Sale of property to an intentionally defective grantor trust.

Editor's note: This case study has been adapted from "PPC Tax Planning Guide--S Corporations," 12th Edition, by Andrew R. Biebl and Gregory B. McKeen, published by Practitioners Publishing Company, Forth Worth, Tex., 1998.

Facts: Ben Buckingham is 60 years old and divorced. In early 1999, he became more focused on the potential estate taxes that will arise on his death. Ben had taken some action in previous years to reduce taxes by making taxable gifts up to his $600,000 lifetime credit equivalent, but is now ready to do some additional planning. * Ben considers himself a sophisticated taxpayer and wants to be reasonably aggressive in conducting his business activities and planning his tax affairs. * The asset that will generate the most estate tax is his 100% ownership in Gregorian, Inc., an S corporation. Gregorian has an estimated fair market value (FMV) of $500,000, but Ben believes that it has the potential to grow much larger (based on some software it has developed). He would like to find a way to transfer Gregorian's value to his only child, Elizabeth, with minimal gift or estate tax cost to him and minimal income tax cost to her. He insists, however, that control of Gregorian not be shifted to Elizabeth (due to her lack of business experience). * Ben also feels strongly that Gregorian must remain an S corporation. * Though he is seeking ways to reduce his ultimate estate tax, Ben does not want to pay any current gift tax. His tax adviser tells him that, as a result of the phase-in of the increased lifetime credit in 1998 and 1999, Ben now has an additional $50,000 that he can give without incurring any actual gift tax liability. Issue: Can a plan be developed that transfers all of the Gregorian stock at no current gift tax and maximizes the value that ultimately can be transferred to Elizabeth?

Analysis

The tax adviser first reviews various basic options for reducing estate tax, to see if any fit Ben's situation:

1. An outright gift to Elizabeth would transfer future appreciation without gift tax, but would create immediate tax on Gregorian's current value (subject to reduction by the $10,000 annual exclusion and partially offset by the remaining portion of Ben's lifetime credit). The current gift tax that Ben would be required to pay and the control that would be placed in Elizabeth's hands makes this unacceptable to Ben.

2. A gift to a trust that qualifies for qualified subchapter S trust (QSST) treatment would not meet Ben's objectives, as it would require all of the trust income to be distributed to Elizabeth. In addition, Ben's initial gift to the trust would result in a substantial current gift tax liability (even after offset by the $50,000 lifetime credit exemption equivalent).

3. A gift to an electing small business trust (ESBT) would not meet Ben's objectives; the trust would be taxed on Gregorian's income at the maximum individual income tax rate. In addition, because the tax liability must be paid by the trust itself, the amount that would eventually pass to Elizabeth from the trust would be reduced. And, finally, a gift to such a trust would once again result in a substantial current gift tax liability.

4. Making smaller annual gifts of Gregorian stock would generate less tax (because of the minority interest discount), but would have disadvantages as well. The gifts would be spread out over several years, so that each would represent a minority interest, but the stock will likely appreciate in the meantime. These gifts would also generate a current gift tax liability, even though somewhat diminished by the minority discount. Control issues might also arise with such gifts.

None of these meet Ben's objectives. The tax adviser then explores the use of a grantor retained annuity trust (GRAT) or grantor retained unitrust (GRUT), in which Ben would retain a defined income interest for a period of years, with the remainder passing to Elizabeth at the end of that term. While this has some appeal, Ben must survive the full term or the property will be thrown back into his estate. If the initial gift to a GRAT or GRUT is to be minimized, the term must be fairly long (or the annual yield must be significantly increased, or both, which would cause the property to flow back into Ben's estate). Even if a GRAT made annual distributions to Ben at a 10% annual rate, its term would need to exceed 20 years for the amount of the taxable gift to be less than Ben's $50,000 remaining lifetime credit exclusion. Because Ben is currently 60 years old, he does not want to rely on living another 20 years to avoid the disastrous possibility of a GRAT being included in his taxable estate.

If Ben's objectives are to be fully met, a more elaborate planning approach is needed. The tax adviser then outlines one that may fit Ben's circumstances. The S corporation characteristics and future income and growth prospects of Gregorian suggest that this new approach may be particularly appropriate to Ben's circumstances. The basic steps are as follows:

1. Ben establishes a trust for the primary benefit of Elizabeth. The trust income can be accumulated or distributed to Elizabeth at the trustee's discretion.

2. The trust document includes certain powers retained by Ben that would cause it to be treated as a grantor trust for income tax purposes. These powers would not be such, however, to prevent a gift to the trust from being a completed gift, or cause the trust's value to be included in Ben's estate at his death. The retained powers that would cause a trust to be a grantor trust for income tax purposes are listed in Secs. 671-678. Several of these powers, such as a power in a nonfiduciary capacity to reacquire trust corpus by substituting other property of equivalent value (Sec. 675(4)(C)) or a power to control the investment of trust funds (Sec. 675(4)(B)), should not cause a trust to be included in a grantor's estate. Note, however, that the Service has taken the position that mere recitation of a Sec. 675(4)(C) power will not automatically make it a grantor trust.

3. Ben would make a gift of $50,000 in cash to the trust.

4. The trust would acquire all of the Gregorian shares from Ben for $50,000 cash plus the issuance of a $450,000 note. The note would provide for payments of interest only for 10 years (at the rate set forth in Sec. 1274), with a balloon payment of the entire balance at end of 10 years. Payment of the note would be secured by the Gregorian stock.

