Estate Planning Techniques Best Suited for the Current Economic Environment
PLANNED GIVING & ENDOWMENTS
ESTATE PLANNING TECHNIQUES BEST SUITED
FOR THE CURRENT
MAY 21, 2009
Outline and Presentation by
Howell Bramson, Esq.
McCarthy Fingar LLP.
11 Martine Avenue
White Plains, New York 10606
Andrew Panken, Esq.
Stern Keiser Panken & Wohl, LLP
1025 Westchester Avenue
White Plains, NY 10604
Grantor Retained Annuity Trusts
In a low interest rate environment, as we now have, grantor retained annuity trusts (“GRATs”) are very beneficial. A GRAT provides the grantor with a “qualified annuity interest,” which is the right to receive a fixed amount, payable at least annually. IRC § 2702(b)(1). Because the annuity is a “qualified interest,” the value of the grantor’s retained interest is valued under Section 7520, and the value of the gift will be the fair market value of the property transferred less the present value of the retained annuity interest determined under Section 7520. As of April 2009, the rate used to value the “qualified annuity interest” (120% of the AFR midterm rate) was only 2.6%. A low interest rate causes the value of the qualified annuity interest to be higher, and thus the value of the remainder, which is the gift element, to be lower.
Overview of Grantor Retained Annuity Trusts
A GRAT is an irrevocable trust that pays the grantor an annuity, at least annually, for a fixed term of years. The annuity interest generally is described as a percentage of the initial value of the assets transferred to the GRAT. If the grantor is living at the end of the term, any property remaining in the GRAT after the last annuity payment is made will pass to the remainder beneficiaries (usually the grantor’s children), either outright or in trust for their benefit. If the expected return on the GRAT assets is less than the applicable Section 7520 rate, all of the trust property will be distributed to the grantor as part of the annuity payments during the trust term and nothing will be left for distribution to the remainder beneficiaries. The grantor will be no worse off than if the grantor had not created the GRAT, except for the cost of creating the GRAT and any gift tax paid upon funding the GRAT. If the return exceeds the applicable Section 7520 rate, however, then the remaining trust property will be distributed tax free to the remainder beneficiaries. If the GRAT is appropriately designed and the assets appreciate significantly, substantial wealth can be transferred to the grantor’s children free of both gift tax and estate tax.
When GRATs Make Sense
As a general rule, a GRAT will be an effect transfer tax technique only if:
The grantor of the trust lives beyond the term for which he or she retained the right to receive annuity payments from the GRAT; and
The GRAT earns more than the applicable Section 7520 rate (at the creation of the GRAT) during the retained term.
What Assets Are Best For Funding GRATs?
Generally, any assets with appreciation potential or total return in excess of the Section 7520 rate are appropriate assets for a GRAT. Assets that can be valued at a discount, such as a minority interest in a closely held corporation, a limited partnership interest or a large block in a publicly traded company, can produce significant savings because the amount of the annuity will be based on the discounted value of the asset, rather than on the full value. In this situation, the grantor’s annuity payments (which are potentially includable in the grantor’s estate) will be smaller than if the annuity payments were based on assets that were not discounted. This will be particularly beneficial if the asset has a high yield because the effective yield will be made even higher by the discount. Additional benefits can be obtained if the asset can be valued at its full value (rather than its discounted value) when distributed as part of the annuity payment or to the remainder beneficiaries at the end of the GRAT term. The latter circumstance can occur, for example, when a GRAT holds limited partnership interests and distributes such interests tax-free to the remainder beneficiaries upon the end of the GRAT term. If the remainder beneficiaries can then terminate the limited partnership, they will receive the undiscounted assets from the limited partnership with no tax consequences.
Example: Grantor creates a one-year GRAT when the Section 7520 rate is 10% and funds the trust with $1 Million, retaining the right to receive (or if the grantor dies during the term for his or her estate to receive) $1,098,900 at the end of the year. The value of the remainder is $1,000. Because the 7520 rate is 10%, the tax law assumes that: (a) the fund will grow to exactly $1,100,000 at the end of the year, (b) $1,098,900 will be paid to the grantor, and (c) $1,100 (which has a present value, using a 10% discount rate, of $1,000) will pass to the remainder beneficiary (“R”).
If the GRAT grows at 9% (less than the 7520 rate), the GRAT will contain $1,090,000 at the end of the year, the grantor will receive that amount, and nothing will pass to R. However, if the property grows at 12% per year, the GRAT will be worth $1,120,000 and R will receive $21,100 ($1,120,000 minus $1,200,000).
