Grantor dynasty trusts: How to reduce estate taxes on a family business

For many successful business-owning families, the company they have spent decades building represents far more than an asset on a balance sheet. It may provide income for the family, employ multiple generations and represent a legacy they hope to pass on.

This can also come with a significant estate tax challenge. If an owner dies while still holding a substantial portion of the company, the value of that ownership is generally included in the owner's estate and may be subject to 40% federal estate tax. For families with significant business holdings, that can mean a substantial portion of the value they hoped to pass to the next generation may instead be needed to satisfy estate taxes.

One way to address that exposure during the owner's lifetime is to transfer a portion of the business out of their estate and into a trust. A sale to a grantor dynasty trust can accomplish this.

How does a sale to a grantor dynasty trust work?

A grantor dynasty trust is an irrevocable trust established to hold assets for future generations.

The owner sells a noncontrolling portion of the business to the trust. The owner is not simply giving the business interest away. The trust purchases it by issuing the owner a promissory note. This allows the transfer to be structured as a sale rather than a gift and will not be subject to gift tax. The sale also does not trigger an immediate capital gains tax because the owner and grantor trust are treated as the same taxpayer for federal income-tax purposes.

The promissory note represents the amount the trust owes the owner for the portion of the business sold and carries a required interest rate. With an interest-only note, the trust pays interest each year, while the principal is repaid or refinanced at the end of the term.

The trust also needs sufficient assets to support the note, which may include assets previously contributed to the trust. Those contributions may be considered gifts. Interest payments may then be funded through distributions from the business or other trust assets.

What are the benefits?

Moving ownership outside the estate can reduce future estate taxes

The primary benefit begins with the ownership transfer itself. Once a portion of the business is owned by the trust rather than the owner, it can remain outside the estate. As a result, its value would not be subject to federal estate tax at the owner’s death.

The benefit can become even more significant if the business continues to grow. Any future appreciation on the transferred interest occurs within the trust rather than the estate.

A lower appraised value can increase potential benefit

A noncontrolling interest in a privately held company may be appraised below its proportional share of the company’s overall value. Depending on the circumstances, the valuation may reflect discounts for a minority interest or lack of control, as well as a lack of marketability, recognizing that the interest provides limited influence over company decisions and may be difficult to sell.

For example, consider a family business worth $25 million. If they decide to sell 40% of the business to the trust, this would represent $10 million on a proportional basis. A qualified independent appraisal values the noncontrolling interest at $7 million. The trust then acquires the full 40% ownership interest in exchange for a $7 million promissory note.

That $3 million difference creates additional wealth transfer potential from the start. If the business grows at a rate greater than the interest rate required on the promissory note, that excess growth can remain in the trust for future generations.

How the potential benefit can grow over time

The valuation discount creates an initial wealth transfer opportunity, but the greater potential benefit can develop over time. As the business grows, additional value can accumulate in the trust while the $7 million note remains fixed. In this example, the trust starts with $10.7 million in assets, including the business interest and $700,000 of existing trust assets to initially fund the note’s interest payments. The illustration below shows how different rates of appreciation could affect the value held in the trust over time. At the end of the 15-year term, the note can either be paid or refinanced.

The grantor pays the income taxes, allowing more wealth to accumulate in the trust

Because the trust is structured as a grantor trust, the business owner, as grantor, generally pays the income taxes attributable to the trust from personal assets. The trust therefore does not have to use its own assets to cover that income-tax cost, allowing more to remain invested.

The tax payments can create another estate planning benefit for the owner. Paying the trust's income taxes can help reduce the owner’s personal assets that might otherwise remain in the estate and, under current law, is not treated as an additional taxable gift to the trust.

Together, these two features can work on both sides of the transaction: reducing the assets that may ultimately be exposed to estate tax while allowing more wealth to remain invested and grow in the trust.

What are the trade-offs?

The potential benefits need to be considered alongside the financial, tax and business obligations the strategy creates. These transactions can receive heightened IRS scrutiny, particularly when valuation discounts are involved, making careful valuation, documentation and administration important.

Both the trust and the owner need sufficient liquidity

The trust needs enough cash flow to make the required interest payments on the promissory note and ultimately repay or refinance the principal. At the same time, the owner needs sufficient personal assets to pay the income taxes attributable to the trust. If either side lacks sufficient liquidity, it can become more difficult to maintain the strategy over time.

Reducing estate taxes could come with a future capital gains tax cost

The ownership stake sold to the trust generally does not receive a step-up in cost basis when the owner dies. As a result, if the business has appreciated significantly and the trust later sells its portion of the company, that can result in a larger taxable gain and potentially higher capital gains taxes. Families therefore need to weigh the potential estate tax benefit of moving the business outside the estate against the potential tax consequences of giving up a future basis adjustment.

Transferring ownership can affect control and succession

Moving a business interest to a trust involves more than tax considerations. Families also need to consider how the transfer may affect voting rights, distributions, control and succession. The structure should support both the family's estate planning objectives and its long-term plans for the business.

Preserving what the family has built

For families who have spent decades building a successful business, planning for the next generation is about more than deciding who will eventually own it. It is about considering how to transfer that ownership in a way that preserves more of what the family has built and gives future generations greater flexibility to carry it forward.

A sale to a grantor dynasty trust is not appropriate for every family. The decision needs to account for the family’s broader wealth, tax circumstances, liquidity needs and long-term plans for ownership, control and succession.

Coordinating with experienced tax, legal, investment and fiduciary professionals can help families evaluate the business and determine an approach that supports both the company and the legacy they hope to carry forward.