plans generally require direct share voting on major shareholder issues.37 However, a statutory carveout expressly allows ‘‘one participant, one vote’’ employee voting on major shareholder issues in lieu of share voting.38 In turn, the trustee votes plan shares accordingly. The statute is somewhat ambiguous whether block voting of plan shares, in accordance with an employee vote, is allowed on major shareholder issues.39 An IDGT succession may be preferable in that a trust might permit, or even require, block voting.

2. Flexible probationary period. Once a class of employees is designated for an ESOP plan, any new employee within the designated class must generally be included after one year of employment.40 Although international standards relating to democratic employee ownership sanction a sixto 12-month probationary period, flexibility is encouraged. Industries with a high degree of technological or administrative complexity — or which are capital-intensive in nature — may ordinarily require up to a three-year probationary period (as well as a costly buy-in).

As a solution, a DESOP trust document may provide employee voting on non-major shareholder issues but only for employees who have completed the longer company-specific probationary period. A shareholders agreement and careful vetting of employees may accommodate the balance of major shareholder issues — and voting in the case of publicly traded securities. However, an IDGT succession avoids these additional steps. A trust can be drafted to include voting rights on all issues — without respect to the registration status of the securities held in the trust — for only those employees who have completed the company-specific probationary period. (As warranted, the trust may limit voting to employees who have made buy-in contributions.)

3. Inclusion of seller, seller’s family, and 25 percent shareholders. Application of the 1042 rollover capital gains deferral for ESOP sales prohibits inclusion of the seller, the seller’s family, and any remaining owners of more than 25 percent of the outstanding stock of any class of the corporation.41 However, for a client whose goal is democratic employee ownership, it is preferable for all current part- and full-time employees to possess equal votes. Thus, it might be desirable for the seller, the seller’s family, or any other owners who remain at the company to be included as equal ‘‘members’’ of the DESOP trust alongside other employees. Creative use of a shareholders agreement or a new membership share class would resolve those exclusions. However, an IDGT succession dispenses with any extra steps. The trust can easily provide for the broad-based inclusion of all employees in voting on shareholder issues and board elections, without any statutory conflicts.

1 Rev. Rul. 85-13, 1985-1 C.B. 184.

2 Section 674(c). The trust document can limit this person in their selection of beneficiaries to charitable or educational organizations, as well as descendants. Madorin v. Commissioner, 84 T.C. 667, 668-669 (1985); LTR 9304017. In principle, the trust might also limit the selection of additional beneficiaries to charitable or educational organizations dedicated to employee ownership.

3 The grantor should be excluded from potential beneficiaries and should not have the power to add beneficiaries. Sections 2036(a)(2) and 2038; Philip M. Lindquist, Lora G. Davis, and Judith K. Tobey, Drafting Defective Grantor Trusts 13 (2012).

4 Section 677(a)(3).

5 The stock holdings of the trust in the target corporation must be ‘‘significant’’ in terms of voting control, which typically requires majority voting control. It is unclear whether this technique applies to limited liability companies or to LLCs that elect to be treated as corporations for tax purposes. Section 675(4)(B); TAM 200733024.

6 If the target company is sold or liquidated, the corpus would revert to the grantor, albeit without any step-up in cost basis. Section 673(a).

7 A grantor’s (or any non-adverse party’s) power to revoke will also qualify the trust as grantor-owned. Section 676(a). However, a grantor’s power to revoke should be removed before death, otherwise the trust assets will not avoid estate tax. Section 645(a) and (b)(1).

8 Rev. Rul. 2004-64, 2004-27 IRB 7. Should such a provision be desired, it is important to note that some states allow a grantor’s creditors to attack a trust in which a trustee has the discretion to reimburse the grantor for their tax liability. Other states, e.g., New York, specifically protect trusts from grantors’ creditors on this account. Section 2036(a)(1); Lisa S. Presser, Lance T. Eisenberg, and Kristen A. Curatolo, ‘‘Sales to IDGTs: A Hearty Recipe for Tax Savings,’’ Cardozo Alumni Quarterly (Fall 2014); N.Y. Est. Powers & Trusts Law, section 7-3.1(d); local law as applicable.

9 Note that ‘‘toggling off’’ grantor trust status generally has no adverse tax consequences for the grantor, as long as payment on the note is complete — otherwise, gain is recognized in the amount of the difference between the grantor’s basis in the transferred stock and the outstanding note. 26 CFR section 1.1001-2; Deborah V. Dunn and David A. Handler, ‘‘Tax Consequences of Outstanding Trust Liabilities When Grantor Status Terminates,’’ J. Tax’n (July 2001); Philip A. Di Giorgio, ‘‘Grantor Trust Basics,’’ New York State Bar Association Trusts and Estates Law Section Newsletter, Vol. 42, No. 3, at 23 (Fall 2009).

10 Presser, Eisenberg, and Curatolo, supra note 8.

11 ‘‘For term loans, in determining whether a loan is a below-market loan, section 7872(f)(1) and (2) requires use of a discount rate equal to the applicable federal rate in effect under section 1274(d) on the date the loan was executed. Section 1274(d)(1)(A) uses the applicable federal long-term rate for debt instruments with a term of over nine years. Thus, in general, under section 7872, a promissory note for a term longer than nine years is not treated as a below-market loan if the interest rate on the note is equal to or higher than the applicable federal long-term rate, compounded semiannually.’’ LTR 9535026.

