GISTs.

Agrantor installment sale trust (GIST) is a relatively new technique that can accomplish an estate freeze by using an installment sale arrangement. It can delay recognition of any income tax gain on the sale and, at the same time, not recognize interest paid while the installment note is outstanding. It is similar in concept to the popular grantor retained annuity trust (GRAT), but has certain distinct advantages, as well as some unknown risks (e.g., how the IRS may respond to this technique).

Background

Over the years, Congress has found many creative ways to implement new taxes, resulting in a plethora of different tax "structures" affecting various transactions. For example, there are income taxes, social security taxes, Medicare taxes, excise taxes, gasoline taxes, gift taxes, estate taxes, generation-skipping transfer (GST) taxes, etc. In some cases, a single transaction can be subject to more than one of these. For example, a single bargain sale to a grandchild can simultaneously have income, gift and GST tax consequences.

Nevertheless, with creative planning, taxpayers can sometimes take advantage of the slightly different rules for various tax structures. One such planning opportunity exists for taxpayers who want to reduce estate tax. A GIST removes an asset's appreciation from the taxable estate at death, while not recognizing the income as a gift or as a sale.

Grantor Trusts 

Before examining the mechanics of creating a GIST, it is necessary to consider the basic rules governing grantor trusts. For legal purposes, if a person retitles assets in the name of a trust, he is no longer the legal owner of the assets transferred to the trust. This is often done to avoid probate proceedings at death. For Federal income tax purposes, however, the IRS continues to treat the grantor (i.e., the person who transferred assets to the trust) as the owner of those assets if he retained any rights or control over them. Although most grantor trusts are revocable, many are actually irrevocable. In either case, the Service essentially ignores (for income tax purposes) the existence of the grantor trust and taxes the income earned on the asset as if there were no tide change. In effect, the taxpayer (not the trust) pays income tax on all income and gains earned by the trust.

Taxpayers can take advantage of the grantor trust rules to draft a trust document that is "intentionally defective" for income tax purposes (i.e., violates the Code's grantor trust rules), but still has a valid transfer for estate and gift tax purposes.

A taxpayer can include several provisions in a trust document to violate the Secs. 671-677 grantor trust rules. Regardless of the method used, the key issue is that the grantor's rights cannot be so substantial that he has sufficient control over the property to enable the IRS to include it in his taxable estate under Secs. 2035-2043. One method commonly used is to give the grantor a nonfiduciary right to reacquire the trust corpus by substituting in its place property of equivalent value (Sec. 675(4)). This generally makes the trust a grantor trust for income tax purposes, while still being a completed transfer for estate and gift tax purposes.

Installment Sale Technique

Overview. In general, the GIST technique involves an individual selling an asset(s) for full fair market value (FMV) to a trust of which he is the grantor. Because the sale is at FMV, there is no gift; because the trust is a grantor trust, the grantor is in essence (for income tax purposes), selling the asset to himself, with no gain or loss recognition. This holds true even though the sale removes the asset(s) from the grantor's taxable estate for gift and estate tax purposes.

Step 1. Because the grantor is selling the asset to the trust, the first step is to ensure that the trust is a legitimate and creditworthy party to the transaction. If the grantor were to sell a valuable asset on credit to the trust with no net worth, the IRS might consider the transaction a sham. Thus, to give the GIST net worth, the grantor should make a completed gift of a substantial sum of cash or assets to a trust; the trust's net worth probably should be at least 10% to 20% of the value of the property being sold. Depending on the size of the gift, and the extent to which the taxpayer has already used his unified credit, gift tax may be due on this initial transfer. Although the value of the initial gift may be substantially reduced by gifting assets subject to valuation discounts (e.g., an interest in a family limited partnership), this could further subject the GIST to IRS scrutiny, especially if the "discounted" value is less than 10% to 20% of the initial value of the property being sold.

The trust should be drafted so that it is "intentionally defective" for grantor trust purposes, rendering the transfer incomplete for income tax purposes, but complete for gift and estate tax purposes. This difference in the treatment of the transfer for income tax purposes and gift and estate tax purposes results in the many advantages of using a GIST.

Step 2. The grantor and the trust enter into a bona fide sales agreement in which the grantor sells an asset to the trust on credit (i.e., in exchange for a promissory note). The trust makes annual interest payments to the grantor using the applicable federal rate, which the Service publishes monthly as specified in Sec. 1274(d). The principal is a single balloon payment due at the end of the term of the note. (Taking into account renewals of the loan, the grantor will probably die with the full note balance still outstanding.) Interest must be paid annually, because for gift and estate tax purposes, the grantor and the trust are separate entities and all transactions must be at arm's-length.

