Let It Burn: A Trust & Taxes Case Study for Business Owners

This hypothetical case study shows how business owners may save their families millions by paying an irrevocable grantor trust's income taxes.

John and Sue are sitting across the table from their advisors. Most of their wealth is in their business: three machine shops they have created, grown, and nurtured over the last three decades. The business is an S corporation worth about $46 million. The business consistently appreciates 15–20% per year.

Given that John and Sue’s net worth already exceeds the $30 million they can leave their three children free of estate taxes, and that, based on its growth rate, the business is estimated to be substantially larger than it is today, their advisors recommend that they recapitalize the company so that it has two classes of stock: 95% nonvoting shares and 5% voting shares. Because nonvoting shares are worth less than voting shares, the nonvoting shares are valued at $30 million (the thirty percent reduction in the value of the nonvoting shares compared with the voting shares is known in planning parlance as a “valuation discount”). John and Sue will then give their nonvoting shares to an irrevocable trust. Under the design of the trust, its value will be excluded from John and Sue’s estate.

What have John and Sue accomplished? First, they were able to use their $30 million exemption to give away approximately $43 million worth of company stock. Second, all of the future appreciation in that stock is free from estate taxation. This is powerful planning. But it is not even close to the most mathematically impactful part of John and Sue’s plan. An additional planning strategy, known as the tax burn, comes when the trust’s first income tax bill arrives and it is still theirs to pay.

At first, that can feel like the plan missed something. Why give the assets away and keep the income tax bill? But that bill is not merely a burden. It is the quiet engine of the strategy: every tax dollar the couple pays is one less dollar in their estate, while the trust keeps its own dollars invested for the family. The tax burn is a gift-tax-free gift.

Let’s take stock of where we are with John and Sue. They recapitalized the company so that 95% of the equity consists of nonvoting shares and 5% consists of voting shares. They then transferred all of the nonvoting shares — valued at $30 million — to an irrevocable grantor trust. They kept the 5% voting block, preserving voting control, while the transferred nonvoting shares and their future appreciation can sit outside the couple’s taxable estate.

Because the company is an S corporation, its taxable income passes through to its shareholders. The trust owns 95% of the equity, but because it is a grantor trust, John and Sue remain legally responsible for the income tax attributable to that trust-owned stock. Assume that bill averages $500,000 a year. Each year, the couple writes the check from assets outside the trust. The trust does not reimburse them, so the trust’s assets grow income-tax-free and estate-tax-free. The impact of the tax burn looks like this:

Here is the payoff: after 20 years, the couple has used $10 million from their taxable estate to pay the trust-related income taxes. If those dollars would otherwise have been exposed to a 40% federal estate tax, the family may avoid approximately $4 million of estate tax. The checks were written one year at a time, but together they created a meaningful transfer of wealth.

There is another part of the story. Every time the couple pays the income tax generated by the trust’s 95% ownership of the S corporation, the trust avoids using distributions or other assets to cover that liability. More value stays associated with the nonvoting shares for the children and grandchildren.

Assume the $500,000 retained each year remains invested for 20 years. At a 15% annual return associated with the company, those amounts would grow to approximately $51.2 million. These figures assume each $500,000 amount is retained at the end of the year and compounds annually. They are not an extra deduction or a guaranteed return; they simply illustrate the potential value of allowing wealth connected to the trust-owned nonvoting S corporation shares to remain invested rather than using it to satisfy the owners’ tax bill.