Top 10 estates planning strategies.

EXECUTIVE SUMMARY

* Because an IDIT is not a creature of statute or regulation, a client must be willing to risk IRS scrutiny.

* In the right circumstances, sales of assets to family members in exchange for an annuity or installment note have significant estate planning benefits.

* The Service has argued that there is no business purpose for the existence of a FLP, and that it should be ignored for estate and gift tax valuation purposes.

Every estate planner has an arsenal of favorite techniques to offer clients. Part II of this two-part article presents five more of the author's favorite methods: use of intentionally defective irrevocable trusts, private annuities and self-canceling installment notes, charitable lead trusts, charitable remainder trusts and family limited partnerships. The article discusses how these techniques work, the types of clients for which each is suitable and technical and planning considerations.

The first part of this two-part article, in the January 2001 issue, discussed five top estate planning techniques: use of lifetime gifts, insurance trusts, dynasty trusts, qualified personal residence trusts and grantor retained annuity trusts (GNATs).(19) Part II, below, examines five more strategies for reducing estate and gift taxes.

Six: Sales to IDITs

A common technique that has gained in popularity in recent years is the sale of an asset to an intentionally defective irrevocable trust (IDIT), a grantor trust created by the seller.

How They Work

The installment sale of property to an IDIT is an estate-freezing technique similar to a GNAT, but takes advantage of the differences between the estate tax rules and the income tax rules governing property ownership. The trust is intentionally drafted so that the creator is treated as the owner for income tax purposes (i.e., a grantor trust). Because of the grantor trust status, the trust is treated as the creator's alter ego; the sale of assets to the trust does not trigger gain recognition.(20)

The grantor then sells assets to the trust in exchange for an interest-bearing note. Because the transaction is structured as a sale, the note bears interest at the applicable Federal rate (AFR) under Sec. 1274, rather than under Sec. 7520 (which is typically used for gifts and thus tends to be higher). The face amount of the note is the fair market value (FMV) of the assets sold, and takes into account any lack of marketability and minority interest discounts. The primary benefit of making an installment sale to an IDIT is that, to the extent the assets generate more than the applicable interest rate in combined income and appreciation, such excess will pass to the trust beneficiaries transfer tax-free.

Suitable Clients

Appreciation Potential

An IDIT works best for a client with assets expected to appreciate significantly (similar to a GNAT), so that appreciation can shift to heirs without gift tax. Ideally, the yield on the property sold to the trust should exceed the note's interest rate.

Risk Tolerance 

Because IDIT principles are not statutory or regulatory (unlike a GNAT or qualified personal residence trust), a client who uses an IDIT must be willing to risk IRs scrutiny.

GST Planning

An IDIT is a useful vehicle for a client interested in generation-skipping transfer (GST) tax planning (as opposed to a GNAT, for instance); the GST exemption may be allocated to the trust, because the grantor has not retained an interest in the trust.

Planning Considerations

Grantor Trust Status

As mentioned above, for income tax purposes only, an IDIT is treated as nonexistent if the grantor is considered to have certain interests or powers that cause the trust to be treated as a grantor trust. Care must be taken to ensure that the powers chosen have the desired income tax effect, but do not cause inclusion in the grantor's estate for estate tax purposes. Because the trust is disregarded for income tax purposes, it will inherit the grantor's basis while the grantor is alive. The grantor will continue to be taxed individually on the income and gains the IDIT generates. By paying the income tax on trust income, the grantor effectively makes additional gift-tax-free transfers to the IDIT's beneficiaries.

Bona Fide Sale

For an IDIT to work, the transfer to the trust must be structured as a bona fide sale, rather than as a gift. Therefore, the property's FMV must be accurately determined. Also, the note must have commercially reasonable terms, so that it represents adequate and full consideration for the property sold. The purchase price in the IDIT note can be expressed in terms of a formula, but it is not clear whether the IRS would respect such a formula.(21)

Estate and Gift Considerations

For estate and gift tax purposes, gifts or sales to the trust are treated as completed transactions between the grantor and the trust. Thus, property owned by the trust will not be treated as part of the grantor's estate for estate tax purposes.

To achieve this result, the sale and the trust must be structured so that the grantor does not retain any "strings" over the property that would trigger inclusion in the estate under Sec. 2036 or 2038. In addition, as mentioned above, because the sale is at FMV, no gift occurs. If a gift is involved, the entire property could be included in the gross estate under Sec. 2036(a). Thus, an appraisal should be obtained to substantiate FMV.