12 Elizabeth M. Nelson, ‘‘Unraveling Trusts: Grantor Trusts and the Reciprocal Trust Doctrine,’’ Probate & Pumpernickel (Nov. 2014).

13 Presser, Eisenberg, and Curatolo, supra note 8.

14 As one potential issue, the grantor may not possess cash (or marketable securities) in the amount of the required 10 percent gift. However, in theory, the ‘‘10 percent gift and down payment’’ could occur in a single transaction at minimal cost: (1) the grantor borrows 10 percent of the total assets to be transferred; (2) the grantor gifts the ten percent to the trust; (3) the grantor transfers the assets; (4) the trust makes the down payment and issues the promissory note; and (5) the grantor returns the 10 percent to the lender. The trust may be drafted so as to require the reimbursement to the grantor of any fee charged for this transaction.

15 A control premium of 25 percent above market price was acceptable to the IRS. Estate of Desmond v. Commissioner, T.C. Memo. 1996-76.

16 For example, a beneficiary not-for-profit employee ownership fund or economic development corporation could guarantee the promissory note, given adequate control rights in case of default. To ensure that the loan guarantee is not viewed as a gift, the trust might pay an additional guarantor’s fee. See Milford B. Hatcher Jr. and Edward M. Manigault, ‘‘Using Beneficiary Guarantees in Defective Grantor Trusts,’’ 92 J. Tax’n (Mar. 2000); Howard M. Zaritsky, Tax Planning for Family Wealth Transfers at Death: Analysis With Forms, para. 12.07[3][e][vi] (2015).

17 Nelson, supra note 12, at 11-12.

18 Lindquist, Davis, and Tobey, supra note 3, at 18-20.

19 Factors determining the balance should include financing, leadership development, and the owner’s desire to stay involved, as well as legal considerations regarding grantor trust status.

20 S.D. Codified Laws section 55-1-20; Del. Code Ann. tit. 25, section 503(a).

21 N.Y. Est. Powers & Trusts Law section 9-1.6; Tex. Prop. Code Ann. section 121.004; Or. Rev. Stat. Ann. section 128.520.

22 See Peth v. Spear, 63 Wash. 291, 295, 115 P. 164, 165 (1911) (holding that a trust established to maintain a cooperative has an educational purpose and is thus charitable).

23 That construction of the trust may also have favorable tax consequences. In a family succession scenario, the IDGT sale is a nontaxable event, although it might be perceived as a gift from the grantor to the family. By analogy, in an employee succession scenario, the IDGT sale should also be a nontaxable event, even though it might be perceived as income to the employees. If the transfer is treated as a taxable event, employees would be liable for income tax on the value of their beneficial interest in the transferred stock. Those liabilities would be minimized when the trust principal is reserved for one or more charitable organizations. Additional provisions may also help to minimize any potential employee tax liability, such as nontransferability of employee interests and distributing trust income in proportion to employees’ labor contributions.

24 Scott Martin, ‘‘Alaska, Delaware, Nevada, South Dakota Remain Top Trust States,’’ The Trust Advisor, Feb. 5, 2011, available at http://thetrustadvisor.com/tag/most-trust-friendlystates.

25 Section 1042.

26 A notable exception is Iowa, where sales to an ESOP benefit from a 50 percent state capital gains exemption. Iowa Admin. Code section 701.40.38(10).

27 In the context of employee control, it is recommended that the trust documents place limits on compensation, e.g., capping bonuses at 20 percent or 30 percent of net annual income.

28 29 U.S.C.A. section 1002(1), (2)(A).

29 29 U.S.C.A. section 1002(2)(A).

30 29 U.S.C.A. section 1003(a).

31 Ruth Simon and Sarah E. Needleman, ‘‘U.S. Increases Scrutiny of Employee-Stock-Ownership Plans,’’ The Wall Street Journal, June 22, 2014 (‘‘Since the start of fiscal 2010, the Labor Department has recovered over $241 million through suits or investigations that were resolved without going to court, nearly all of which involve valuations. Overall, the agency has filed 28 suits tied to employee-stock-ownership plans since October 2009, double the total in the previous six years, according to an internal tally reviewed by The Wall Street Journal.’’).

32 Avoiding employee beneficiaries would further minimize potential employee tax liabilities (in relation to the initial transfer) and provide additional guarantees against challenges to the trust. If perpetuity is a goal, the planner might establish a noncharitable purpose trust in a state that exempts those trusts from the rule against perpetuities.

33 ″Valuation Discounts in ESOPs,’’ National Center for Employee Ownership, available at https://www.nceo.org/articles/ valuation-discounts-esops.

34 Id.

35 Barbara S. Petitt and Kenneth R. Ferris, Valuation for Mergers and Acquisitions 9 (2013).

36 Section 409(e)(2), (4).

37 Section 409(e)(3).

38 Section 409(e)(5).

39 Section 409(e)(5)(B).

40 Section 410(a)(1)(A)(ii).

41 Section 409(n)(1).