The annuity must be a fixed amount, that is, a stated dollar amount or a fixed fraction or percentage of the initial fair market value of the assets transferred to the GRAT. Treas. Reg. § 25.2702-3(b)(1)(ii).
The annuity amount may increase annually by up to 120% of the preceding year’s annuity amount. Id. For example, the annuity could be 6% in the first year, 7.2% in the second year, 8.64% in the third year, and so on. The advantage of an increasing annuity is that less property is distributed to the grantor in the beginning, and, therefore, property grows within the trust for a longer period of time. An increasing annuity is particularly useful for assets that are not expected to achieve a high return in the early years but that are expected to achieve an increasing return in the future.
The annuity can be paid from income, and, if income is insufficient, from principal.
If the income generated by the GRAT assets is insufficient to pay the annuity, the trustee can transfer trust principal in kind to the grantor to pay the annuity. This is a common practice when highly appreciating assets with low cash flow are contributed to a GRAT.
Treas. Reg. 25.2702-3(d)(6)(i) requires that the governing instrument of any GRAT created on or after September 20, 1999, must prohibit the payment of the annuity or unitrust amount by a note, other debt instrument, option, or other similar financial arrangement.
The annuity payments can be made on a calendar year or anniversary year basis and can be made annually or more frequently. If the payment is for a short taxable year, the payment must be prorated. Treas. Reg. § 25.2702-3(b)(3).
Gift Tax Issues
The gift made on the creation of a GRAT is a gift of a future interest. Therefore, it will not qualify for the gift tax annual exclusion. Gift tax will not be due, however, if the gift is sheltered by the grantor’s applicable exclusion amount.
From a leveraging of gift perspective, a zeroed-out GRAT (i.e. one in which the actuarial value of the remainder is zero) is desirable. With a zeroed-out GRAT, the grantor will receive back all of the original assets transferred to the trust and some appreciation in the value of the trust assets, while shifting the appreciation in excess of the Section 7520 rate during the term of the GRAT to the beneficiaries.
The IRS’s former position under Example 5 of Treas. Reg. § 25.2702-3(e) (“Example 5”) was that, even if the grantor retains an annuity for a fixed term, an annuity for a fixed term must be valued as if the grantor’s right to the annuity terminates at death, regardless of whether payments are made to the grantor’s estate after death. Example 5 provided that an annuity for a term of years must be valued as if it were an annuity for the shorter of the term or the grantor’s life because the possibility that the grantor may die during the term must he considered. Thus, under the prior version of Example 5, even if the grantor does not retain a reversion, the annuity must be valued as if the grantor had retained one.
The IRS’s position that because of Example 5 zeroed-out GRATs were not possible was rejected by the Tax Court in Walton v. Comm’r, 115 T.C. 589 (2000); acq., Notice 2003-72. Moreover, the Treasury Department has promulgated regulations adopting the Walton diction, thereby indicating the value of the remainder can be made extremely small if not zero by having the annuity payments continue for the grantor’s estate for the balance of the fixed annuity term if the grantor dies during that term. See Treas. Reg. § 25.2702-3(e), Examples 5 and 6 (as amended by T.D. 9181).
In light of Walton, practitioners should consider structuring GRATs for a fixed term with payments to be made to the grantor or, if the grantor dies during the fixed term, to the grantor’s estate (hereinafter referred to as a “Walton GRAT”). If minimizing gift tax on creation of the GRAT is a primary goal, a GRAT should not be structured to terminate at the grantor’s death and then to pay the remaining assets to the remainder beneficiaries or to the grantor’s estate. Such a structure would result in the value of the annuity interest being valued as the lesser of the fixed term or the grantor’s life, and, therefore, would not benefit from the holding in Walton. The value of the retained interest for the shorter of term or life will be less than the value of the retained interest for a term, resulting in a taxable gift.
(1) Minimize the extent to which years with poor returns offset years with favorable returns and drag down overall GRAT performance.
(2) Minimize mortality risk.
(3) Transfer wealth to beneficiaries sooner.
(4) Wealth transfers can be cut off at any time the donor believes beneficiaries have already received enough.
(1) Can’t lock in a low Section 7520 rate,
(2) High payout rates generally necessitate making the bulk of each payment in kind, greatly reducing the benefit of valuation discounts.
(3) The cost of appraisals must be taken into account if distributions must be made in kind.
(4) Using a 20% increasing payout feature provides less benefit over a short term.
(5) The administrative costs of creating multiple GRATs instead of a single GRAT must be considered.
(6) The possibility of the legislative repeal of GRATs
1. When Section 7520 rates are low, favorable interest rates can be locked in.
2. Eliminate or minimize the need to make payments in kind, maintaining the benefit of valuation discounts and making appraisals unnecessary.