Trust Capitalization 

In addition, if no assets are available to finance the interest payments on the note other than income from the assets sold, it is easier for the Service to argue that the grantor transferred assets to the trust and indirectly retained the right to their income, causing inclusion of the trust property in the grantor's estate under Sec. 2036.(22) Accordingly, it is advisable either to use an existing grantor trust as the IDIT sale vehicle, or to transfer other assets to the trust. Of course, the transfer of other assets is subject to the gift tax rules. Generally, the trust should be capitalized with assets having a value of more than 10% of the note's face amount. Otherwise, the Service has a better argument that the note is not true debt but, rather, equity contributed by the grantor with a retained income interest.

Commercial Reasonableness

In determining FMV, numerous other factors should also be considered. In particular, whether the note is commercially reasonable is a factor in determining whether the transaction is bona fide and at arm's length, as opposed to a gift.

For example, is the note secured? In commercial transactions, a note is often secured by the debtor's property, so that the lender can be better assured of repayment. Lack of security is evidence that the transaction is not at arm's length. On the other hand, if the note is secured by the property sold to the trust (particularly when the income generated by the property is closely tied to the payments on the note), it can be argued that the transferor transferred the property and retained the right to income therefrom, in the form of the interest stream from the payments on the note. Thus, it might be argued that the property should be included in the transferor's estate for estate tax purposes under Sec. 2036.

One possible way to support the commercial reasonableness of the sale without using the property as security is to have the principal trust beneficiary (assuming a competent adult) guarantee the note. In this way there may be someone with greater assets than the trust (or at least, an individual with potential access to trust income) responsible for note payments, thereby bolstering its value. However, the gift and estate tax consequences to the guarantor of such a guarantee (if any) are not clear. If the beneficiary is not compensated for the guarantee, it can be argued that the beneficiary has made a gift of the guarantee's FMV to the trust.

Another issue is whether the note has a fixed term or is a demand note, and the interest rate it bears. Generally, the shorter the term, the lower the interest rate. A demand note is treated as a short-term note, and thus has the lowest interest rate. Arguably, although a demand note bears the lowest rate of interest, it is not the ideal form. The Service ,nay take the position that the continuing failure to exercise the demand is not commercially reasonable and is a gift under Sec. 7872 in the amount of the forgone higher interest that could have been received based on changing interest rates over time. One way around this might be to have a term locked in for one year. At the end of the year, the note could be callable for a limited time, and, if not called, extended with a current interest rate.

Income Tax Considerations and Mortality Risk

What are the income tax consequences if the grantor dies while the note is outstanding? Although no gain is triggered on the sale or from any other transaction between the grantor and the trust during the grantor's life, the IRS may argue that the grantor's death (which causes grantor trust status to cease) results in a deemed sale, triggering income equal to the FMV of the amount unpaid under the note.(23)

The Service made a similar argument in Letter Ruling (TAM) 200011005,(24) in which the termination of a GRAT'S grantor trust status triggered gain to the grantor in the amount of any outstanding note. This factor argues in favor of ensuring that the trust pays off the note while the grantor is still alive, so that the trust stays a grantor trust.

Satisfying the Note

There are several methods of satisfying the note, including the following:

* The trust can borrow from another source.

* All or a portion of the purchased trust property (including income earned thereon) can be returned to the seller in satisfaction of the note (although an independent appraisal will most likely be necessary if the property is not publicly traded).

* The remainder of the note can be discharged in the form of a gift.

* The trustee can sell the trust property to a third party and the proceeds (up to the note's unpaid balance) can be distributed to the grantor.

Only the gift or sale of the trust property has tax consequences to the grantor. As to the gift discharge, grantor trust status will preclude the grantor's recognition of capital gain or loss and the trust's recognition of discharge of indebtedness income. In addition, the discharge will be deemed a taxable gift from the grantor to the trust beneficiary. As to the sale to a third party, the grantor trust status will cause the gain to be taxed to the grantor.

Seven: Private Annuities and SCINs

Sales of assets to family members in exchange for an annuity or an installment note have significant estate planning benefits, in the right circumstances.

How Private Annuties Work

In this technique, an individual transfers assets in exchange for an annuity, typically paid for life. The promise to pay the annuity is an obligation to pay a specified amount periodically. The transferor is typically a parent; the obligor is typically a lower-generation family member (e.g., a child).

