[Louis A. Mezzullo, Esq., of Mezzullo & McCandlish, Richmond, Va., presented a paper discussing installment sales to grantor trusts at the ABA Tax Section’s midyear meeting in San Diego.]
Generally, the grantor of a trust who retains the right to enjoy or to control the enjoyment of the income or principal is treated as owning the assets for income tax purposes. The objective of the grantor trust rules found in IRC §§ 671 – 679 is to prevent income-shifting by the grantor. Asset sales to grantor trusts exploit this income tax attribute.
When the grantor of a grantor trust sells assets to the trust, no taxable event occurs — the sale is considered a sale to the grantor himself, provided the sale is made for full and adequate consideration, and the note bears interest at a rate at least equal to the AFR determined under §1274. (Rev. Rul. 85-13, 1985-1)
For transfer tax purposes, if the grantor takes back an installment note and does not retain incidents of ownership, the sale could remove appreciating assets from the estate without the imposition of any gift or estate taxes ever. Moreover, the grantor’s estate would be reduced by the yearly income taxes which the grantor must pay on trust income. In effect, this would accomplish a gift tax-free transfer of income tax payments to beneficiaries of the trust. It is true that the trust would take a transferred, rather than a cost, basis in the trust assets, since the grantor and trust are the same income tax entities. However, the flip side of this is that neither the trust nor the grantor would be required to recognize gain if appreciated assets were later used to satisfy the outstanding note.
If grantor trust status terminates before the note is repaid, Mr. Mezzullo concludes that the grantor would “presumably” recognize taxable income equal to the amount of the gain represented by the unpaid portion of the note. However, unlike the situation with a GRAT, the early death of the grantor would not result in a tax fiasco: Whereas the early death of the grantor of a GRAT results in gross estate inclusion of the trust assets, no inclusion would result where the grantor-noteholder died before the repayment of the note (although the estate may have been augmented by principal and interest payments made on the note).
Another advantage an asset sale to a grantor trust possesses over the GRAT reflects the interests rates which must be employed: The GRAT must use an annuity rate equal to 120 percent of the AFR. The note securing the assets sold to the grantor trust need only bear interest at AFR rate itself. In the GRAT context, the IRS has also threatened in rulings to contest the gift tax-free transfer of income tax payments by the grantor by requiring the grantor to pick up gift tax on these payments. Mr. Mezzullo believes that the IRS could not make the same argument with respect to asset sales to grantor trusts since the grantor is obligated under the Code to pay the tax.
The grantor trust asset sale can also achieve non-tax objectives, as note proceeds can be used to provide income for family members who do not wish to participate in the business which is sold to the trust. The installment sale to a grantor trust may also constitute an effective way of transferring assets to younger family members at their current value without incurring any gift tax. The only real cost to the beneficiaries would be the loss of the carryover basis. The importance of this drawback diminishes if the if the grantor expects the family members to continue the business.
Mr. Mezzullo concludes that “if the installment-sale-to-a-grantor trust technique is used, the formalities should be followed to the letter, including a properly drafted trust agreement, installment note, and any other documents required under state law to transfer ownership of the assets to the trust and to support the grantor’s status as bona fide creditor of the trust.” He adds that the “safest” means of achieving grantor trust status while still effectuating a transfer for gift tax purposes would be to permit an independent party to add beneficiaries.
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Mr. Mezzullo also discussed the perplexing Simplot case (112 T.C. 190; see Tax News, Oct. 1999), which held that the premium for voting rights on only a few shares owned by the decedent should be based on the entity’s equity value, rather than merely as a percentage of the voting shares, resulting in a premium of $325,724 per share. He concluded that Simplot was simply a reaction to a situation where the total number of voting shares was extremely small, and was therefore an anomaly.