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Gifts to GRATS versus Sales to Grantor Trusts

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I. Introduction

A. The Idea

    1. The primary approach used by estate planners to reduce estate taxes is for taxpayers to transfer assets to children or grandchildren (or trusts for their benefit) when assets aren’t worth a lot, so that when they become worth a lot the appreciation is transferred without the imposition of estate or gift tax.
    1. The simplest way to accomplish this end for an entrepreneur is to put trusts for the children and/or grandchildren “into” the business from the start. Instead of the parents owing 100% of the business, they can gift cash to trusts for issue and those trusts can invest that cash initially into the business (typically for non-voting interests so that the parents can keep control).  Since cash to initially capitalize a business can be nominal, this approach can allow trusts for issue to own a significant share of the business using the $15,000 annual gift tax exclusion and leaving unified credit intact.  Gift tax risk is also taken out of the picture – the gift is of cash, before the business is a going concern – so there is nothing for IRS to challenge.A similar approach can be undertaken with an existing business that is coming out with a new product or going into a new geographic area.  If new entities are created for these purposes the trusts for issue can invest in a similar fashion.

      The benefits of this approach are illustrated by Example 1, below:

Example 1:

Assume parents intend to initially capitalize a business with $10,000.  Parents gift $7,000 to a trust for their children, remainder to grandchildren.  Parents allocate $10,000 of their generation-skipping tax exemption to the trust.  The trust invests $7,000 in the business in exchange for a 70% non-voting interest in it.  Parents invest $3,000 in the business in exchange for a 30% voting interest in it.

The business operations begin, and in 10 years parents sell the business for $20 million.  The trust for children, remainder to grandchildren, receives $14 million of the proceeds (parents receive $6 million).

Assume that the trust is a “grantor trust” for income tax purposes.[1]  Parents pay the income tax on the trust’s $14 million received; the trust “nets” $14 million.[2]  Transfer tax is avoided on that amount.  Assuming the estate tax rate is 40%, the tax savings is $5,600,000.

Assume that the children don’t spend the trust money during their lifetimes, and the assets grow to be worth $60 million when the children die and the assets pass for grandchildren.  Since the trust is generation-skipping tax exempt, the $60 million will pass to the grandchildren without additional transfer tax.  This means another 40% tax is avoided – saving another $24 million.

If parents want to benefit from the upside, the asset can be declared one parent’s separate property, and then he or she can create a spousal lifetime access trust (“SLAT”) for the benefit of the other spouse.[3]  The SLAT can be the initial investor in the business – so in this example, when the business is sold, the SLAT will hold the $14 million.[4]  If the parents need the cash generated by the SLAT’s share of the business the trustee could make a distribution to the spouse beneficiary who could use the cash for the parents’ benefits – but the spouse would try not to tap into the SLAT assets so that whatever remains in the SLAT when she dies can pass to future generations without transfer tax.

    1. If parents have an existing business that is an appreciating asset, they can sell that asset to a grantor trust for a child in exchange for a small down payment (make sure it’s enough to avoid IRC Section 2036 inclusion under the “transfer with a retained interest” theory) and a promissory note.  Interest on the note must be charged at a rate that avoids imputed interest under Section 7872 of the Internal Revenue Code.  The effect is to “freeze” the value of the asset in the parents’ estates at the sales price; any appreciation (in excess of the required interest rate) passes with the imposition of the transfer tax.  (When interest rates are low the technique can be most effective.)  This technique is called a sale to an intentionally defective irrevocable trust (“IDIT”).
    1. Grantor retained annuity trusts (“GRATs”) are similar to sales to IDITS in that they are used to transfer appreciation in existing businesses from parents to future generations. What the parents receive in return is an annuity payment plus an additional “interest like” amount that is calculated using the IRC Section 7520 rates.  Those Section 7520 rates are calculated based on the AFR, so as interest rates drop the Section 7520 rates drop.  Lower Section 7520 rates mean that the return “hurdle” is less in order to push appreciation to the children without transfer tax.
    1. In addition, GRATs are often constructed as “zero out” trusts – meaning that the amount retained by the parents in the form of an annuity equals the value of what the parents contributed to the GRAT. The result of zero out GRAT planning is that the parents use no lifetime gift tax exemption in their attempt to transfer the appreciation to the children.  In its most desired form, the GRAT assets generate enough cash to pay the annuity (avoiding the need to value the GRAT assets each year to make the annuity payment with those assets if there is a cash shortfall).  When interest rates are low, less cash is needed to pay the interest factor so more is available to pay the balance of the annuity – in essence making this desirable option more readily available.
    2. Consider the following example:

Example 2:

Parents anticipate that their closely held business will be purchased within the next 6-9 months for a substantial sum.  They value the business now at $10 million, and gift all of their stock in the business to a 2-year GRAT.  Based on October 2015 rates, the annuity that must be paid to “zero out” the gift is 51.50391% of the value of the asset gifted to the GRAT each year.  The present value of that annuity is $10 million, so the value of the gift for gift tax purposes is zero.  The “hurdle rate” is 2% – so any appreciation in the value of the business in excess of that amount is transferred to the children without incurring transfer tax.

