Taxes & Valuation Issues; Special Valuation Rules under Chapter 14

by Howell Bramson on 05/19/2011

 

 

UJA FEDERATION

PLANNED GIVING & ENDOWMENTS

TAXES AND VALUATION ISSUES

SPECIAL VALUATION RULES UNDER CHAPTER 14

 

MAY 19, 2011

 

 

 

 

Howell Bramson, Esq.

McCarthy Fingar LLP.

11 Martine Avenue

White Plains, New York 10606

914-946-3700

 

 

I. Background

 

A. History

1. Beginning in the inflationary mid-1970s, many owners of income producing and appreciating assets, including closely-held businesses, turned to “freezing” techniques as part of a plan to shift future appreciation in the value of those assets to younger family members. An estate freeze is a technique that has as its objective limiting or reducing the value of an interest in a business or other property for estate tax purposes. Typically, this is accomplished by having an older-generation transferor retain a non-appreciating interest in a business while transferring the interest that will appreciate to a younger- generation transferee.

1.  

    

   1. These “freezing” techniques (detailed below) included: (a) corporate and partnership recapitalizations, (b) grantor retained income trusts, (c) split-purchases of property, (d) buy-sell agreements, (e) lapsing rights, and (f) restrictions on liquidation.

    

B. Corporate and Partnership Recapitalizations

1.  

    

   1. An older family member owning a business that was expected to appreciate in value could use a corporate or partnership recapitalization to freeze the value of the business.

    

    

   2. The business was thereby recapitalized using two new equity interests: (1) a senior equity interest entitled to both a fixed annual payment and a fixed amount upon liquidation or redemption (e.g., preferred stock), and (2) a subordinate equity interest entitled to neither of these payment rights, instead receiving the residual growth in value of the business (e.g., common stock).

    

    

   3. As part of the same transaction, the older family member would exchange his or her existing equity for these two interests and then give or sell the subordinate equity interest (the common stock) to younger family members.

    

    

    

   4. Because most of the value of the business would be retained by the owner of the senior equity interests, the value of the subordinate equity interests would either be nominal or a small fraction of the value of the business.

    

5. Then, upon the death of the older family member, the value includible in his or her estate would be limited to the value of the senior equity interest.

6. The appreciation in the value of the business after the date of the recapitalization would accrue to the younger family members without being subject to transfer taxes.

C. Grantor Retained Income Trusts

1. Grantor retained income trusts (GRITs) were another vehicle used to shift future appreciation in the value of an asset (such as a commercial real estate) from older to younger family members.

2. An older family member would transfer the asset to a trust and retain the right to the income from the asset for a term of years.

3. Upon termination of the trust, the asset would pass to younger family members.

4. The gift of the remainder interest to the younger family members would be valued at the present value of the right to receive the asset at the end of the term interest using an interest rate prescribed by the Internal Revenue Service (IRS).

5. When the asset passed to the younger family members, the value of the asset might have increased substantially.

 

1.  

    

   1. In addition, it was likely that the current income produced by the asset would be considerably less than the prescribed interest rate.

    

    

   2. If the older family member died before the end of the term interest, the value of the asset would be included in his or her federal gross estate.

    

D. Buy-Sell Agreements

1.  

    

   1. Aggressive planners also attempted to reduce the value of a corporation or partnership interest for estate tax purposes through the use of a buy-sell agreement.

    

    

   2. The buy-sell agreement would value stock or an interest in a partnership using a formula price applicable at the death of the shareholder or partner.

    

3. However, over time, the IRS began successfully challenging buy-sell agreements as not establishing an interest‘s fair market value if the agreement was a testamentary device to transfer the interest to the natural objects of the decedent‘s bounty for less than full and adequate consideration in money or money‘s worth.

 

II. Section 2701: Application of Special Valuation Rules to Transfers of Interests in Corporations and Partnerships

1.  

    

   1. Introduction

    

1.  

    

   1. An entire statutory scheme of rules was enacted to apply to a variety of transactions that typically are used in an estate freeze context. These rules are contained in Code Section 2701, 2702, 2704 and 2704, which make up Chapter 14 of the Code. They represent a more-or-less integrated approach with a common theme of addressing a particular kind of tax-motivated transaction, for which the property in question may vary.

    

    

   2. The approach taken by the special rules is to disregard, for gift tax valuation purposes, interests retained by the transferor after a transfer to a family member. This insures that a high gift tax will be imposed on the transferred interest at the time of the transfer. This is in contrast to the approach taken by former Code Section 2036(c) (which was repealed at the same time the special rules were enacted). Code Section 2036(c) dealt with estate freezes by requiring that the transferred interest be included in the transferor’s gross estate at the time of his death. Section 2701 applies special valuation rules to determine the value for gift tax purposes of certain interests in corporations and partnerships that are transferred to members of the transferor’s family.”

    

    

   3. For transfers subject to these rules, the rules replace the general valuation principles that were previously applicable. For transfers not subject to these rules, the old valuation principles continue to apply. The new rules will almost always result in a higher gift tax than the old rules for estate freeze transfers.

    

1.  

    

   1. Transfers of Interests in Corporations or Partnerships

    

1.  

