By Stephanie Casteel, Partner, King & Spalding LLP

Andrew is a founder of a start-up biotech company, BioTex. He has had the good fortune to find venture capital to fund the expansion of the company. BioTex will be one of several biotech portfolio companies included in a private equity fund formed as a limited liability company.

Investors in the private equity fund will infuse capital into the fund for a cumulative preferred return on investment capital and a profits interest.

In addition, the owners of the manager of the private equity fund (the “venture capitalists”) will contribute capital for an interest with the same rights as the investors and for the additional right to residual profits, known as “carried interests.”

Andrew is caught up in the middle of negotiating the terms of the deal with the venture capitalists, and his mind is on the potential success of his company.

The venture capitalists are busy with the launch of the fund. But the low current value of Biotex, in relation to its potential future value upon a successful acquisition or merger, makes it an ideal time for Andrew to transfer a portion of Biotex to a trust for his children and grandchildren so that such stock, and its increase in value, is not part of Andrew’s estate.

Likewise, the carried interest of the venture capitalist is an excellent asset to transfer from his estate because of its low value at the formation of the fund and its significant potential for appreciation.

In both cases, the value is low because the investment is speculative, the future value depends on a whole range of uncertain factors, such as the exit market several years down the road, and it may be many years before the investment become liquid (in fact, for the venture capitalists, multiple investments must become liquid before any return on carried interests can be realized).

Because transfers are taxed based on the value of what is transferred when it is transferred, the most tax-efficient time to transfer assets to children and grandchildren or trusts for their benefit is when the value is low.

Limits on gifts
Under current law, an individual may transfer up to $1 million of value during his lifetime to his descendants without incurring any gift tax. In addition, an individual may transfer up to $2 million of value at death, reduced by gifts made during his lifetime.

Any amount transferred by gift during life or at death in excess of these limits is taxed at the maximum federal tax rate of 45 percent (the state also may impose an additional estate or inheritance tax upon transfers at death).

It is the current low value of start-up biotech companies and their corresponding private equity funds, and their potential significant appreciation, that makes current estate planning so attractive.

Not only will assets transferred during life no longer be a part of the transferor’s estate, any subsequent appreciation on what is transferred also will not be part of his estate.

For example, Andrew’s business colleague, Lily, made gifts of interests in ARF Drugs, Inc. when the company was a start-up and the stock’s value was then only $.01 per share. Lily transferred 1 million shares of the company’s common stock to a trust for her children and grandchildren.

Lily’s gift used only $10,000 of her $1 million lifetime credit, and she paid no gift tax.

When ARF Drugs, Inc. later went public at $12 per share, the trust received approximately $12 million. Further, the trust was structured in such a way that Lily paid all capital gains tax attributable to the stock sold by the trust. The trust will be held in perpetuity for the benefit of Lily’s descendants without the payment of any additional gift or estate tax. If Lily had waited until after ARF Drugs was sold, the gift tax cost of transferring $12 million to a trust for her descendants would have been approximately $5.4 million.

If Lily had waited even later until her death, the estate tax cost of transferring $12 million would have been approximately $22 million (estate tax is a tax-inclusive calculation, so it will be higher than gift tax even at the same tax rate). Instead, the gift and estate tax cost was zero!

Estate Planning Techniques,
There are several very effective techniques that can be used to most efficiently achieve maximum gift and estate tax savings.

Stock in Biotex first could be placed into a limited partnership or limited liability company prior to the transfer in order to further discount the value of the Biotex stock. The limited partnership or limited liability company would impose restrictions on its interests, such as limits on the ability to make transfers and the prohibition of withdrawals.

These restrictions, coupled with lack of control, may depress the already-low value of the Biotex stock prior to a gift by Andrew. Alternatively, like Lily, Andrew could recapitalize Biotex to issue a nonvoting class of stock and make a gift of nonvoting interests, subject to restrictions and lack of control, which may provide additional discounts to the value.

The interests then could be transferred to Andrew’s younger generations by a variety of effective techniques, depending on the goals of Andrew.