3. Over a longer period of time, 20% back-loading substantially improves GRAT economics.
4. If GRATs are legislatively repealed, as the Obama Administration has suggested, existing GRATs will probably be grandfathered but new GRATs will not be permitted.
(1) Low returns in some years offset high returns in other years, adversely affecting overall performance, particularly when low returns occur early in the GRAT term.
(2) The longer the term, the higher the mortality risk.
Because some of the advantages and disadvantages are difficult or impossible to quantify, only those factors related to the amount of the tax-free transfer and how it is affected by mortality will be considered here.
The case for short-term GRATs
The belief that a series of rolling short-term GRATs is superior to a single long-term GRAT finds considerable support in the estate planning literature. The literature suggests that a series of short-term GRATs (1) are more likely to be successful, (2) could produce tax-free transfers even during periods when returns are generally poor, and (3) produces substantially higher tax-free transfers even before mortality risk is taken into account. Moreover, interim asset volatility appears to be a more important factor than changes in the Section 7520 rates. Thus, a series of short-term GRATs generally outperforms a single long-term GRAT.
If the grantor is living at the end of the trust term, any property remaining in the GRAT (which will be the case if the total return on the trust assets is greater than the Section 7520 rate in effect when the GRAT is created) will pass to the named beneficiaries and avoid gift and estate tax. If the grantor dies during the trust term, however, some portion or all of the trust property will be included in the grantor’s gross estate for federal estate tax purposes. In such a case, there will be no estate tax savings. Nevertheless, the grantor will be no worse off than if he or she had not created the GRAT, except for the cost of creating the GRAT and any gift tax paid upon funding the GRAT.
In Rev. Rul. 82-105, the IRS determined the amount includable in the gross estate of the grantor of a charitable remainder annuity trust in which the grantor retained an annuity interest for his life. Based on that ruling, the value of the GRAT property that is includable in the grantor’s gross estate is the amount necessary to yield the guaranteed annual payments using the Section 7520 rate applicable at the grantor’s death. In June 2007, the IRS issued proposed regulations that would incorporate the guidance in Rev. Rul. 82-105. See Prop. Regs. §§ 20.2036-1(c)(2)(i).
The GRAT will be a grantor trust for income tax purposes. As a result of the grantor trust status, the following favorable income tax results are achieved:
• No gain or loss is recognized on the creation of the GRAT when the grantor transfers assets to fund the trust because the grantor is deemed to have transferred the assets to himself or herself for income tax purposes;
• The payment of the annual annuity by the GRAT to the grantor is ignored for income tax purposes, as the grantor is deemed to have paid it to himself or herself; and
• The income and capital gains generated by the GRAT assets are taxable to the grantor whether or not distributed to him or her.
Thus, if the grantor funds the trust with appreciated property, the distribution of such property in satisfaction of the annuity will not cause the grantor to recognize gain.
Valuation of the Gift
The value of the retained annuity interest generally depends on the value of the property transferred to the GRAT, the annuity rate, the Section 7520 rate in effect for the month in which the GRAT is created, the age of the grantor at the creation of the GRAT and the length of the term for which the grantor is retaining the annuity.
Valuing the Reversion
In addition to the annuity interest that the grantor retains, the grantor also can retain a contingent reversion in the property transferred to the GRAT. A reversion is the possibility that the trust property will revert to the grantor’s estate if the grantor dies before the end of the term of the GRAT. Thus, if a GRAT provides that the trust property will he paid to the grantor’s estate if the grantor dies before the end of the term, the grantor has retained a reversion in the trust property.
The law has now been clarified that a qualified interest includes one payable to the grantor for a stated term or to the grantor’s estate for the balance of the term if the grantor dies within it. See Regs. 25.2702-3(e), Examples 5 & 6, as amended by T.D. 9181, effective for trusts created on or after July 26, 2004. Previously, the regulations had provided htat only the interest of the grantor and not that of the grantor’s estate was a qualified interest in such a case. In effect, the prior regulations required that the value of the annuity be determined by reducing the value of the grantor’s retained interest by the probability of his or her death during the stated term. Now, if the annuity is payable to the grantor’s estate for the remainder of the term if the grantor dies before the term ends, the value of the annuity (and the remainder following it) may be determined without regard to any mortality factor, thereby allowing the retained interest to be larger.
