Selling a Company Directly to Employees

Introduction
Selling a Closely Held Company Directly to Insiders
Valuation Considerations in a Sale to Employees
Using Buy-Sell Agreements in Employee Buyouts
The Manager's Dilemma: Buy Out Your Company or Do an ESOP?

From "Selling a Closely Held Company Directly to Insiders"

Grantor trusts of the type described here and in the next section are most often used for transfers to children or other family members, although they theoretically could be used for employees. An intentionally defective grantor trust (IDGT) is an irrevocable trust that the grantor purposely creates to be "defective" for income tax purposes, but "effective" for transfer tax purposes. If properly designed, the IRS treats the grantor as the owner of the trust's assets only for income tax purposes (a so-called "grantor" trust). After the IDGT is established and a small gift (i.e., seed money) is made to the trust, the grantor sells income-producing assets (i.e., stock) to the trust in exchange for the trust's installment note. The sales price may incorporate valuation discounts.

In the typical sale to an IDIT no down payment is made, the IDIT pays the grantor annual interest only at the IRS Applicable Federal Rate for the month of the sale, and there is a balloon payment at the end of nine or more years. Because the sale is between the grantor and his or her grantor trust, the IRS does not recognize any gain or loss on the sale. Under Revenue Ruling 85-13, transactions between a grantor and his or her grantor trust are disregarded for income tax purposes. If the assets in the IDGT appreciate greater than the IRS Applicable Federal Rate, such excess value is removed from the grantor's estate. Additional transfer tax savings occur because the grantor is not separately taxed on the interest payments but instead is responsible for paying all of the IDGT's income taxes.

The expectation is that the growth of the assets in the trust outpaces the income needed to pay interest and someday deliver on the balloon payment. If valuation discounts are applied (and they almost always are) this is easier to achieve. If the grantor dies before the balloon payment is made, the value of the balloon payment is includable in his or her gross estate, but the growth in the asset from the date of transfer to the date of death is still outside of the estate.

Note that the very benefit that makes this technique attractive (defective for tax purposes, causing no capital gain upon sale) can also be its biggest liability. All of the income taxes owed by the IDGT are the responsibility of the grantor, not the trust. As a result, it is important to make arrangements for that liability. Practitioners of this technique advise that grantor trusts are not for those who cannot afford them.

The ability to transact large amounts of value without recognizing capital gain and the flexibility of payment options presented by the IDGT has made this a very popular technique among practitioners. However, they involve more than a basic level of complexity and a fair amount of analysis and arithmetic to ensure they are a good fit for a given situation.