For example:
If Andrew wanted to keep assets in trust for his descendants in perpetuity, to protect them from “too much too soon,” as well as from divorcing spouses and other creditors, the gift could be made to a “dynasty” trust structured under Delaware law.

If Andrew wanted to transfer only the future appreciation on Biotex stock, but not also the current value (in order to avoid reducing his balance sheet), he could make his gift using a grantor retained annuity trust (GRAT).

Using this technique, Brian would transfer his interests into a trust and retain the right to an annuity payment for a certain number of years. The value of the annuity payments would be roughly equivalent to the value of what was transferred into the trust, as increased by an interest component, resulting in a zero gift. To the extent the trust outperforms the assumed interest rate, which would occur if Biotex is acquired, the additional value remains in the trust and will pass to Andrew’s children or a trust for their benefit at no tax cost.

In addition to the use of no gift tax credit to implement, this technique has a very low risk, and if the valuation of the initial transfer is later proved by the IRS to be too low, the trust “self-adjusts” so that there is no inadvertent gift of the additional value.

A GRAT may not be used, however, to transfer value to grandchildren or younger generations, and the annuity payment must be made each year, although it may be paid in-kind.

Installment sale has more risk
Similar to a GRAT is an installment sale to a trust, which also may be used to transfer only the appreciation on the value of the transferred interest. Under this technique, Andrew would sell interests to a trust for an installment note equal to the current value of the interests. The note would provide an interest rate and allow the accrual of interest.

After the acquisition of Biotex, the trust would pay off the note, and the appreciation in excess of the owed interest would remain in the trust with no additional gift or estate tax. An installment sale has more risk than a GRAT, it would require some initial funding of the trust, and an additional taxable gift may result if the initial value of the note is determined by the IRS to have been too low.

An installment sale, however, may be made to a trust that benefits grandchildren and younger generations, the interest rate “hurdle” required to be used is lower than that required for a GRAT, and an annual principal payment is not required.

If Andrew wanted to be responsible for the capital gains tax on the Biotex stock held by the trust to which his gift is made, the trust could be structured as a “defective grantor trust” for income tax purposes. (By definition, a GRAT is such a trust.)

The effect is that Andrew is making an additional gift to his descendants by paying their income tax liability, without technically having made an additional gift.

Furthermore, if the trust that receives the GRAT assets after the term or the trust to which an installment sale is made is structured as a defective grantor trust, Andrew could continue to pay the income tax liability of the trust without being deemed to have made any additional gift.

Key to success
If Andrew wanted to defer income tax on the sale of Biotex and ultimately benefit charity, he could contribute interests to a charitable remainder trust.

Like a GRAT, Andrew would be entitled to an annual payment for a term of years or the remainder of his lifetime, after which time, any remaining value would pass to charity, which may include a private foundation.

Andrew would receive a current income tax charitable deduction for the projected value of what will remain at the termination of the trust, which must be at least 10 percent of the current value of what is contributed to the trust, based on the current federal interest rate, Andrew’s age, and the term of the trust.

The annual payment could be structured so that it is not paid until after the sale of Biotex and/or such that the payment would increase when the trust value increases upon the sale of Biotex.

When the trust sold its Biotex stock in an acquisition, the trust would pay no capital gains tax and instead, Andrew would recognize a portion of each annual payment as capital gain.

If Andrew wanted to avoid income tax on the sale of Biotex and benefit charity currently, he could make a charitable gift. Andrew would be entitled to a current income tax deduction equal to the value of the gift. The charity would not be subject to income tax on its interests upon the acquisition of Biotex.

Note for Venture Capitalists
The same estate planning techniques may be used for a transfer of carried interests by a venture capitalist of a private equity fund. In this case, however, additional federal tax rules applicable to transfers of carried interests must carefully be considered.

The key to success of any of these techniques is making a transfer sooner rather than later, when the value of the transferred interest is low and the appreciation potential is significant.

Planning allows significant value to be removed from your estate and accrue for the benefit of your children and grandchildren or charity, with the payment of little or no gift tax and no estate tax.

It is important to consult with an experienced estate and tax planning attorney to implement any of these strategies.