Sale to Intentionally Defective Grantor Trust for Promissory Note
SALE TO INTENTIONALLY DEFECTIVE GRANTOR TRUST FOR PROMISSORY NOTE
By DAVID T. LEWIS and MAUREEN C. LANNING
Estate planning recently has focused upon leveraging the clients applicable credit amount and generation-skipping transfer ("GST") exemption through discounted or split-interest gifts. Although the primary vehicles for leveraging valuation discounts have been family limited partnerships and limited liability companies, the future availability of these discounts is under challenge.1 In light of this challenge, and because no single technique solves the needs of every client, practitioners must consider alternative transactions. The current U.S. economy, with strong financial markets and low interest rates, highlights the advantages of a relatively new estate planning technique: the sale of assets to an intentionally defective grantor trust in exchange for a promissory note. Although this technique is superior in many respects to traditional split-interest transfers, practitioners must be aware of its uncertainties to avoid potential Internal Revenue Service ("Service") attacks.
ADVANTAGES OF SPLIT-INTEREST TRANSFERS
In a typical split-interest transfer, the grantor creates an irrevocable trust and retains an income interest for a period of years. At the end of the period, the trust assets pass to designated beneficiaries. The potential transfer tax advantages of a split-interest transfer derive from the assumptions used to value the income and remainder interests under Internal Revenue Code section 7520.2 In determining the present value of the interests, section 7520 assumes that that the transferred property will produce income equal to a prescribed interest rate (the "§7520 rate" ) and that the principal value of the property will not increase or decrease. If the property produces income greater than the §7520 rate or the principal value of the property increases, the remainder interest will have been undervalued for federal transfer tax purposes and any excess value passes to the remaindermen tax free.
Creative estate planners have capitalized upon these valuation assumptions to avoid transfer taxes for years. Congress attempted to close these loopholes in 1990 with the enactment of Chapter 14 of the Internal Revenue Code. Under Code section 2702, enacted as part of the Revenue Conciliation Act of 1990 and the new Code Chapter 14, when an individual makes a gift of a remainder interest in trust to a family member (e.g., a child), the interest retained by the grantor generally will be valued at zero, resulting in a taxable gift equal to the full fair market value of the property transferred to the trust. If the grantor's retained interest in the trust is in the form of a "qualified interest" (e.g., a fixed annuity or unitrust interest), however, the value of the grantor's interest will be calculated under section 7520 and subtracted from the fair market value of the property, thereby reducing the value of the remainder interest and resulting gift tax.
A grantor retained annuity trust ("GRAT" ) is a split-interest transfer that, if properly drafted, meets the requirements of Chapter 14. A GRAT is an irrevocable trust that pays an annuity to the grantor for a specified time period. At the end of the period, the trust assets are distributed to the remainder beneficiaries selected by the grantor and named in the trust agreement. Because the trust is irrevocable, the grantor makes a completed gift of the remainder interest upon formation of the trust. Assuming the trust instrument meets the requirements of section 2702, the value of the grantor's retained annuity interest is determined under the rules of section 7520. Section 7520 is intended to prevent the shifting of economic enjoyment between income and remainder beneficiaries based on investment decisions made by the trustee by assuming a fixed rate of return keyed to the current federal mid-term interest rate over the trust period. Although section 7520 limits the ability to manipulate the economic benefits of the trust, it also provides an opportunity for leverage and transfer tax savings if the trust assets outperform the applicable §7520 rate at the time of the trust's creation. For the most part, the Service has a clearly defined position with respect to GRATs.3
SALE OF ASSETS TO INTENTIONALLY DEFECTIVE GRANTOR TRUST FOR PROMISSORY NOTE
An "intentionally defective grantor trust" is a trust of which the grantor is treated as the owner for income tax purposes, but not for estate, gift or (GST) tax purposes. This result is achieved by deliberately drafting the trust so that its terms violate one or more of the provisions of sections 673 through 677 or section 679. If properly drafted, the Service takes the position that the trust is disregarded for income tax purposes and that transactions between the grantor and the trust have no income tax consequerices.4 The sale of assets to an intentionally defective grantor trust in exchange for a promissory note offers similar leverage and tax savings advantages as the GRAT; however, the sale to the intentionally defective grantor trust produces superior results in many cases.5
Structure. The structure of the typical transaction is not complicated. First, the grantor creates an intentionally defective grantor trust and selects the beneficiaries of this trust (typically the grantor's descendants). Next, the grantor funds the trust with cash or other assets. The funding of the trust will be a taxable gift and the grantor will use some or all of the grantor's applicable credit amount, and where appropriate, some or all of the grantor's GST exemption. After the trust is funded, the grantor sells selected assets to the trust in exchange for a cash down payment and a promissory note representing the balance of the purchase price. To qualify as a sale rather than a gift, the purchase price must be for the fair market value of the transferred assets, and the note must hear interest at the appropriate applicable federal rate (AFR) prescribed by sections 1274 (the "§1274 rate").
