Asset Freezing Techniques
Why an Installment Sale to an Intentionally Defective Grantor Trust is Better Than a Grantor Retained Annuity Trust
Freezing techniques have been a popular way of reducing federal transfer taxes for a long time. A freezing technique is a transaction in which the value of an asset is frozen for purposes of determining the transfer tax base of the transferor, which is the total value of his or her adjusted taxable gifts during lifetime and his or her taxable estate at death. This article will analyze the difference between two of the most common asset freezing techniques. The first technique, called A Grantor Retained Annuity Trust (GRAT) involves a transfer of assets to an irrevocable trust in which the transferor retains the right to receive an annuity for a fixed term of years. When the GRAT term expires, appreciation of the assets not paid according to the terms of the annuity and left in the trust pass to the remainder beneficiaries, or to trusts for their benefit, without any further transfer tax consequences. Gift tax is imposed only on the present value of the remainder interest when the trust is created. The second, and in the author's opinion, more secure technique concerns an installment sale to an Irrevocable Defective Grantor Trust.
The Intentionally Defective Grantor Trust (IDGT) borrows upon Sections 671 through 677 on the Internal Revenue Code, the desired goal of which is to create an irrevocable trust the property of which is removed from the grantor/creator's estate, but the income of which is taxable to the grantor. Planning in this context requires that at least one right or power be included in the grantor trust document that "captures" the trust and ties it to the grantor for income tax purposes, but "frees" the trust from association with the grantor for estate tax purposes, such as the power to substitute trust assets for non-trust assets of equal value. The Internal Revenue Code requires that the trust must be irrevocable, and the grantor may not be a beneficiary and should not be a trustee.
The greatest benefit of an intentionally defective grantor trust is the fact that transactions between the grantor and the trust are disregarded for income tax purposes. (IRS Rev. Rul. 85-13, 1985-1 C.B. 184). When a person sells an asset to him or herself, such a sale does not create an income tax consequence. A sale by a grantor to a defective trust is a sale by the grantor to the grantor. This rule makes it possible to introduce very favorable planning techniques such as sales of assets to a defective grantor trust in exchange for installment notes, the effect of which is, once again, to return the transferred property to the grantor while passing all appreciation to remainder beneficiaries at no gift tax cost to the grantor.
In a comparison between a GRAT and an installment sale to an IDGT, the following benefits are available with regard to the sale to the IDGT:
First, in the case of the GRAT, if the grantor dies during the term of the retained interest, all of the trust property is included in the grantor's estate at its then fair market value, including any post-transfer appreciation. In the case of the installment sale to the IDGT, survivorship to any specific term is not required. Only the value of the unpaid balance of the installment note is included in the grantor's estate in the case of the IDGT. Post-sale appreciation escapes transfer tax.
Another advantage of the installment sale to the IDGT over the GRAT is that the required interest rate used in the installment sale transaction will be lower than the rate used for a GRAT. A lower interest rate reduces the amount to be repaid to the grantor and correspondingly increases the amount that is passed to the beneficiaries without being taxed to the grantor.
Additionally, where there is a desire to involve grandchildren as trust beneficiaries, the installment sale to the IDGT is the preferred vehicle. If a GRAT is used for this purpose, the generation-skipping transfer tax exemption may not be allocated until the end of the initial term of the trust. Thus the opportunity to leverage the GST exemption (by allocating it to the value of the initial transfer of "seed money" as referenced hereinafter and having the post-allocation appreciation be free of GST tax) is lost with the GRAT. Since there is no interest in the IDGT retained by the grantor that would cause the trust property to be included in the grantor's estate in the event of the grantor's death, the trust can be structured with multigenerational provisions.
Also, in the case of the GRAT, the payment schedule to the grantor must be established at the inception of the trust. Property cannot be added to a GRAT once it has been created and funded. The GRAT payments are fixed by the trust document and are therefore inflexible. Each year's annuity payment may not exceed 120 percent of the amount paid in the preceding year. To the extent that the GRAT does not produce sufficient income to cover the required annuity payments, it is possible that the trust will have to return principal to the grantor to satisfy the annual payment obligation. Conversely, the installment sale is typically structured as an interest-only note with a balloon principal payment due at the end of the term. The trust (and its beneficiaries) are able to derive the benefit of the earnings and the growth of the unpaid deferred principal free of any income tax liability. Less money is returning to the grantor when the IDGT technique is used. If desired, additional gifts or sales can be made to the IDGT at any time. As we also importantly discussed, if funds are needed by the two of you before they become due in accordance with the payment schedule of the note, a right held by the trustee to prepay the note without penalty can solve this issue.
Finally, when the GRAT is used, no one other than the grantor of the trust can participate in the trust until the end of the retained interest term. No similar restrictions apply in the case of a trust that acquires an installment note. The trust beneficiaries can receive trust distributions or otherwise enjoy the trust property at any time.
In contrast to these apparent advantages of the installment sale to the IDGT over the GRAT, there are several points that should be noted in the GRAT's favor.
First, in the event of an incorrect valuation of the assets transferred to the trust, there is exposure to gift tax in the case of the installment sale to the IDGT. If no gift is reported, no GST tax exemption would be claimed. Where these valuation determinations are upset, and the value of the transferred property increased, the amount of the note is deemed insufficient, and transfer tax liability is the likely result. In order to avoid this result, a clause can be added to the IDGT providing for a price adjustment based upon an independent third party appraisal, not upon the value determined by the IRS or a court, as allowed under IRS Revenue Ruling 86-41, 1986-1 CB 300.
Also, in the installment sale to an IDGT transaction, the income tax basis of the property held by the trust retains a carry over basis from the grantor/seller, while the outstanding balance due on the note is included in the grantor/seller's estate where death occurs before the note is repaid. Accordingly, if the trust property does not increase in value, the grantor's estate must pay estate tax on the value of the note, without benefiting from a corresponding step-up in the basis of the property held by the trust. There are, however, techniques to avoid this result, for instance, where the note payments are partially paid in the return of shares of stock.
An essential requirement to an installment sale to an IDGT is that "seed money" must be gifted to the IDGT, even though this causes a gift tax implication to the grantor. The IRS has indicated that he initial cash contribution should be equal to at least 10% of the value of the property that will be held by the trust, including the assets being gifted to the trust to satisfy this requirement, as well as the assets to be sold to the IDGT by the grantor in exchange for a promissory note. The reason for this is to avoid having the assets eventually sold to the IDGT in exchange for a note become the only source of funds to satisfy the required note payments. If this is the case, the IRS may have grounds to argue that the grantor retained an interest in the assets sold to the trust and thereby include the value of the trust property at the time of death in grantor's estate.
Internal Revenue Code Section 2702 and the regulations thereunder provide specific statutory authority and rather detailed guidance to structure a GRAT transaction in a manner that will qualify it without any doubt. The installment sale to the IDGT does not enjoy such published clarity. There is no Code section and no definitive pronouncement from the IRS specifically authorizing the use of this technique, although IRS Revenue Ruling 2004-64 has provided significant comfort that, if properly structured, the defective trust technique is viable. As a result, as well as a review of the previously referenced benefits, the installment sale to the IDGT is currently regarded as a more viable technique.