The offer to buy the business comes in, and it is sold for $20 million 9 months after the GRAT is created.  The parents are paid $5,150,391 (i.e., 51.150391% x $10,000,000) at the end of the first year, $5,150,391 at the end of the second year, and the remaining $9,699,218 passes to the children without transfer tax.  Assuming a 40% rate, the estate tax saved (no unified credit has been used) is $3,879,687.[5]

    1. A sale to an IDIT is intended to accomplish the same results as a gift to a GRAT – a transfer of business appreciation for an existing business occurring after the sale to the (trust for the) children. In this context, the parents establish a “grantor” trust for the benefit of their children.  Parents make a gift to the trust, typically equal to 10% of the amount of the asset to be sold.[6]  The IDIT then uses its cash gift to purchase the asset expected to appreciate, for 10% down and a promissory note.  In many cases, the note is an interest-only note, with no prepayment penalty.  The applicable federal rate is the interest rate charged – in essence, the AFR serves as the “hurdle rate”.  In a low interest rate environment, the “hurdle rate” is low – enhancing the amount of appreciation that can be passed to the children (or a trust for their benefit).There is no gain or loss recognized on the sale – and no income tax payable as a result of interest received by the parents.  When the parents believe that the asset has “peaked” in value, the parents can ask the trustee of the IDIT to repay the note.  What remains after the note is repaid passes to the children without transfer tax.
    2. Consider the following example to show how an IDIT sale is supposed to work:

Example 3:

Assume parents gift $1 million to an IDIT.  Then, they sell the business described in Example 2 to the IDIT for $1 million down and a $9 million interest-only note, with principal due in 3 years.  Using October 2015 rates, the interest rate equal to the AFR is .55% (assuming interest is payable annually).

The business generates a dividend of .55%, which is just enough to make the interest payment due under the note from the IDIT.  Two years later, a buyer purchases the business from the IDIT for $20 million.  The IDIT pays off the $9 million principal balance due on the note and retains $11 million of the sales proceeds.  (Note:  since the IDIT is a “grantor” trust, it retains the gross proceeds – the parent grantors pay the capital gains tax due on the sale.)

The end result is that $11 million has been transferred without gift or estate tax.  Because $1 million of unified credit has been used on the gift, the tax savings is on the $10,000,000 of appreciation transferred – assuming a 40% estate tax rate, the tax savings is $4,000,000 in transfer tax.

The IDIT is retained in trust for the lifetime of the Settlors’ children.  Assuming that $1 million of GST exemption was allocated to the initial gift to the IDIT, it has an inclusion ratio of zero.  That means that whatever is held in the IDIT when the children die passes to their children (the Settlors’ grandchildren) without transfer tax.

A. Which Approach is “Better”?

GRATs and sales to IDITs are complementary techniques.  In estate planning discussions, lawyers typically discuss both with their clients.  Their clients ask them to recommend one approach over the other.  The purpose of this outline is to help lawyers determine which to recommend.

II. IDIT Sales are “Better” than GRAT Gifts in Five Ways

A. First, the AFR (.55% in October 2015 for a 3-year note) is less than the Section 7520 rate (2% in October 2013).  Therefore, the “hurdle rate” that has to be exceeded for the transaction to succeed.

B. Payments can be made at any time in the IDIT context, as opposed to the GRAT context where payments must be made on specified dates.  Further, only interest is required to be paid in the IDIT sale (before the due date of the note), while “principal” payments must be made each year when a GRAT is used (payments aren’t really principal payments, as the GRAT doesn’t involve a sale – this term is used for analogy only).  These differences make the IDIT sales a more “flexible” technique than the GRAT technique.

C. Most importantly, IDIT sales allow generation-skipping tax (“GST”) exemption to be allocated to the IDIT in connection with the gift of the down payment on initial funding.  Later growth in the value of the IDIT assets can therefore pass without GST to grandchildren when the children die (so long as the IDIT lasts for the child’s lifetime).  Since GST exemption can’t be allocated to the GRAT until the end of the GRAT term, it is effectively impractical to use the GRAT technique to pass assets further than one generation down.[7]

D. The parents must outlive the GRAT term for the GRAT to work.  There is no such survivorship requirement for an IDIT.

E. A GRAT requires yearly valuations and transfers; where principal is returned to the donor to make the annuity payment, the donor may consider transferring that returned portion of the asset given to a new GRAT (called “rolling GRATs”).  This can increase the cost and hassle of administration for the client.  With an IDIT, there are simply annual interest payments with principal payments due once, at the date the note comes due.  There is therefore only the need for one IDIT (rather than multiple GRATs), one valuation (at the date that principal is used to pay off the note), and one transfer.  The IDIT is simpler to administer.