Tax Consequences. Because transactions between the grantor and the grantor trust have no income tax consequences, there is no gain or loss recognized on this sale of assets to the trust. Additionally, the grantor is not taxed separately on interest payments on the note. However, the grantor continues to be taxed individually on all income or loss generated by assets held by the trust as though the trust did not exist. The estate and gift tax (or GST tax) savings of this transaction result if the assets held by the trust have a total net return (i.e., income and capital appreciation) that exceeds the interest rate on the note.
Advantages Over GRAT. Although a GRAT and a sale to a intentionally defective grantor trust offer similar planning opportunities, there are several reasons why a client may achieve greater leverage and transfer tax savings using the sale technique.
Both a sale to an intentionally defective grantor trust and a GRAT achieve transfer tax savings to the extent the assets of the trust outperform the applicable interest rate. Because a GRATis within the parameters of Chapter 14, the applicable interest rate is the §7520 rate, which is 120% of the federal mid-term rate in effect under section 1274. Because the sale to the intentionally defective grantor trust is not within the parameters of Chapter 14, the applicable interest rate is the appropriate federal rate (i.e., short-, mid-, or long-term) under section 1274, which is almost always less than the §7520 rate. It is therefore more likely that property will pass to the trust beneficiaries tax free under the sale technique.
The sale technique also permits possible leverage of the GST exemption. A grantor cannot allocate GST exemption to a trust during any estate tax inclusion period ("ETIP").6 Any period during which a grantor receives annuity payments from a GRAT is ETIP. Therefore, the grantor cannot allocate GST exemption to a GRAT until the termination of the grantor retained annuity interest. With the sale to the intentionally defective grantor trust, there is no ETIP. Consequently, the grantor can assign GST exemption to the intentionally defective grantor trust at the time of the initial funding of the trust. Any subsequent appreciation in the trust assets will be exempt from GST taxes.
Another advantage of the sale technique is the ability to delay payments to the grantor. The regulations under Chapter 14 are designed to prevent delayed payments to the grantor by providing that any amount payable from a GRATin any year may not exceed 120 percent of the amount paid to. the grantor during the preceding year.7 With the sale to the intentionally defective grantor trust, it is theoretically possible to use a balloon note in which the repayment of principal is deferred until the end of the term of the note (15 years or longer), thereby allowing the greatest compounding of appreciation.
The potential advantages of a sale to an intentionally defective grantor trust are available because the transaction presumably is outside the restrictions of Code Chapter 14. Consequently, the practitioner must engage in such a transaction without the safety net of regulations defining qualifying and non-qualifying interests.
Uncertain Estate Tax Consequences. Perhaps the most likely attack by the Service would be an argument that the payments from the promissory note constitute a transaction with a retained income interest. Consequently, the entire corpus of the trust would be included in the grantor's estate under section 2036. This attack is similar to the Service's attempt to recharacterize sales to trusts in exchange for fixed annuity payments as transfers with retained interests.
The leading case on this issue is Fidelity-Philadelphia Trust v. Smith.8 In Fidelity-Philadelphia Trust, the Supreme Court held that an irrevocable assignment of rights in insurance policies combined with a retention of annuity contracts did not subject the corpus of the trust to inclusion in the grantor's estate under the predecessor to section 2036. The Court held that the annuity was not a retained income interest primarily because there was no substantial link between the income produced by the transferred property and the annuity payment and the obligation was not chargeable to the transferred property.9 The Court's rationale in Fidelity-Philadelphia Trust has been strictly applied in cases favorable to the Service,10 as well as cases favorable to the taxpayer.} 11 Although there is no safety net of controlling regulations or cases, the taxpayer should be able to avoid an attack under section 2036 provided: (1) the note is payable from the entire trust corpus instead of just the transferred property; (2) the note payments are not tied to the yield on the transferred assets; (3) the trust principal is at risk; and (4) the grantor retains no control over the trust and enforces his rights as a creditor.
