Sales to Grantor Trusts
This is a sophisticated planning technique that had been used by a larger number of wealthy clients prior to the TRA, and will likely remain popular after the TRA for those concerned about the future burden the estate tax will have on their estates. Sales to Intentionally Defective (grantor) Irrevocable Trusts (IDITs) have been a favored planning technique for many high net worth taxpayers. These family sale transactions have become almost ubiquitous in estate planning for larger estates. In particular, the installment sale to a grantor trust (an intentionally defective irrevocable trust, also called by some an IDGT), is used as a wealth freeze and transfer technique. Incidentally, popularity does not mean without risk and issues.
The concept in broad terms might be intelligible, but the details are daunting; a taxpayer forms an irrevocable (cannot be changed) trust. The trust is structured to be a grantor trust for income tax purposes. This means that the taxpayer/grantor will be taxed on the income earned by the trust. It also, importantly, means that the taxpayer can sell appreciated assets to the trust without triggering any income tax consequences because the trust is ignored for income tax purposes. The sale is typically for a note and the result is freezing the value of the assets sold in the grantor’s estate. The value of the note will not increase in value but the value of the assets sold (e.g., a family business or a limited liability company owning rental real estate) will hopefully, as the economy recovers, appreciate substantially more than the interest payments paid to the taxpayer/grantor.
The TRA has a significant impact on the use of these transactions. As explained in Chapter 2, the TRA estate tax generosity is a limited duration give away—just two years until 2013. So high net worth taxpayers should take aggressive planning steps, before 2013 brings with it a more costly estate tax. The large gift exclusion created as part of TRA, $5 million per taxpayer, can facilitate much larger, and perhaps more secure, note sale transactions. See the discussion of seed gifts that follows.
An IDIT sale transaction can take various forms:
- Format: The sale could be for a note, perhaps a Self Cancelling Installment Note (“SCIN”), or a private annuity. A SCIN is a note that automatically cancels on death. A premium is typically paid in terms of a higher interest rate to compensate the lender for this risk. The benefit is that on death the note is terminated, and its value should not be included in the taxpayer’s estate. A private annuity is similar, conceptually, to an annuity that is paid by an insurance company or investment firm, only it is paid by a family member or family trust. If there is a sale for a private annuity the grantor (often a parent) sells assets (typically to a grantor trust) and receives back a fixed periodic payment for life. On death the annuity payment ceases and the estate would claim that there is no value to include in the estate.
- Payment: The financial aspects of the transactions can also be structured in a myriad of ways. These could include the intent to pay the note or annuity amounts from cash flow, and the expectation that equity interests sold to the IDIT will be retransferred back to the seller to in part cover the required payments, but all with the expectation of substantial post-sale appreciation. At the end of 2010 and the beginning of 2011, interest rates remain at historical lows so that the payments for interest will remain very modest.
- Security: Some practitioners insist on seed money, some even advocate that there is a biblical mandate for not less than 10 percent seed capital in the IDIT. Other practitioners structure transactions without any seed money (or with less seed money). Some practitioners will incorporate various types or levels of guarantees to support the sale transaction. Sometimes the nature of the guarantees correlates inversely with the amount of seed money (the more seed money the less significant the guarantees). Practices vary across the board. But in all instances the flexibility to shift $5 million of current gifts with no tax rather than merely $1 million makes planning more flexible and arguably more secure (depending where on the seed gift/guarantee controversy you place your chips). If a couple can gift $10 million to a dynasty trust, the amount of assets that can be leveraged in such a sale is tremendous.
- Grantor Trust: These trusts are almost invariably structured as grantor trusts so that the grantor/parent will pay the income taxes on the income earned by the trust. If a transaction based on a $10 million gift involves a hundred million or more in value being transferred, perhaps a large multiple with guarantees (see next section), almost no one should have to be subject to the full brunt of the estate tax.
Seed Gifts and Guarantees after TRA Changes
With a $1 million gift exclusion, large estate planning transactions were limited, and the debate over the need for and use of seed gifts and/or guarantees, has been important. A taxpayer who restricted the size of assets subjected to a note sale to a grantor trust transaction, in 2010 or prior years, as a result of his or her advisers beliefs about seed gifts (e.g., insistence on seed gifts using the 9:1 ratio), can revisit that transaction and replicate it fourfold in 2011 by making up to $4 million of incremental seed gifts to the trust.
The increased gift tax exclusion in 2011 might afford taxpayers, who consummated leveraged note sale transactions in prior years, the opportunity to gift additional assets to a buying grantor trust, perhaps negotiate the cancellation of the existing note guarantees, and unwind some of the complexity of those transactions.