Gift Tax

Ben would report the $50,000 cash as a taxable gift. Because the terms of the trust create a future interest, the annual exclusion is not available. The gift tax calculated on the $50,000, however, will be fully offset by Ben's additional available lifetime unified credit. No other gift tax liability should arise. The stock will be sold at its FMV, so a constructive gift would not be created from the sale. And, because the interest rate on the note issued will be consistent with Sec. 1274, no gift will arise based on a "bargain" interest rate.

Estate Tax

The value of the Gregorian stock should not be included in Ben's estate; the powers to be retained will not be sufficient to require that the trust assets be added back. Ben is not required to outlive a certain term to avoid inclusion of the trust assets in his estate, since he has not retained an income interest in a GRAT or GRUT. Thus, the Gregorian stock (which Ben feels will appreciate substantially) will not be subject to any estate tax. The proceeds from Ben's sale of the stock to the trust will be included in his estate.

Income Tax

The trust will be treated as a grantor trust for income tax purposes because of the powers retained by Ben. This treatment will actually create some favorable tax results:

1. The trust will clearly qualify as an eligible S shareholder.

2. Because Ben is considered owner of the entire trust, the transfer of the stock from Ben to the trust is not considered a sale for Federal income tax purposes. Note that, for the transaction to be respected as a sale and for the note not to be considered a retained interest under Sec. 2701, there should be a respectable downpayment, an arm's-length interest rate and a reasonable term.

3. Because Ben is considered the owner of the entire trust, the interest paid from the trust to him on the purchase note is not taxable to him (nor is it deductible by the trust).

4. Because Ben is considered the trust's owner, all of its income is reported on his income tax return. It is beneficial for Ben (rather than the trust) to pay this tax, because the income tax he pays reduces the size of his eventual estate. The trust assets are not reduced by this income tax expense and therefore are maximized for Elizabeth's benefit.

The tax adviser notes that, if Sec. 1274 required an 8% interest rate, the annual required interest payment on the note would be $36,000. Ben is comfortable that Gregorian can generate annual distributions well in excess of this amount without negatively affecting the cash needed for its continuing operations.

The tax adviser points out that, since he will no longer own the stock, Ben will pay income' tax from including all of Gregorian's income on his return without receiving cash distributions from Gregorian to pay this liability. Ben feels that he has adequate cashflow from other sources to handle this.

Although the trust will qualify as an S shareholder during Ben's life (because of its grantor status), qualification after his death must come from another source. Because Elizabeth will then be the sole beneficiary, however, qualification should be available as either a QSST or ESBT, depending on what best fits Elizabeth's planning needs at that time.

The potential tax savings are substantial. If Gregorian grows at a compounded annual 12% rate, its current $500,000 value will have grown in 15 years to about $2,736,800; at Ben's anticipated 55% rate, estate tax on that amount would be about $1,505,000. In contrast, the value of the $50,000 downpayment and $450,000 note he receives on the sale of Gregorian, compounded at an 8% rate, should grow to about $1,586,000 in 15 years; estate tax on this amount would be $872,000 at a 55% rate. Thus, the estimated estate tax savings is $633,000 ($1,505,000 - $872,000), which could be much higher if Gregorian's growth rate exceeds the 12% assumed rate. Further estate tax savings will result from Ben's estate being reduced by the income tax he pays on Gregorian's income. This savings results at a cost of only using Ben's additional unified credit equivalent of $50,000, without him paying any actual gift tax.

In Ben's situation, use of an "intentionally defective" grantor trust is preferable to using a GRAT for several reasons;

1. Ben is not required to survive for a certain period of years to secure the benefit.

2. The initial gift involved is smaller and will produce no current gift tax liability.

3. The interest rate required for the note (Sec. 1274) is lower than that used in establishing the GRAT (Sec. 7520).

4. The note's payment structure is more flexible than the GRAT's required annual annuity.

Ben is cautioned that the professional fees involved with establishing this approach can be fairly significant (although a small fraction of the tax involved). The tax adviser recommends that an estate planning attorney with experience in this type of arrangement be engaged to draft the necessary documents. Even with such quality involvement, the Service may argue that the desired tax consequences should not be allowed on several grounds:

1. The powers retained by Ben are such that a completed gift has not occurred, meaning that all property arising from the incomplete gift should be included in his estate.

2. Even though the powers were not sufficient to prevent a completed gift, they are the types of powers that would cause the trust's assets to be included in Ben's taxable estate under Secs. 2036-2038.

3. The trust is not a grantor trust; therefore, the sale from Ben to the trust would have capital gain consequences. This argument could also raise significant issues regarding Gregorian's S status.

4. The payment of tax by Ben on the grantor's trust income constitutes a gift by Ben to the trust, subject to gift tax.

Ben understands the risks involved, and believes they can be reasonably controlled by using the expertise of the tax adviser and the estate planning specialist (although recognizing that some risks involve potential future legislation, litigation on new issues and shifts in IRS policy).

Conclusion

This approach is one that will satisfy Ben's major objectives. The fact that the asset that Ben wishes to transfer is an ownership interest in a high-growth S corporation with distribution capabilities is the key factor. It does not endanger Gregorian's S status and will generate significant potential transfer tax savings.

The tax adviser should take a great deal of care to be certain that Ben is aware of and accepts the risks involved with this approach. He knows that Ben is a sophisticated client capable of understanding and evaluating the risks. He also knows that the risks will be reduced by retaining an experienced attorney to draft the documents and paying consistent attention to the day-to-day operation of the structure.

Albert B. Ellentuck, Esq. Of Counsel King and Nordlinger, L.L.P. Washington, DC