Another possible attack by the Service would be to require a sale to a defective grantor trust to compete on the same grounds as a GRAT by applying section 2702 to the transaction. Because the repayment of the promissory note would not be a qualified interest under section 2702, the promissory note would be disregarded for valuation purposes and the transaction would be treated as a gift to the trust of the transferred assets. Although there are two favorable private letter rulings providing that similar transactions are not within Code Chapter 14,12 these rulings are not precedent and do not prohibit the Service from making this argument with other taxpayers.
In addition to the Service attacks specific to this transaction, planners always should take care when drafting trusts in which the grantor is a trustee or beneficiary of the trust. In these situations, sections 2036, 2037 and 2038 should always be considered as sources of potential attack.
Uncertain Income Tax Consequences. It is clear that during the grantor's lifetime, the intentionally defective grantor trust is disregarded for income tax purposes and transactions between the grantor and the trust have no income tax consequences.l3 At the grantor's death, however, the trust loses its grantor trust status. The income tax impact, if any, that this might have if the grantor dies during the term of the note should be seriously considered by the practitioner when advising a client about such a transaction. The most logical choice, and the position the practitioner should take with the Service, is that there is no income tax consequence upon the death of the grantor. This position respects the transaction as a completed sale by the grantor in that the note is included in the grantor's estate and should have a basis equal to the balance due on the note at the time of the decedent's death. Because the assets sold to the intentionally defective grantor trust are not included in the grantor's estate, the basis of those assets in the trust is not adjusted pursuant to section 1014. The only income tax difference after the grantor's death is that interest on the note will be taxable to the estate. This approach is the most logical alternative because the position is consistent with that taken during the grantor's lifetime.
An alternative approach the Internal Revenue Service could take would be to treat the transaction as a sale at death and taxed as a sale between the grantor's estate and the trust immediately after the death of the grantor. This position respects the notion that there are no income tax consequences in transactions between the grantor and the grantor trust. This analysis takes the position that the income tax impact of the sale is suspended until the death of the grantor when the trust .no longer qualifies as a grantor trust. One fundamental problem with this approach is that it disregards the original sale between the grantor and the grantor trust and assumes that the grantor owned the assets at death. Accordingly, the assets should receive an adjusted basis under section 1014. If the Service takes this position, an additional question remains whether the basis of the transferred assets sold should be the fair market value of the assets (section 1014) or limited to the outstanding balance due on the note. Because this approach makes inconsistent assumptions, and in one respect disregards the transaction, the Service should not be successful in taking the position that the transaction is treated as a sale immediately after the death of the grantor.
Yet another approach that the Service could take, and one possibly founded on precedent, is that the transaction will be treated as a sale at death and taxed as if the transaction occurred immediately before the death of the grantor. Under this theory, the analysis would be that the sale occurred immediately before death and gain would be recognized by the grantor to the extent that the remaining balance of the note exceeds the grantor's basis in the assets sold to the trust. Similarly, the assets in the trust would receive an adjustment in basis equal to the amount of gain recognized. This position has potential support from precedent. 14 This authority resulted from grantor trusts established to own tax shelters. In each situation, the grantor status of the trust was terminated to avoid recognition of income and the Service treated the termination of grantor status as a disposition causing the recognition of income under section 1274. This authority illustrates that bad facts can result in bad law, and is distinguishable from a.sale to a grantor trust for a promissory note. Also, this approach ignores the structure of the transaction as a sale between the grantor and the grantor trust and disregards Revenue Ruling 85-13 which holds that transactions between the grantor and a grantor trust have no income tax consequences.
Arguably, if the sale qualifies for installment sale treatment under this analysis, payments on the note received by the estate after the grantor's death would be income in respect of a decedent (IRD), despite the fact that payment of the note during the grantor's life would not have been recognized as income by the grantor.15 If the sale does not qualify for installment treatment, the income would be recognized on the grantor's final income tax return, and a corresponding deduction for taxes owed should be allowed, on the estate tax return.