One theory espoused by some pundits concerning seed gifts and guarantees, is that so long as a significant sum of capital was at risk in the transaction, regardless of the ratio of that risk capital (seed gift) to debt, the transaction should be respected. For adherents to this view, the ability to increase the amount of a trust’s funding by perhaps an incremental $4 million of seed gifts in 2011, may support almost unlimited note purchases by such trusts. Remember, $4 million bucks is real money almost anywhere outside of Washington, D.C.
A significant unresolved issue in the structure of an installment sale to an IDGT, is whether there must be a certain quantum of equity in the IDGT for the transaction to be respected. For a transaction of more modest size, seed gifts alone may suffice. The term “modest,” however, is defined relative to the wealthiest component of taxpayers whose net worth would justify their engaging in these types of transactions. But the $1 million gift tax exemption ($2 million if the donor’s spouse consents to gift split) had served as a restriction on the size of transaction that can be structured with only a seed gift, according to some tax experts. For example, if the equity in the trust purchasing assets is desired to meet a 10 percent rule of thumb (of the value of the assets) purchased (an arbitrary benchmark), then a seed gift of up to $1 million could be used without gift tax prior to 2011 (assuming that the donor has not made any prior adjusted taxable gifts). That amount of gift, according to some tax advisers, could only support, at most, a $10 million sale, a 9:1 ratio ($10 million sale supported by $1 million of equity for a down payment and $9 million of debt). Whatever the view taken, 2011 opens a wide door of planning opportunities to reconsider, restructure, and revisit these transactions.
Discounts are a cornerstone of many estate planning leveraging techniques. A discount is simply illustrated as follows: 30 percent of a $100 business is worth less than $30, because the minority (less than 50 percent) ownership interest is hard to market and has no control. When this is combined with the substantial $5 million gift tax exemption in 2011, tremendous wealth can be shifted. Since there is only a two-year time horizon assured for the $5 million exemption, this may open a new and unprecedented opportunity for the wealthy to plan.
Discounts can be used in a number of ways. In a simple manner, a taxpayer might make a gift of an interest in a family business or rental property that is valued at significantly less than the underlying asset values because the interests in the entity are not controlling, and because the interests are not readily marketable. Consummating such a gift to use some or all of the new $5 million 2011 gift exclusion, may be an adequate plan for some taxpayers who might face an estate tax.
For taxpayers who might ever be subject to an estate tax (think 2013—$1 million possible exclusion) but and have not yet consummated significant leveraged gift or IDIT sale transactions, now have an opportune time while valuation discounts might be permitted, asset values may be depressed as a result of the recession, and interest rates remain low. The movement of interest rates, independent of future estate tax law changes, could adversely affect the leverage many of the common estate tax minimization transactions can provide. Thus, waiting to the wee hours of 2012 to plan, could result in far less advantageous results. The possibility of more restrictive estate tax rules in 2013, provide further encouragement for clients to proceed and not delay planning.
: This taxpayer is single and age 85. She has an estate comprised entirely of a 40 percent interest in a family business. The overall business is worth $15 million. Her 40 percent interest is nominally worth $6 million, and would, alone, subject her to an estate tax. The taxpayer has her 40 percent interest appraised. The appraiser determines that, based on the nature of the business, with the restrictions in the governing documents, and other factors, her interest should be valued with a 35 percent discount, or at $3.9 million. The taxpayer has three tax worries: the ability to use discounts may be eliminated (see below), the business may appreciate in value, and the estate tax exclusion may be reduced to $3.5 million in 2013 (she doesn’t believe a $1 million exclusion is likely). She gives away 20 percent of her interest to her heirs, using up $1,750,000 of her exclusion. She has retained some exclusion for future planning, but has locked in a discount and low value for the business.She might feel that this is adequate planning to undertake to address the estate tax risks that she has identified.
Legislation introduced by Representative Pomeroy in 2009, the President’s budget proposal (in the “Green Book”), and many other proposals, had called for the restriction of the estate planning elixir of discounts. The 2010 TRA includes no such restrictions, so that discount planning should remain viable. But no one can be sure for how long.
So, for many wealthy taxpayers who will remain subject to the estate tax after the TRA, or for those whose wealth will likely grow sufficiently, to subject to them to the estate tax in the future, and perhaps even for taxpayers who face substantial state estate tax burdens, capitalizing on the combination of high gift exclusions and discounts may be the answer.