Marital Deduction Planning
When the grantor retains a reversionary interest in a GRAT, which is generally the case with a GRAT that is not structured as a Walton GRAT, and dies before the end of the GRAT term, the GRAT usually provides that some portion (that portion that is included in the grantor’s gross estate) or all of the remaining GRAT property will be distributed to the grantor’s estate. Such planning allows the GRAT property to be disposed of in accordance with the grantor’s will or revocable trust and often will allow the GRAT property to qualify for the marital deduction. With a Walton GRAT, however, the remaining GRAT property is not paid to the grantor’s estate, to be disposed of according to his or her will or revocable trust. Rather, the annuity payments continue to the grantor’s estate. Therefore, if the grantor wants to ensure that the entire GRAT, including both the remainder interest and the grantor’s right to continuing annuity payments for the balance of the term, qualifies for the marital deduction, some additional planning will be required. Two alternatives follow:
Direction in Will that Payments Be Made to the Surviving Spouse. The grantor’s will can direct that the continuing annuity payments, once they are paid to the estate, will be distributed outright to the surviving spouse and that the remainder will be paid directly to the surviving spouse when the GRAT term ends. If, however, the planner believes that IRC § 2039 does not cause inclusion of all of the GRAT assets in the grantor’s gross estate, but rather that IRC § 2036 applies to include only a portion of the GRAT property in the grantor’s gross estate, then the GRAT should be structured so that only that portion of the property that is included in the gross estate will be distributed to the surviving spouse.
Distribution to a Marital Trust. The GRAT instrument can provide that, if the grantor dies during the fixed term and is survived by a spouse, the remaining annuity payments and the GRAT remainder will be distributed to a marital trust for the surviving spouse’s benefit. To ensure that the surviving spouse receives all of the income earned by the GRAT (which is a requirement to qualify the trust for the marital deduction), the GRAT must distribute any income in excess of the annuity amount to the marital trust. The GRAT itself could establish the marital trust as a remainder trust, or a separate irrevocable marital trust could be established. The latter alternative may be preferable if more than one GRAT has been created, in which case all of the GRATs could he payable to the separate irrevocable marital trust.
By creating a series of GRATs, often called rolling GRATs, rather than a single long-term GRAT, a grantor can take advantage of the benefits of short-term GRATs. For example, the grantor might create a two year GRAT each year. The annuity payment in year 1 from the first GRAT is used to fund the second GRAT, also for a 2-year term. The annuity payments in year 2 of GRAT 1 and year 1 of GRAT 2 would be used to create the third GRAT. Annuity payments from GRAT 2 and GRAT 3 would be used to create the fourth GRAT.
Advantages of Short-Term GRATs. Short-term GRATs have the following advantages:
• The risk of death during the term of the GRAT is minimized.
• The risk that a year or two of poor performance during the term of the GRAT will adversely affect the overall benefit of the GRAT is minimized. The failure of one GRAT because of poor investment performance will not affect the success of the future GRATs in the series. Thus, a series of short-term GRATs may result in a larger gift to the remainder beneficiary.
Disadvantages of Short-Term GRATs. Short-term GRATs have the following disadvantages:
The risk of the Section 7520 rate increasing is an issue. With a long-term GRAT, the grantor can lock in the benefits of a low Section 7520 rate;
• A change in the tax law may prohibit later GRATs; and
• There will be additional transaction costs in doing a series of short-term GRATs, including fees to prepare trust instruments and, possibly, the revaluation of the trust property.
Generation-Skipping Transfer Tax Considerations
A GRAT is not an effective mechanism to reduce GST taxation. If the grantor survives the retained term, the property should pass to or in further trust for the remainder beneficiary, without further gift or estate tax. However, if the GRAT becomes payable to the grantor’s grandchildren a GST tax would be imposed. Under Section 2642(f), during lifetime, a grantor cannot allocate his or her GST exemption to property transferred during that period of time for which the property would be includible in the grantor’s estate (the estate tax inclusion period) if he or she were to die. Hence, no effective allocation of GST exemption can be made until the grantor’s retained term expires.
Sale of Remainder Interest in a GRAT. Having the grantor’s children sell their remainder interests in the GRAT to a GST exempt trust for the benefit of the grantor’s grandchildren may be a way to avoid the problem caused by the ETIP rules. The effect is to create a generation-skipping GRAT.
Installment Sale to a Grantor Trust
An installment sale to a grantor trust, often referred to as an intentionally defective grantor trust (“IDGT”), is often proposed as an alternative to a GRAT, as it is a similar technique to transfer property to beneficiaries at no, or a reduced, transfer tax cost. As with a GRAT, the success of this technique depends upon the assets that are the subject of the transaction achieving a rate of return in excess of the IRS’ assumed interest rate.
