Installment sales of assets to irrevocable grantor trusts is one of the most powerful estate planning techniques available today. Sales to “intentionally defective” irrevocable grantor trusts capitalize on different definitions of “transfer” for income and transfer tax purposes. Following such a sale, the grantor reports income tax on trust income. However, the grantor no longer owns the assets for gift and estate tax purposes. Therefore, the trust assets (and appreciation) will be removed from the grantor’s gross estate. Assets sold to the trust may consist of stock in a closely held business, real estate, marketable securities, or limited partnership interests. The trust may even hold S Corporation stock without jeopardizing the election.
(Although not discussed in this article, assets sales to trusts will also further asset protection objectives.)
Revenue Ruling 2004-64 states that a grantor’s payment of income tax attributable to the trust is not a gift to trust beneficiaries. Furthermore, an independent trustee’s discretionary power to reimburse the grantor for the payment of income taxes will not cause inclusion in the grantor’s estate. The grantor’s payment of income tax will result in accelerated growth of trust assets, since the trust will not be burdened with tax payments.
Rev. Rul. 85-13 and Madorin v. Com’r, 84 TC 667 (1985) held no gain or loss is recognized on a sale of assets to a grantor trust. Thus, appreciated assets can be sold to the trust without any gain. In exchange for assets sold, the grantor will receive cash or a promissory note. The note may provide for interest payments only, with a balloon payment of principal at the end. By so providing, the amount of assets “leaking” back into the estate is minimized. The note may also provide for refinancing. This will enable the trust to postpone seriatim the date the principal obligation becomes due.
The note must bear interest at a rate determined under §7872(f)(2)(A), which references the applicable federal rate (AFR) under §1274(d). The AFR for short-term obligations (less than 3 years) is 4.99% for June, 2006. In comparison, a GRAT, to its disadvantage, must bear interest at rate which is 120% of the AFR.
The grantor realizes no income upon receipt of interest payments — he is treated as paying interest to himself. To minimize the risk that the grantor will be treated as having retained possession or enjoyment of the transferred interest under §2036, the grantor should fund the trust with assets worth at least 10% of the note. This is referred to as “seed” money. PLR 9515039 stated that § 2036 can be avoided if beneficiaries guarantee the note’s payment. Whichever method is used, the grantor will be treated as owner of all trust assets for income tax purposes.
To avoid the risk of inclusion in the grantor’s estate, the grantor should not be trustee. If the grantor will require trust assets during his lifetime, another person could be given the power to make discretionary distributions to the grantor without unduly increasing the risk of inclusion. If the grantor insists on being named trustee, his powers should be limited to administrative powers, such as allocating receipts and disbursements, or distributing income or principal to beneficiaries, when limited by an ascertainable standard.
Trust assets will not receive a basis step-up under §1014(a), since the assets (having been sold to the trust) are not included in the grantor’s estate. This problem can be avoided by substituting higher basis assets for lower basis assets during the grantor’s life. The trust instrument must be drafted to allow this.
The retained right to substitute assets of equal value pursuant to § 675(4)(C) is actually the one of a few provisions that will ensure the trust is taxed as a grantor trust. Another is a provision allowing the grantor to borrow from the trust without being required to pay interest or provide adequate security. § 675(2). When drafting, one must carefully consider which provision will be used to achieve grantor trust status.
Since the initial asset sale is ignored for income tax purposes, the balance due on the note will not constitute income in respect of a decedent (IRD). However, the remaining discounted balance of the note will be included in the grantor’s estate, and will acquire a fair market value basis. Remaining principals to the grantor (if he is alive when the balloon payment becomes due) or to his estate (if he is not alive), should not result in income, since having been included in the grantor’s estate, the note’s basis will offset the principal payment.
By combining an asset sale with minority discounts available for closely held businesses and partnerships, estate tax savings can be enhanced. The value of discounted interests transferred to the trust is less than the value of a proportionate part of the entity’s underlying assets. Accordingly, the price the trust must pay for the assets is reduced. The smaller note will result in lower interest and principal payments, and more estate tax savings.