Example 1: In July 2000 (when the Sec. 7520 rate is 8%), X, a 55-year-old parent, transfers an asset worth $5,000,000 to Y, X's child, in exchange for an annuity payable annually at the end of each year for the rest of X's life. Under IRS tables, the life expectancy of a 55-year-old individual is about 28 years. The required annual payment would be $507,393.

If X dies after two years, having received only two payments totaling $1,014,786, Y will have received $3,985,214 (plus earnings) gift and estate tax-free. At a 55% marginal estate tax rate, the estate tax savings would be $2,191,868.

Suitable Clients

Shortened anticipated life expectancy: When using actuarial tables to value an annuity to be received over a transferor's life, the transferor's (i.e., annuity recipient's) actuarial life expectancy is used, according to Regs. Secs. 25.25125 et seq. and 25.7520-1(b)(2).

If it is anticipated that the transferor may not reach actuarial life expectancy, using that life expectancy assumes that much smaller payments will be made over a much longer term than is in fact likely under the circumstances. If the transferor has at least a 50% chance of living for one year, the actuarial tables can be used, according to Regs. Sec. 25.7520-3(b)(3), and will probably overstate the value of the annuity to be received, yielding significant estate planning benefits.

Spousal annuity: If the annuity is for the joint and survivor of the owner and spouse, the owner can provide an income stream to the spouse.

Appreciating assets: If the transferor has assets that may appreciate significantly in value, a private annuity acts as a freezing technique, allowing the appreciation to inure to the benefit of a child.

Technical Considerations

Gift Tax Treatment

To avoid gift tax, the value of the annuity received by the transferor must be equal, under Sec. 7520, to the value of the asset transferred. If property other than cash is transferred to a child in exchange for an annuity, the value of the transferred asset must be carefully substantiated.(25) If publicly traded stock is transferred, the value is fairly easy to ascertain. If a closely held business interest or real estate is transferred, an appraisal will be needed.

In Example 1 above, because the present value of the stream of annuity payments (using the valuation tables) exactly equals the value of the property transferred, there is no taxable gift.(26)

Estate Tax Treatment

To avoid inclusion in the transferor's estate, the transferor should not retain any strings over the property, the property should nor secure the obligation, the annuity to be received should not be tied to the income produced by the property and the transferee should have sufficient income to make the payments.(27) If the annuity payments are tied to the property transferred, or if the transferor has no other sources of income, it can be argued that the transferor has made a transfer and retained the right to income from the property, so that the property has to be included in the transferor's estate under Sec. 2036.

Income Tax Treatment

Because a parent who transfers property in exchange for a private annuity in effect sells the property for the annuity, the parent will have to recognize some income tax on the receipt of the annuity payments. To avoid immediate recognition of the entire gain from the transaction, the promise to pay the annuity should be unsecured.(28)

The income tax treatment of the payments is determined under Rev. Rul. 69-74.(29) Under that ruling, the transferor can spread basis in the property transferred (investment in the contract) over the annuity's expected term (the parent's life expectancy). Similarly, the capital gain component of the transaction can be spread over the term. Any excess of the annuity payment over the return of basis and capital gain is treated as the interest component and taxable as ordinary income.

The child does not get an interest expense deduction for the interest component. The child's basis in the property received will be the present value of the annuity payments. However, there may be an adjustment if the actual amount paid for the property is less than anticipated (i.e., if the parent dies before the actuarial life expectancy).

Example 2: The facts are the same as in Example 1, except that X had a $2,000,000 basis in the asset transferred and, thus, a $3,000,000 gain. Because X was 55 years old at the time of the transfer, and his life expectancy was about 28 years, he could spread the basis and the capital gain over the 28-year period, recognizing $106,762 capital gain each year, and $71,174 return of basis. The excess of $329,457 ($507,393 - $106,762 - $71,174), representing the interest, would be reported as ordinary income.

A downside of this scenario is that the child may now have an asset worth $5 million with a $1,014,786 basis (the payments made under the annuity). Thus, if appreciated assets are transferred to a child using this technique, the income tax consequences to the child should be weighed against the estate tax savings.

Example 3: The facts are the same as in Example 2, except that, instead of transferring appreciated property, X transfers cash to Y in exchange for the annuity. There is no capital gain component and the interest component remains the same. Y, however, would have a $5,000,000 basis in the cash transferred.