Description of Transaction
An installment sale to a grantor trust is a sale by the grantor to at rust that is a grantor trust in its entirety for federal income tax purposes with respect to the grantor. Such a trust is one that has its income, deductions, and credits against tax attributed to the grantor essentially as though the trust does not exist for income tax purposes.
Under Rev. Rul. 85-13, the IRS announced, in effect, that no gain or loss is recognized by the grantor when the grantor sells assets to a grantor trust even if the assets sold are appreciated or depreciated. The trust usually pays for all or part of the assets by issuing a note payable to the grantor bearing appropriate interest at the applicable federal rate. Also, as a result of Rev. Rul. 85-13, the interest paid or accrued on the note should not be included in the grantor’s gross income because the trust and the grantor are considered to be the same taxpayer for federal income tax purposes, and there can be no income tax realization event as a result of a transaction with oneself. At the end of the note’s term, any income and appreciation on the trust assets that exceed the payments required to satisfy the promissory note pass to the beneficiaries of the trust (usually the grantor’s children and/or grandchildren) free of estate, gift and, if appropriately structured, GST transfer taxes.
If the trust assets appreciate at a rate that is less than the interest rate used to determine the interest payments on the promissory note, or if the assets decline in value, the grantor will receive back (as promissory note payments) the value of the original property sold to the trust, and nothing will be left to distribute to the remainder beneficiaries. Thus, if the trust assets underperform, some of the grantor’s assets could be subject to double taxation: assets that are gifted to the trust to fund the note payments will be subject to gift tax upon funding the trust and subject to estate tax at the grantor’s death). Assets transferred to the grantor as payment on the note are eligible for a stepped-up basis at the grantor’s death.
If the trust’s total return exceeds the applicable interest rate but the income generated by the trust assets is insufficient to pay the interest on the note (i.e., the assets have a high growth rate, but a low income yield), the trustee can transfer trust principal back to the grantor in order to make the annual interest payment. This method of payment is common where the assets sold to the trust are highly appreciating assets with low cash flow.
Generally, any assets with appreciation potential or yield in excess of the applicable interest rate are appropriate assets to sell to an IDGT. Assets that can be valued at a discount, such as a minority interest in a closely held corporation or limited partnership interests, can produce significant savings because the face amount of the note will be based on the discounted value of the assets sold, rather than on the full value.
The basis of the assets sold to the IDGT is equal to the grantor’s basis in such assets (i.e., a carryover basis). Because the value of the IDGT will not be included in the grantor’s gross estate, the trust assets will not receive a stepped-up basis at the grantor’s death. The loss of the step-up in basis for the assets sold to the IDGT must be considered in determining the tax consequences of the sale transaction.
Example: Grantor, age 55, transfers $100,000 to a grantor trust. The income and principal of the trust are to be paid, in the trustee’s discretion, for his daughter’s health, education, support and maintenance. At his daughter’s death, the trust assets will be held in the trust for the benefit of his grandchildren. Grantor files a gift tax return to report the $100,000 gift to the trust and allocates GST exemption to the transfer. After funding the trust, Grantor sells $1,000,000 worth of assets to the trust in exchange for a 5-year, $1,000,000 promissory note. The promissory note is structured so that interest is paid annually at the mid-term AFR of 5%, and a balloon payment of principal is due at the end of the 5-year note.
No gain or loss is recognized on the sale of $1,000,000 of assets to the trust, and the annual interest payments of $50,000 will not be taxable as income to Grantor. Assuming a 12% annual growth rate (after payment of the interest), at the end of the note term, the trust will pay Grantor a balloon payment of $1,000,000. After the payment of the note, $762,341 will be left in the trust and will pass to the trust beneficiaries free of gift, estate and GST taxes.
If the assets were sold to an existing trust, however, Grantor would avoid the $100,000 gift.
Tax Consequences of a Sale to an Intentionally Defective Grantor Trust Gift Tax
A promissory note bearing interest at the AFR is deemed to have a fair market value equal to its face amount. Therefore, the sale of assets to the IDGT in return for a promissory note will not be a gift as long as the promissory note equals the value of the property transferred and bears interest at the AFR. An accurate appraisal is essential to support the fair market value claimed in the transaction.
If the assets are not sold to an existing trust, the initial funding of the IDGT will be a taxable gift. The grantor can use, if available, a portion of his or her applicable exclusion amount to shelter the gift from tax.
