Combining a GRAT with an FLP to increase transfer tax leverage on gifts of family assets.

Facts: Lionel Trane, age 55, owns an old farmstead and surrounding real estate, known as Tangled Webb Farms. Tangled Webb Farms has been in Lionel's family for years and is located outside Biggalopolis. Development in the Biggalopolis area has recently expanded toward this property. * Tangled Webb Farms was recently appraised at $1 million. Lionel believes that the value of the property, even with no development, could quadruple in the next few years because of its prime location; with development, the appreciation could be even greater. Lionel would like to transfer the property to his three adult, unmarried children (Sam, Cokie and George) as soon as possible, to remove this appreciation from his estate with as little transfer tax as possible. Issue: Would combining a partnership with a grantor retained annuity trust (GRAT) make sense for Lionel?

Analysis

Lionel's tax adviser suggested that he form a family limited partnership (FLP) with his wife (Jane, age 52) and use this as a vehicle to gift the property. A reliable appraiser has indicated that minority limited partnership (LP) interests would have a value that is 30% less than their proportionate share of the underlying asset values.

Based on this, Lionel gives a gift of 50% of Tangled Webb Farms to Jane, and together they form TWF LP, with Lionel owning a 1% general partnership interest and a 49% LP, interest and Jane owning a 50% LP interest.

Based on the appraisals mentioned, a 1% TWF LP has a value of $7,000 (70% of its 1% share of the underlying $1 million value). Both Lionel and Jane give each of their children 1.425% LP interests, using their annual $10,000 gift tax exclusions. After these gifts, however, Lionel and Jane still own 91.45% of the partnership.

Lionel would like to give an additional 89.45% to the children as soon as possible. (He and Jane each would like to retain 1% interests, with Lionel's being the general partnership interest.) Outright gifts of the 89.45% interests would be valued at $626,150. With such gifts, Lionel and Jane each would use up approximately $313,075 of the ability they have to make roughly $675,000 of tax-free gifts under their applicable credit amounts (previously referred to as the unified tax credit). They wish to preserve their applicable credit amount for the time being.

Lionel's tax adviser suggests that Lionel and Jane each consider making these gifts through a GRAT. A donor using a GRAT transfers assets to an irrevocable trust, retaining a qualified interest (i.e., a fixed-term income (annuity) interest for a term period of years that does not exceed the donor's remaining life expectancy). The income right must be an irrevocable right to receive a fixed amount for each tax year of the term. At the end of the term, the donor's interest is extinguished and the trust property passes to the remainder beneficiary. The governing instrument of the trust must meet a number of requirements, including a prohibition on additional contributions to the trust and distributions to or for the benefit of any person other than the holder of the qualified annuity interest.

For gift tax purposes, the property transfer to the trust is divided, with separate values assigned to the retained annuity interest and the remainder interest. The retained interest is valued at its present value under tables prescribed by the IRS; the remainder interest will include the remaining value of the property transferred into the trust. Because the gift consists of only the remainder interest, only that value is subject to transfer tax. This is usually much less than the value of the contributed property.

Making gifts through a GRAT carries a significant risk. The GRAT donor must survive the term of years established for the income interest, or the value of the gifted asset will be taxed in the donor's estate at its date-of-death (or alternate valuation date) value, which would cause the appreciation subsequent to the transfer date to be taxed in the donor's estate. Lionel and Jane are willing to take this risk. (To the extent they want to provide for this risk, they could structure life insurance protection as a hedge.)

In this case, Lionel's tax adviser suggests that he and Jane each establish a GRAT, with their children as the remainder beneficiaries. He suggests an annuity at eight percent for a term of seven years, at the end of which Lionel will be 62 and Jane will be 59. This will produce annual payments of $25,046 to both Lionel and Jane. They believe the partnership will have no problem finding the cash for these payments. (If cashflow could be a problem because the appreciating assets will be illiquid or of questionable liquidity, the partnership interests could be combined with more liquid assets to minimize the burden of future payment obligations.)

After considering all of this, Lionel and Jane each transfer LP interests worth $313,075 to the GRATs. Based on these facts, Lionel's retained annuity interest is valued at approximately $126,875, and Jane's is valued at approximately $127,850. As a consequence, their gifts of remainder interests are valued at approximately $186,200 and $185,225, respectively.

Lionel and Jane each plan to use the annuity payments to make annual exclusion gifts during the term of the annuity interest.

Variation

If Lionel and Jane wished to further enhance the estate planning leverage of their GRATs, they could consider causing one of the trusts to be structured as an "intentionally defective grantor trust." If, for example, the settlor gave his spouse a power to allocate the remainder among his children, the settlor would be treated as the owner of the entire trust for income tax purposes. In such case, Lionel or Jane would bear all of the income tax liability associated with the trust's income and gains. As those tax payments would not diminish the value of the trust assets that would ultimately pass to their children, they would be the equivalent of additional gifts not subject to gift tax. As long as the settlor has surrendered all dominion and control over the trust's remainder interest, this arrangement would have no effect on the transfer taxation of the arrangement, which would remain as described. (It would be best not to have both Lionel and Jane create similar defective grantor GRATs. Under the reciprocal-trust role, each could be deemed the settlor of the other's trust, causing the entire trust corpus to be included in the settlor's estate.)

Conclusion

Combining an FLP with GRATs makes sense for Lionel. By doing so, Lionel and Jane are able to transfer interests in more than $890,000 of real estate to their children for an aggregate girl tax value of slightly more than $371,400. The GRAT, however, is accompanied by risk. A tax adviser must caution his clients on the risk of premature death, and ensure that they take this risk into account before going forward.

Editor's note: This case study has been adapted from "PPC Tax Planning Guide--Partnerships, 15th edition, by Grover A. Cleveland, James A. Keller, William D. Klein, Terry W. Lovelace, Sara S. McMurrian and Linda A. Markwood, published by Practitioners Publishing Company, Fort Worth, Tex., 2001 ((800) 323/8241; www.ppcnet.com).

Albert B. Ellentuck, Esq. Of Counsel King and Nordlinger, L.L.P. Arlington, VA