III. The GRAT can be “Better” than the IDIT in Two Ways

A. A “zero out” GRAT is guaranteed to protect the taxpayer from having to pay gift tax if the IRS on audit increases the value of the gifted asset.

    1. If the annuity is stated as a percentage of the value of the gift as finally determined for Federal gift tax purposes, a “zero out” GRAT effectively keeps the value of the gift at zero – and no gift tax will be due. The regulations say that this works – there is absolutely no risk to the taxpayer.
    1. With an IDIT sale, the same result cannot be guaranteed by using “defined value clauses” or other similar approaches.[8] Even with the Wandry decision, there cannot be absolute certainty.

B. A “zero out” GRAT doesn’t use unified credit, so if the value of the gifted asset drops, no unified credit is wasted in the context of a “failed” GRAT. In an IDIT sale, at least the down payment must be given to the IDIT – meaning that some unified credit is used.  In a “failed” IDIT sale that unified credit is lost without benefit to the taxpayer.

IV. GRATs Can Be Used to Enhance the IDIT Sale

A. An IDIT sale transfers the appreciation on the property sold to the next generations. But the sales proceeds (down payment and note) remain part of the taxpayer’s estate, subject to estate tax when the taxpayer dies.

B. Assume that the note is contributed to a very long-term, zero out GRAT, where the payments to the donor are equal to the interest payments on the note. (Since interest rates are very low, the GRAT term will almost certainly not end before the donor dies.)  When the note is paid off, the GRAT has the cash but continues to make the small payments to the donor.

C. When the grantor dies, that portion of the GRAT necessary to generate the annuity payments to the donor is included in the donor’s estate and subject to estate tax. Notice – the entire GRAT is not necessarily included and taxed.  If the value of the GRAT assets has appreciated, or if the interest rate at the time of the donor’s death is higher than the date the GRAT was created, only a portion of the GRAT is taxed – the balance escapes the transfer tax system.  Because interest rates today are extremely low, it is likely that GRATs created with IDIT sale notes today will not all be subject to tax when the donor dies – each tick up in interest rate allows more to escape estate taxation when the donor dies.

D. Consider the following example:

Example 4:

A $1,000,000 note payable is taken back in an IDIT sale, bearing 2.58550% interest payable annually.  That note is contributed to a zero-out GRAT, that (based on a Section 7520 rate of 2%) requires a 2.58550% payout for 75 years.

Because interest rates are low now, it is likely that they will be higher at his death.  Note that there doesn’t have to be too big an increase for significant savings to arise.

Assume the donor dies 10 years later.  If the Section 7520 rate is 2% at his death, the entire GRAT is included in his estate and no taxes are avoided.  However, if the Section 7520 rate is 3% at his death, only $767,940 is included as part of his estate – and $232,060 is excluded from his estate (saving 40% of that or $92,824).   If the Section 7520 rate is 4% at his death, only $612,256  is included – and $387,744 is excluded from his estate (saving 40% of that or $155,098).  In fact, if the note can be discounted (low interest rate compared to prevailing rates when the donor dies, unsecured, etc.)[9] the tax savings can be enhanced.

[1]           The parent creators of a grantor trust pay all the income tax on income of a “grantor trust”.  When a parent pays that tax, there is an additional transfer tax savings on the amount of cash effectively “given” to the grantor trust by the parents’ paying its tax – but that isn’t treated as a gift for gift tax purposes, so gift tax on that amount is avoided.  Here, if the income tax on the $14 million would be approximately 30% ($4,200,000), the transfer tax “savings” is 40% of that or $1,680,000.

[2]           If, when the business is sold, parents don’t want to pay the income tax on the trust’s share of the proceeds, they can release the power that makes the trust a grantor trust before the sale so that the trust will, instead, pay the tax.

[3]           While the spouse who created the SLAT is alive, distributions to the beneficiary spouse may only be made for “best interests”.  (After the creator spouse dies, distributions can be for “support”.)  Neither spouse can act as trustee of the SLAT until the first spouse dies – though the creator spouse can have the power to remove and replace the trustee.  Children cannot act as trustee at the outset either.  If the beneficiary spouse dies before the creator spouse, the assets pass immediately for children.  As a result, those assets will not be available to the creator spouse for the rest of his or her lifetime (though the creator spouse might borrow from the trust then held by the children if needed for support).  Similarly, if there is a divorce, the creator spouse won’t be able to access SLAT funds thereafter.