Avoiding the Undervaluation of Assets
Gift tax concerns may arise if the property that is the subject of the sale is a hard-to-value asset, such as closely held stock. A taxable gift will occur if the value of the property transferred is later determined to be greater than the sale price. The leading case in this area is Comm’r v. Procter; 142 F.2d 824 (4th Cir. 1944). Procter involved a transfer by gift to a trust. The trust provided that if a federal court of last resort held that any part of the transfer was a taxable gift, that portion of the property subject to gift tax would be excluded from the transfer. The court held that this was a condition subsequent and it violated public policy. The court stated that there were three reasons for declaring the condition subsequent void:
* It would deter the IRS from auditing returns because there would be no possibility to collect tax,
* The donees would not be parties to the tax litigation and might later try to enforce the gift and
* This type of provision would obstruct the administration of justice because as soon as a court rules that the value of the gift should be increased, the trust instrument revokes the gift and makes the court’s ruling moot.
With a GRAT, the risk of undervaluing the assets transferred to the trust can be mitigated by expressing the annuity as a percentage of the value of the property transferred, as finally determined for federal gift tax purposes. With an installment sale to a grantor trust, it is not certain that a formula may be used, although in McCord v. Comm’r, 120 T.C. 358 (May 14, 2003), the Tax Court may have given some hope for the validity of a formula. In McCord, the taxpayers formed a limited partnership to hold various investment assets, including stocks, bonds, real estate and other limited partnership interests. The taxpayers transferred certain fractional value of interests in the partnership, the numerator of which was a fixed dollar amount. The Tax Court rejected, for federal gift tax purposes, the use of the formula transfer but indicated the result could have been otherwise if the dollar amount had been described by reference to the property’s value “as finally determined for Federal gift tax purposes”.
If the grantor dies before the note is fully paid, then the balance due on the note will be included in the grantor’s gross estate. Post-sale appreciation on the trust assets, however, will not be subject to estate tax.
The trust must be designed so that the trust assets will be excluded from the grantor’s gross estate for federal estate tax purposes. Accordingly, the grantor must not retain any interests in or powers over the property transferred to the trust that would cause the trust property to be includable in his or her gross estate for federal estate tax purposes.
If the sale is structured correctly as a bona fide sale, then the grantor’s sale of assets to the IDGT should not be characterized as a transfer with a retained interest under IRC § 2036(a)(1). The argument for inclusion is that the right to annual interest payments on the note constitutes a right to receive the income from the transferred property. The concern is one of “coverage” or “thin capitalization,” i.e., if the only assets held by the trust are the assets the trust received in exchange for the note, then the grantor is relying on the income from the transferred property to make interest payments on the note. The result of thin capitalization would be that the trust assets would be included in the grantor’s gross estate at their date of death value, including the appreciation and accumulated income.
To minimize the risk of such inclusion, the trust assets should not be the sole source of the debt repayment. This factor should be satisfied if the IDGT is funded with assets other than those sold to the trust, which can be used to meet the trust’s obligation under the note. One solution is to sell the assets to a preexisting, funded trust. If that is not possible, the trust should be funded with assets equal to ten percent of the face amount of the note. The contribution of the downpayment to the IDGT will be a gift and will generate a gift tax unless it is sheltered by the grantor’s applicable exclusion amount. Funding the trust with assets other than those sold to the trust lends credence to the fact that the sale is a “bona fide sale.”
Rather than creating a new trust to which the assets will be sold, the assets could be sold to an irrevocable grantor trust that already exists. Doing so will avoid the need to fund the trust with cash or other assets in order to support the assertion that the eventual sale is a bona-fide sale. As an alternative to a gift of a 10 percent down payment, coverage can be afforded by the personal guarantees of the beneficiaries.
Achieving Grantor Trust Status
Grantor trust status can be achieved by intentionally violating one of the grantor trust rules specified in IRC §§ 671-679 of the Code. Some of the typical provisions used to cause grantor trust status are as follows:
* Granting the grantor the power, in a non-fiduciary capacity, to reacquire the trust corpus by substituting property of equivalent value. IRC § 675(4)(C). The IRS, in an apparent attempt to discourage the use of this provision as a means of achieving grantor trust status, has declined to rule on whether or not this provision will cause grantor trust status. Instead, the IRS has stated that the determination as to whether the grantor is acting in a non-fiduciary capacity is a factual issue that must await the filing of the fiduciary income tax return.
* Granting the grantor the power, in a non-fiduciary capacity, to control the investment of the trust funds by directing investments or reinvestments and by vetoing proposed investments or reinvestments. IRC § 675(4)(B).
Basis of Property Sold to IDGT
The basis of the assets sold to the IDGT is equal to the grantor’s basis in such assets. That is, the assets have a carryover basis. Because the IDGT will not be included in the grantor’s gross estate, the assets in the trust will not receive an increased basis, as is the case with assets held by the grantor at death (the basis is “stepped up” to equal the fair market value at death). If highly appreciated assets are sold to the IDGT and the assets do not continue to appreciate as expected, the grantor may have been better off had the sale not taken place, in which case the assets would be included in his or her gross estate, but they also would receive a stepped-up basis.