Uncertain Gift Tax Consequences. Another uncertainty concerns the potential treatment of income tax payments made by the grantor with respect to trust income as additional taxable gifts. Beginning in 1993, the Service. issued a series of private letter rulings in which it suggested. that the grantor's payment of income tax on the accumulated income of a grantor trust constitutes (1) a gift by the grantor .to. the remainder beneficiaries and (2) a constructive addition to the trust by the grantor for GST purposes.16
Before the letter rulings, it was widely. known on informal basis that the Service would not provide a favorable letter ruling for a GRAT that did not contain a provision requiring the trustee to reimburse the grantor for income tax liability on undistributed trust income. The Service formally announced its position in Private Letter Ruling 9444033. The trust at issue was a GRAT that was treated as wholly owned by· the grantor under section 677(a) because both the income and principal could be distributed to the grantor to satisfy the retained annuity interest. The facts stated that the trust required the trustee to reimburse the grantor each year for the income tax liability for income received by the trust but not distributed to the grantor. After ruling that the GRAT was an eligible S corporation shareholder and that no gain would be recognized on the distribution of appreciated property in satisfaction of the trust's annuity obligations, the Service stated in dictum: "If there were no reimbursement provision, an additional gift to the remainder person would occur when the grantor paid tax of [sic] any income that would otherwise be payable from the corpus of the trust." 17 The Service offered no supporting authority for this statement. In Private Letter Ruling 9504021, the Service again stated in dictum (and again without supporting authority) that a reimbursement requirement in a grantor trust "relieves the grantor from paying a liability that actually belongs to the trust (and consequently, to the remaindermen)."18 Commentators have consistently agreed that the Service's position lacks any statutory, regulatory, or precedential support, and is contrary to fundamental income and gift tax principles.19
Although it is well-established that payment of taxes for which another person is primarily liable will be treated as a gift or income to the other person, there is no basis for an assertion that a tax paid by the primary obligor is a gift to another. Code section 671 expressly imposes income tax liability upon the grantor rather than the trust. As noted by one commentator, although an employer who pays the portion of employment taxes that should have been withheld is paying added compensation, the portion that the employer is required to pay from the employer's own funds also benefits the employee. There is no suggestion that this payment is therefore income or a gift to the employee.20 Similarly, one spouse's payment of income tax liability reported on a joint return filed by both spouses is not a gift to the other spouse.21 Rather, it is generally accepted that the discharge of a liability for which one is personally and primarily responsible is not a gift to another; that the remainder beneficiaries are incidentally benefited by the grantor's payment of these taxes does not transform these payments into gifts. The income tax and transfer tax regimes are not in pari materia and courts have repeatedly rejected attempts to apply income tax concepts to gift tax liability.22
Additionally, the Service position is patently inconsistent with the definition of a gift as a voluntary gratuitous transfer. The grantor pays tax upon the income of a grantor trust because of an involuntary statutory obligation, and such payment discharges a bona fide debt of the grantor. As such, the payments cannot be characterized as gifts.
Some commentators have suggested that the Uniform Principal and Income Act ("UPIA" ) may support the treatment of income tax payments as additional taxable gifts.23 The analysis is that the UPIA may impose an obligation on the trustee to pay certain taxes out of principal, in which case the grantor's failure to enforce the trustee's legal obligation results in a series of annual transfers to the beneficiaries. In two Pennsylvania lower court decisions, the courts applied the UPIA in authorizing the trustee to reimburse the income beneficiary (the grantor in these cases) for taxes on capital gains that were allocable to principal.24 A close analysis of the UPIA and the Pennsylvania cases, however, indicates that the UPIA neither imposes nor supports gift tax liability upon the grantor of a grantor trust.25 The UPIA is intended to govern the apportionment of receipts and expenses of a trust between the income beneficiaries and the remainder beneficiaries; it does not impose fiduciary or legal obligations not otherwise imposed by law. The Service's position may be correct, then, only if, under applicable state law and the terms of the trust, the grantor has the right to be reimbursed by the trustee for income tax liability, and did not exercise that right.
Significantly, in 1995, the Service amended Private Letter Ruling 9444033 and removed the controversial language. Without further explanation or discussion, the Service stated: "[A]fter reconsidering the language addressing the gift tax consequences of the reimbursement clause in· each trust, the Service has decided to delete [it]."26 Because the facts of the amended ruling still recite that the trustee is required to reimburse the grantor for income tax liability for accumulated income, however, the extent to which the Service has abandoned its position is unclear.
Given this uncertainty, practitioners should draft to prevent inadvertent gifts. If the trustee is directed not to pay the taxes or reimburse the grantor for any tax liability on undistributed income or gains, or is given discretion whether or not to reimburse the grantor, no gift should result. The former option is the more cautious; the latter option affords greater flexibility to the trustee.
The sale of assets to an intentionally defective grantor trust for a promissory note is a relatively new estate planning technique that often produces results superior to traditional split-interest transfers. These results, however, do not come without a certain measure of risk. This technique is subject to challenge by the Internal Revenue Service on a number of grounds. Some challenges are against the weight of authority or could be avoided with careful drafting. Other issues remain unsettled and will be resolved as case law develops in this area. Until that time, practitioners must recognize the opportunities presented and appreciate the inherent risks.