[4]           The SLAT will always be treated as a “grantor trust” – so the parents will need to pay the income tax on sale for the SLAT’s share of the sales proceeds.  However, because one spouse is the beneficiary of the SLAT, he or she can borrow or receive a distribution of enough cash to pay the income tax if the parents don’t have outside assets available for that purpose.  If the spouse beneficiary borrows, then a debt is owed to the SLAT when he or she dies, providing an estate tax deduction and allowing the SLAT to be “filled up” so that more can pass to future generations without incurring transfer taxes.

[5]           The GRAT is a grantor trust, so the parents paid the capital gains tax generated by the sale.  As a result, the children receive the entire $9,699,218, and the “net” tax saved is $3,879,687!

[6]           See Mulligan, Sale to an Intentionally Defective Irrevocable Trust for a Balloon Note – An End Run Around Chapter 14?, 32 u. of miami, phillip e. heckerling inst. of est. plan (1998) at 1505.2.

[7]           An allocation of GST exemption to certain transfers is not effective until the close of the Estate Tax Inclusion Period, or “ETIP”.  IRC §2642(f).  The ETIP is the period during which, if the transferor died, the transferred property would be included in the transferor’s estate.  The ETIP terminates upon the first to occur of the transferor’s death or the time at which no portion of the transferred property would be includible in the transferor’s gross estate (except by reason of IRC §2035).  Treas. Reg. §26.2632-1(c)(3).  Hence, no effective allocation of GST exemption can be made until the end of the GRAT term.  See, e.g., PLR 200227022.

The court cases now allowing defined value clauses to avoid payment of gift tax in the context of an IDIT sale are summarized below:

One of the first cases on the subject was Christiansen v. Comm’r, 104 AFTR 2d 2009-7352 (8th Cir. 2009), the Court upheld a formula disclaimer (that operated much like a “defined value” transfer clause, where “excess amounts” poured-over to charitable foundation) over public policy objections by the IRS, thereby “blessing” defined value clauses.  The IRS argued that fractional disclaimers fail to preserve a financial incentive for the IRS to audit an estate’s tax return (because any post-challenge adjustment to the value of an estate would consist entirely of an increased charitable donation), and should be categorically disqualified as against public policy.  The Court rejected the IRS’ argument on three grounds.  First, the IRS’ role is to enforce tax laws, not simply maximize tax receipts.  Second, Congress seeks to encourage charitable donations by allowing deductions for such donations.  And third, there are sufficient other mechanisms imposing duties on taxpayers, such as fiduciary obligations of executors and trustees, to accurately report estate values, so that the IRS is not the only arbiter of a “watchdog function.”  The first and third reasons given by the Court apply to all defined value clauses, while the second would apply only to formula allocation clauses that pour-over the “excess” over a defined value amount to charity.

Further, in another recent case, Petter v. Comm’r, TC Memo 2009-280, aff’d 653 F.3d 1012 (9th Cir. 2011), the Tax Court upheld a defined value gift clause for LLC interests given to the grantor’s children and charities.  The IRS argued that the defined value gift clause was unenforceable as against public policy.  The Court noted in its categorization of prior cases that “savings clauses are void, but formula clauses are fine.”  The Court disagreed that defined value clauses are against public policy and referenced other situations where the IRS expressly blesses formula clauses, such as disclaimers, charitable remainder trusts and marital deductions.  This decision was affirmed on August 4, 2011 by the Ninth Circuit.  See also McCord v. Comm’r, 461 F.3d 614 (5th Cir. 2006), rev’g 120 T.C. 358 (2003).

Another case is Hendrix V. Comm’r., T.C. Memo 2011-133 (June 15, 2011); the court again rejected the public policy argument raised by the IRS.

The most recent, and quite frankly exciting case, is the Tax Court’s March 26, 2012 memorandum decision in Wandry v. Comm’r, T.C. Memo 2012-88.  Wandry is the first “naked” defined value clause that has been approved by the courts.  The decision came down in the 10th Circuit, which decided the King v. United States, 545 F.2d 700 (10th Cir. 1976) – so if Wandry is appealed, there is a strong possibility it will be affirmed.  (King was a straight “price adjustment clause” case.)  However, the Tax Court in Wandry said that because the clause was a defined value clause rather than a price adjustment clause, it would reach its decision based on Petter.  Since Petter is a 9th Circuit case, those of us with clients in the 9th Circuit have great hope that naked defined value clauses will be given effect in California.

[9] Discounts can be available in the range of 10% – 20%. The effect is to increase the tax savings by another 10% – 20%, depending on the amount of the discount allowed by IRS.

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