Death of the Grantor during the Note Term
If the grantor dies before the note is paid in full, the IDGT will lose its status as a grantor trust and become a separate entity for income tax purposes. When grantor trust status terminates, the grantor is treated as transferring assets to the IDGT for income tax purposes. Treas. Reg. § 1.1001-2(c), Ex. 5. As a general rule, the trust’s assumption of the grantor’s debt is treated as consideration received by the grantor for the trust assets he is deemed to have transferred. There is an exception, however, when the liability was incurred in order to acquire the property and that liability was not taken into account in determining the trust’s basis thereof. In that situation, the assumed debt is not included in the amount realized by the grantor and thus does not cause recognition of gain. See Treas. Reg. §1.1001-2(a)(3). Based on this exception, there should be no tax upon the death of the grantor.
In TAM 200011005, however, the Service ruled that this exception does not apply to exclude liabilities from which the grantor is discharged on termination of grantor trust status where such liabilities were incurred by the trust to acquire assets. Accordingly, until the Courts address this issue, it is unclear whether the exception contained in the Treasury Regulations apply, in which case there is no tax upon the death of the grantor while the note is outstanding, or if the TAM applies, in which case the death of the grantor triggers a tax.
Even if the TAM applies, it is unclear whether the deemed transfer to the trust, usually presumed to be in exchange for the note, occurs before or after the grantor’s death. The time when the exchange is deemed to occur affects the tax treatment, as follows:
1. A Sale Occurred Immediately Before Death. Under the view that a sale occurred immediately before death, gain would be recognized by the grantor to the extent the balance due on the note exceeds the grantor’s basis in the assets sold to the IDGT. The assets purchased would acquire a new income tax basis in the hands of the IDGT equal to the balance due on the note. If the sale did not qualify for installment treatment under IRC § 453 because, for example, it involved marketable securities for which installment treatment is not available, the gain would be reportable on the grantor’s final return. The additional income taxes generated by the gain would be deductible for estate tax purposes under IRC § 2053 as a claim against the estate. If the sale qualifies for installment treatment, the gain would not be reported on the grantor’s final return, but payments received by the grantor’s estate after death would be income to the estate or a beneficiary of the estate.
2. A Sale Occurred Immediately After Death. Under the view that a sale occurred immediately after death, the property deemed sold would be considered owned by the grantor at death and, therefore, should acquire a new income tax basis under IRC § 1014 with no gain resulting. This may be a difficult position to sustain, because for transfer tax purposes, the trust owned the property on the date of grantor’s death.
3. Sale at Death with No Recognition of Income. Under the view that a sale occurs at death without any recognition of gain, the basis of the trust assets is the amount the IDGT paid for the assets, i.e., the amount of the note. The note is included in the grantor’s gross estate and receives a stepped-up basis to its fair market value at death. In this case, neither the grantor nor the grantor’s estate will recognize gain.
Repaying the Note Prior to the Grantor’s Death.
Given the uncertainty as to which of the above views would prevail, every effort should be made to pay the note off with appreciated assets during the grantor’s lifetime (thereby causing the appreciated assets to be included in the grantor’s gross estate, where they will receive a stepped-up basis). Because the trust is a grantor trust, the grantor would not recognize gain or loss on the payment. Assuming the trust property has appreciated since the original transfer, the note could be satisfied with a return of only part of the original trust property, with sufficient assets remaining in the trust for the benefit of the trust beneficiaries. The property remaining in. the trust would retain the grantor’s original basis. Satisfying the note in kind is preferable to the trust’s selling property to satisfy the note because the trust would incur income tax upon the sale of the property, which could decrease the overall tax savings of the transaction.
An alternative which might also avoid the loss of basis step-up for all of the trust property when the note is satisfied with part of the trust property, the grantor could reacquire the remaining property in the trust during the grantor’s life by substituting it for a high-basis asset. Again, there would be no income tax consequences on the substitution, and the substitution would bring low-basis assets back into the grantor’s estate to get a step-up in basis. This method could avoid both the problems of gain recognition and loss of step-up in basis for all of the assets.