    

   1. Special valuation rules apply when a transfer of an interest in a corporation or partnership is made to a member of the transferor’s family and, after the transfer, the transferor or an applicable family member holds an applicable retained interest in the entity.

    

    

   2. An applicable retained interest is any interest that confers a discretionary liquidation, put, call or conversion right, or a distribution right in a family-controlled entity.

    

    

   3. In determining the gift tax consequences of the transfer, a retained liquidation, put, call or conversion right is valued at zero. A retained distribution right in a controlled entity is also valued at zero, unless it is a right to a fixed rate cumulative dividend payable on a periodic basis or the partnership equivalent (a “qualified payment”).

    

    

   4. A lapse of a voting or liquidation right in a controlled entity is treated as a gift by the individual holding the right immediately before the lapse.

    

    

   5. According to the Senate Finance Committee Report, the special valuation rules do not affect minority discounts or other discounts available under normal valuation rules (including, presumably, lack of marketability discounts).

       

   6. The special valuation rules apparently do not apply to any other interests retained in a corporation or partnership

    

, including rental payments under a lease, principal and interest payments with respect to debt, and compensation pursuant to an employment contract.

 

2. General

 

 

In valuing interests in trusts held by the transferor or applicable family members after the transfer of an interest in trust to a member of the transferor’s family, the Treasury tables that are ordinarily used to value trust interests are disregarded, and retained interests are valued at zero unless they take a form comparable to an annuity or unitrust interest. Sales of remainder interests and joint purchases of interests in property are treated like transfers of interests in trusts for purposes of these rules.

 

 

3. Grantor Retained Annuity Trusts

 

 

 

III. Transfer of Interests in Trusts

 

1.  

 

1.  

    

   1. General

    

    

   A grantor retained annuity trust (“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.

    

    

   2. 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.

    

    

   3. 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.

    

    

   4. What Assets Are Best for Funding GRAT’s?

    

    

   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. 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”). . 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.

    

   5. 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.

    

   6. Valuing the Reversion

    

    

   7. Rolling GRATs

    

    

    

    

   Example:

   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).

    

   8. The Annuity

    

    

1.  

    

   1. 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).

    

    

    

   2. 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.

    

    

   3. The annuity can be paid from income, and, if income is insufficient, from principal.

    

    

    

   4. 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.

    

    

    

   5. 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.

    

    

    

   6. 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).

    

 

1.  

    

   1. 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.

    

    

   2. Zeroed-Out GRAT

    

 

 

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.  

1.  

    

   1. Estate Tax

    

    

   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).

    

    

   2. Income Tax

    

   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

   a. 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;

   b. 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

   c

1.  

    

   1. 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.

    

    

   2. 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 that 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.

    

1.  

    

   1. Marital Deduction Planning

    

1.  

    

   1. 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:

    

    

    

   2. Direction in Will that Payments Be Made to the Surviving Spouse.

    

    

    

   3. 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. 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.

 

1.  

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.

 

1.  

    

   1. Advantages of Short-Term GRATs.

    

    

   • 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.

    

    

    

    

    

   2. Disadvantages of Short-Term GRATs

    

   . Short-term GRATs have the following disadvantages:

   .

   Short-term GRATs have the following advantages:

 

•  

   

  • 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.

 

 

IV. Discounts in valuing fractional interests in real property.

1.  

    

   1. General.

    

   In valuing fractional interests in real property, on proper proof, various discounts of 44%, 20%, 15%, and 12.5% of the proportionate value of the whole been approved as reasonable. See e.g. Estate of Ellie B. William v. Commissioner, T.C. Memo 1998-59; and Propstra, John v. U.S., 690 F.2d 1248 (9^th Cir, 1982).

    

   2. Joint Tenancy.

    

   No discount is allowed for valuing a joint tenancy interest. See Estate of Young, 110 T.C. 297 (1998). The Tax Court determined that Section 2040(a) was the sole method for valuing joint tenancy interests.

    

   3. Retained Life Interest.

    

   No fractional interest discount was allowed in valuing real property for estate tax purposes where the decedent, during his life, had transferred an undivided one-fifth interest in the property to each of his children, while expressly reserving the full use, control, income and possession of the property for his life. The Tax Court said that whether property should be valued as whole or as separate fractional interests, with appropriate discounts for split ownership, depends on when the interests are separated. If ownership is split during the decedent’s lifetime, the interest the decedent retained is valued separately. If the split occurs only at death, the property is valued as a whole, without a discount for split ownership. And the court said that, for these purposes, the ownership of the real property should be considered to have been split up at the decedent’s death. During his life, the decedent transferred a one-fifth remainder interest to each of his five children, and retained a life estate in the property. Thus, it was as if the decedent had retained the entire interest in the land during his life and transferred the property to his children at his death. See Estate of Adler, T.C. Memo 2011-28 (2011).

    

   4. Implied Retained Life Interest.

    

If a parent transfers his residence to his son or a daughter and thereafter continues to live in the residence, the value of the residence is included in the parent’s gross estate when he dies, if there was an implied agreement that the parent would continue to live there. IRS takes this position whether the parent occupied the residence exclusively, or together with his children, the transferees. See Rev. Rul. 70-155, 1970-1 C.B. 189.

 

 

 

 

 

Outline and Presentation by