For estates in which a family owned business comprises at least 50% of the adjusted gross estate, careful planning to qualify under §2057 may result in significant estate tax savings, since when combined with the AEA, with which it is coordinated, up to $1.3 million can excluded. Since §2057 is an all-or-nothing proposition, precise planning is crucial.
The QPRT, excluded from the restrictive rules of IRC §2702 is discussed below in January Comment. §2702 also exempts from its restrictive provisions grantor retained annuity trusts. GRATs can effectively reduce taxable gifts to the mere value of the remainder interest, provided the grantor retains a “qualified annuity interest” in the trust assets for a term of years. One condition is that the grantor must outlive the trust term in order to reap the benefits of the GRAT. As a fail-safe mechanism, the GRAT can provide that in the event the grantor dies before the expiration of the term, the trust will convert to a marital deduction trust.
LLCs have enjoyed explosive growth as business and estate planning vehicles due to their sunny tax and nontax attributes. LLC interests may be transferred to children or other family members at a greatly reduced gift tax cost due to availability of minority and lack of marketability discounts. (A professional discount valuation and a separate valuation for real estate, if applicable, are essential.) Such transfers can be made with a simple assignment, and do not require the filing of annual deeds, which would be required for yearly transfers of fractional interests in real estate.
The parent can retain control over business decisions and distributions as managing member, despite holding only a small interest in the LLC, without the danger of inclusion under IRC §2036, if business decisions reflect his status as a fiduciary. It may no longer be necessary to “forum shop” in order to find a state which places restrictions on the ability of a member to dispose of his interest, since NY LLC §701 now provides that the operating agreement may contain its own restrictions on dissolution. This may prevent the IRS from invoking §2704(b) in an attempt to deny valuation discounts in NY LLCs. Since the legislation is not grandfathered, existing LLC agreements should be amended. LLCs also provide a broad measure of asset protection, since creditors can at best obtain a “charging order” and cannot reach partnership assets.
Intentionally defective grantor trusts (IDGTs) are now being used in tandem with GRATs. An IDGT is created when the grantor makes a complete transfer for gift tax purposes, but makes an incomplete transfer for income tax purposes. Trust assets are not diminished by yearly income taxes, since the grantor pays income tax on trust growth. Often, the grantor will sell appreciating assets to the IDGT in exchange for a note. No income tax event occurs since the grantor and trust are one income tax entity.
IDGTs possess advantages over GRATs: First, the premature death of the grantor of an IDGT should not result in the full value of the trust being included in the grantor’s gross estate; second, a true “estate freeze” should be possible, since an appreciating asset is replaced by a nonappreciating asset, a note; third, the rate of growth of assets required to produce transfer tax savings is lower, since the GRAT uses the higher IRC §7520 rate, while the IDGT uses the lower §1274 rate; and fourth, IDGTs also permit utilization of the GST tax exemption, while GRATs do not.
The principal drawback of the IDGT is that is may not work: Although GRATs are blessed with a statutory imprimatur, IDGTs are not, and may pose an unacceptable degree of risk to some. To those persons, a series of short-term GRATs, where the risk of death during the trust term is minimized, may strike an acceptable middle ground.