This is why it is necessary to establish a gift's legitimacy. Specifically, it would be hard to argue that a legitimate sale exists when the sale is to an entity that holds no other cash or assets. In addition, if the income from the asset sold to the trust is seen as the sole source for repayment of the promissory note, the Service might argue that the taxpayer had retained an interest in the assets, thereby bringing them back into the taxpayer's estate. Because a GIST's purpose is to remove assets from the taxpayer's estate, this would obviously be an undesirable consequence. Further, the taxpayer should not structure the payments such that the cash flow generated by the assets in the trust exactly equals the interest payments due on the promissory note; this could allow the Ilks to argue that the transaction has no separate non-tax business purpose and legitimacy.

Step 3. As a third step, a trust may want to purchase life insurance on the grantor in an amount that pays off the note to the grantor when he dies. This aspect is optional but logical, because the note must be paid on the grantor's death, and it may be easier to make the payment using life insurance proceeds (rather than to return a fractional interest in the original property back to the grantor).

Advantages. When the grantor dies, the note (plus any accumulated interest at the time of death) would be included in his estate. Because the value of the note does not appreciate, any increase in the value of the original asset sold to the trust is not taxed in the grantor's taxable estate; the grantor removed a portion of the post-sale appreciation in the value of the asset sold to the trust from his estate. Therefore, he has effectively "frozen" the value of that portion of his estate.

As previously mentioned, even though the initial gift to the trust, as shown in the first step, is a completed transfer for gift and estate tax purposes (and thus both the assets gibed and sold to the trust will be removed from the taxpayer's taxable estate), as the trust is intentionally defective for income tax purposes, the trust assets are treated as still owned by the grantor (i.e., the trust is ignored and treated as if it does not exist). Consequently, the grantor recognizes no gain when he sells assets to the trust.

Because the trust is not treated as an entity separate from the grantor, the grantor does not recognize income on the interest payments on the promissory note received from the trust. Again, no income is recognized, because the grantor is effectively paying interest to himself.

A final advantage of a GIST is that the grantor is responsible each year for paying the income tax on the income and gains earned by the assets held in the trust. Although this effectively benefits the grantor's heirs (resulting in further reduction in the size of the grantor's estate), no gift tax is imposed on the "gift" because the grantor is simply paying a tax that he is legally due to pay. As such, the grantor is merely fulfilling a personal obligation to pay the income tax properly assessed, rather than making an additional gift.

Disadvantages. If the grantor dies while the note is outstanding, he has effectively reduced his estate tax burden by freezing the value of that portion of his estate. From an income tax perspective, however, death during the note's term potentially has a negative effect. When the grantor dies, the trust ceases to be a grantor trust. At that point, the IRS can either treat the transaction as a sale of the trust's assets immediately prior to the grantor's death at a value equal to the outstanding balance on the note or ignore the grantor's "sale to himself" altogether and treat the beneficiary as receiving the property with a basis equal to the grantor's basis in the property prior to the sale. If the Service treats the transaction as a sale, the installment sale rules would result in the gain likely being recognized not on the grantor's final income tax return, but by his estate or the successor beneficiaries, or both. Despite this recognition of the gain on the sale, the gain has effectively been deferred (possibly for many years) between the date of the freeze and the grantor's death.

A GIST can create other potential risks. However, with careful drafting of the trust documents based on current case law and Ilks rulings, the risks should be minimized.

Comparison to a GRAT

Overall, net estate tax savings can be achieved with a GIST if the asset sold appreciates between the dates of the sale and at a rate higher than the interest rate on the promissory note. In this respect, a GIST is similar to a GRAT, but there are two reasons a GIST may be superior.

First, the interest rate required by the Service under Sec. 1274(d) to determine the amount of the annual interest payment to a grantor using a GIST is lower than the interest rate required under Sec. 7520 to determine the annual annuity payment to a grantor using a GRAT. Therefore, more of the asset's appreciation can be transferred estate tax-free using a GIST.

Second, if the grantor dies during the GRAT's term, the asset transferred (including most, if not all, appreciation in its value) is taxable in his estate, thereby negating the benefit of the GRAT. On the other hand, with a GIST, the death of the grantor during the term of the installment note does not bring the intervening appreciation in the value of the asset sold back into his estate.

Conclusion

By taking advantage of the differences between the income tax rules and the estate and gift tax rules, GISTs provide taxpayers with a unique opportunity to enjoy significant estate tax savings. Taxpayers looking to reduce their tax burden at minimal risk should give them serious consideration.