Discount Planning with Sale Technique
The benefit of a sale to the IDGT to freeze the value of an asset can be leveraged by selling an asset with a discounted fair market value. Such assets include interests in a family limited partnership and non-voting shares in a closely held business. For example, assume a client owns an S corporation with an appraised value of approximately $7,000,000. The corporation is recapitalized to authorize the issuance of 100 shares of voting stock and 1000 shares of non-voting stock. A tax free stock dividend of 900 non-voting shares is issued to the holder of the 100 reclassified Class A voting shares. The client then sells 30% of the Class B non-voting shares to the IDGT at a discount of 35% from fair market value. The $7,000,000 figure x 90% = $6,300,000. That sum of $6,300,000 x 30% = $1,890,000. With a discount of 35%, the sale price is approximately $1,305,450. A promissory note is issued by the IDGT providing for 40 equal consecutive quarter-annual installments of $41,000 including interest at 4.65%. The dividend paid to the IDGT is used to make payment of the note. The client may decide to sell additional shares in the future, but may want to retain shares in the event the business is sold. Assuming the client uses the payments for his living expenses, a substantial portion of his asset base is eliminated from the estate. His Will may be drafted to pour other assets into the IDGT. As he pays the income taxes on the dividend income of the IDGT, he is, in effect, making an additional unreported gift to the children as beneficiaries of the IDGT.
Sale to a Grantor Trust vs. Grantor Retained Annuity Trust
A GRAT offers similar transfer tax saving opportunities as a sale to an intentionally defective grantor trust, in that they both result in tax savings when the trust assets outperform (from an investment return perspective) the applicable interest rate. Following is a discussion of how GRAT’s and sales to an IDGT compare on several important issues.
Inclusion in the Grantor’s Gross Estate.
If the sale to an IDGT is structured correctly, no portion of the IDGT will be included in the grantor’s gross estate for federal estate tax purposes. If the grantor dies before the promissory note is fully paid, only the unpaid balance of the note is included in his or her gross estate. Any appreciation in the value of the assets in the grantor trust escapes taxation. In contrast, if the grantor of a GRAT dies during the GRAT term, most or all of the GRAT property, including any appreciation in the value of the GRAT property, will be included in the grantor’s gross estate for federal estate tax purposes. Therefore, there is a mortality risk with a GRAT that is not an issue with a sale to an IDGT. The mortality risk of a GRAT, however, can be eliminated by use of the guaranteed GRAT approach discussed above.
The Section 7520 rate, which is used to value the retained annuity interest in a GRAT, equals 120% of the federal midterm rate under IRC § 1274. As such, the Section 7520 rate is almost always higher than the interest rate on the note (the short-, mid-, or longterm AFR). Thus, the annual annuity payments under a GRAT almost always will be greater than interest payments required under the promissory note used in a sale to an intentionally defective grantor trust. In addition, the GRAT annuity payments often result in a portion of the underlying trust assets being returned to the grantor at a time that is often earlier than would be the case where a sale to an IDGT is used. As a result, with a GRAT, more property will be returned to the grantor in the form of an annuity payment (to be subject to estate tax if not consumed by the grantor), and less property will pass to the beneficiaries. Thus, more property usually will pass to trust beneficiaries free of transfer taxes under the sale technique than under a GRAT.
The sale technique, unlike a GRAT, permits the leveraging of the grantor’s GST exemption. This is because the ETIP rules, which prohibit the allocation of GST exemption to a GRAT before its term of years expires, do not apply to an irrevocable trust of the type used in connection with the sale technique. Thus, a grantor of an IDGT can allocate GST exemption to an IDGT immediately, and any appreciation after the sale will avoid GST tax. To achieve a similar result for generation-skipping transfer tax purposes with a GRAT, the family needs to consider employing the remainder sale technique discussed above.
By structuring the transaction as a sale to an intentionally defective grantor trust, it is possible to use a balloon note in which the repayment of principal is deferred until the end of the term of the note. Thus, it is possible to delay payments to the grantor, which has the effect of causing more growth to occur inside the irrevocable trust. With a GRAT, however, the extent to which annuity payments may be postponed is limited because the annuity for a given year cannot exceed 120% of the preceding year’s annuity amount. Treas. Reg. § 25.2702- 3(b)(1)(ii). Thus, a sale to an IDGT allows the greatest compounding of appreciation inside the trust.
Amount of the Gift.
The sale of assets to an IDGT, if structured correctly, will not be a taxable gift. The only gift will be the gift upon contributing the “seed” money to the IDGT. As discussed above, a gift can be avoided entirely if the sale is to an existing funded grantor trust or if the beneficiaries guarantee payments on the note. In light of Walton, discussed in the section on GRATs above, a GRAT can be structured as a zeroed-out GRAT so that there is no gift upon creation. Before Walton, a sale to an IDGT was considered to have the advantage on this point because it could be structured to avoid any gift.
Short Update on Family Partnerships