David T Lewis is an associate in the Richmond office of McGuire, Woods, Battle & Boothe LLP, where he practices in the areas of estate planning, business tax planning, estate and trust administration, and related matters. Mr. Lewis received his B.S. degree from the E. Claiborne Robins School of Business at the University of Richmond in 1988, a J.D. degree, cum laude, in 1992 from Cumberland School of Law and an L.L.M. degree in taxation from the University of Alabama School of Law in 1996. He is admitted to practice in Virginia, Alabama and Mississippi.
Maureen C. Lanning is an associate in the Richmond office of McGuire, Woods, Battle & Boothe LLP, where she practices in the areas of estate planning, estate and trust administration~ and related matters. Ms. Lanning received a B.A. degree, cum laude, from Duke University in 1991 and a J.D. degree in 1994from The Marshall Wythe School of Law at the College of William & Mary. Following law school, Ms. Lanning served as Law Clerk to the Honorable Marvin J Garbis, United States District Court Judge in the District of Maryland. She is admitted to practice in New York.
1. General Explanations of the Administration's Revenue Proposals, Dept. of Treasury, Feb., 199-8.
2. All section references, unless otherwise indicated, are to the Internal Revenue Code of 1986, as amended.
3. Treas. Reg. §25.2702.
4. Rev. Rul. 85-13 1985-1 C.B. 184.
5. See, Michael D. Mulligan, Sale to a Defective Grantor Trust: An Alternative to a GRAT, Est. Planning, January 1996, Vol. 23, No.1.
6. I.R.C. § 2642(f).
7. Treas. Reg. 25.2702-3(b)(1)(ii).
8. 356 U.S. 274 (1958).
9. Fidelity-Philadelphia, 356 U.S. at 277.
10. See, Lazarus v. Comm'r, 513 F.2d 824 (9th Cir. 1975), aff'g 58 T.C. 854 (1972); Samuel v. Comm'r, 306 F.2d 682 (1 st Cir. 1962).
11. See, Stern v. Comm'r, 747 F.2d 555 (9th Cir.1984); Cain v. Comm'r, 37 T.C. 185 (1961 ). Priv. Ltr. Rul. 9535026;
12. Priv. Ltr. Rul. 9436006.
13. Rev. Rul 85-13,1985-1 C.B. 184.
14. Madorin v. Comm'r, 84 T.C. 667 (1985); Rev. Rul. 77-402, 1977-2 C.B. 222.
15. But see, Sun first Nat'l Bank v. United States, 607 F.2d 1347 (Ct. CIs. 1975); Rev. Rut 76-100,1976-1 C.B. 123.
16. Priv. Ltr. Rul. 9352004; Priv. Ltr. Rul. 9413045; Priv. Ltr. Rul. 9416009; Priv. Ltr. Rul. 9444033; Priv. Ltr. Rul. 9504021.
17. Priv. Ltr. Rul. 9444033.
18. Priv. Ltr. Rul. 9504021.
19. Carmela T. Montesano and Ann St. Laurent, Defective Grantor Trusts: Gift Tax Consequences of Payment of Income Tax Liability by Grantor, 20 Tax Mgmt. Est., Gifts & Tr. J. 183 (Sept. 1995); John B. Huffaker, Edward Kessel & Lynne M. Sindoni, Is Income Tax Payment by Grantor-Owner of Subpart E Trust A Taxable Gift?, 82 J. of Tax n 202 (April 1995); Dennis I. Belcher and James D. Bridgeman, Defective May Be More Effective: ,The Tax Advantages of Intentional Grantor Trusts, 7 Probate and Property 24 (March/April 1993).
20. Huffaker et al., supra note 18, at 203.
21. Treas. Regs. 25.251I-l(d)
22. See Belcher and Bridgeman, supra note 18, at 25.
23. See Richard B. Covey, Payment of Trust's Income Taxes By Grantor as Gift and GST Addition, Practical Drafting 2575-76 (July 1991).
24. French Estate, 61 Pa. D. & C.2d 654 (O.C. Philadelphia County 1963) and Doughty Trust, 6 Fid. Rep. 2d 260 (O.C. Montgomery County 1985).
25. Belcher and Bridgeman, supra note 18, at 26.
26. Priv. Ltr. Rul. 9543049.