Planning Considerations

Back-loaded Annuity

One commentator has suggested using a "back-loaded" private annuity, while recognizing that the result may be too good to be true.(30) A back-loaded annuity is one in which the transferee pays, rather than a level amount, an amount that increases annually; the highest payments are at the end of the term.

Example 4: The facts are the same as in Example 3, except that X transfers $5,000,000 to Y in exchange for a 20% increasing annuity. Rather than a level payment of $507,393, Y would pay only about $33,100 in the first year and $39,720 in the second year, for a total of only $72,820 before X's death after the second year. The roughly $942,000 that Y saves in annuity payments saves X about $518,100 more in estate taxes.

Reverse Mortality Risk

One drawback of a private annuity is that if the parent lives beyond life expectancy, the child will be forced to continue paying the annuity; thus, assets are transferred back to the senior generation's estate. Conversely, if the parent dies prematurely, the child gets a windfall, with the attendant estate and gift tax savings.

How SCINs Work

Use of a self-canceling installment note (SCIN) is similar to a sale to an IDIT or a private annuity. A transferor sells property in exchange for an obligation. A SCIN is an installment obligation with a fixed duration. However, if the obligee (seller) dies before the note is paid off, the note is cancelled. When calculating the property's initial purchase price and interest rate (and, thus, the annuity's present value), the cancellation feature is taken into account, resulting in a premium payment for it (in the form of increased principal or increased interest on the note).

Suitable Clients

Similar to a private annuity, the greatest transfer tax advantages are achieved if the transferor (payee) does not survive the term or if there is significant appreciation potential. The lower-generation family member will have effectively paid less for the asset than it was actually worth.

In addition, the technique does not work well from an income tax perspective for publicly traded securities, which are not eligible for installment-sale treatment.

Technical Considerations

For income tax purposes, under Sec. 453, income is reported by the transferor (payee) as installments are received, in the same proportion to the payment as the payment bears to the total to be received over the term. If the transferor dies before the entire gain is realized, the transferor's estate recognizes the unreported gain.(31)

Similar to a private annuity, nothing is included in the transferor's estate, because there is no asset left at the transferor's death.

Planning Considerations

Spousal annuity: Similar to a private annuity, if the asset is owned and sold jointly by both spouses, cancelable only on the survivor's death, the surviving spouse will have a continuing income stream.

Term: It is preferable not to use a term longer than the transferor's actuarial life expectancy. To do so could cause a SCIN to be recharacterized as a private annuity, with tax treatment and considerations as described above.

Eight: CLTs

Charitable lead trusts (CLTs) have become popular tools in the recent economic expansion.(32)

How They Work

In a CLT, a grantor gives cash or other property to a trustee to pay a specified amount (either an annuity or unitrust amount) to charity for a term certain or for an individual's life, with the remainder either reverting to the grantor or passing to heirs at termination.

Technical Considerations

Estate and Gift Tax Treatment

Under Secs. 2055 (e) (2) (B) and 2522 (c)(2)(B), an estate and gift tax charitable deduction is allowed for a CLT if the interest passing to charitable and noncharitable beneficiaries is in the form of a charitable lead annuity trust (CLAT) or a charitable lead unitrust (CLUT).

A CLAT requires that the charitable lead interest be in the form of a guaranteed annuity, payable at least annually. The annuity can be a fixed dollar amount (e.g., "in each taxable year of the trust, the trustees shall pay the amount of $50,000 to the Unbroken Chain Foundation") or a percentage of the initial net FMV of the property transferred to the trust (e.g., "in each taxable year of the trust, the trustees shall pay an amount equal to five percent (5%) of the initial net FMV of the property listed in Schedule A to the Rex Foundation").(33)

A CLUT requires that the payment of the charitable lead interest be in the form of an annual or more frequent distribution of a fixed percentage of the net FMV of the trust property, determined annually. For example, the trust instrument may provide that "in each taxable year of the trust the trustees shall pay four percent (4%) of the net FMV of the trust property, as determined on the valuation date, to Barnard College."

There are numerous technical rules contained in Secs. 2055(e) and 2522(c) and the regulations thereunder, involving, among other things, the permissible term and measuring lives.(34) In determining the value of an interest in the trust, Sec. 7520 applies.

Private Foundation Rules

Under Sec. 508(d)(2), no estate or gift tax charitable deduction is allowable for a transfer to a split-interest trust, unless the trust complies with the private foundation governing instrument requirements under Sec. 508(e).(35) These rules, which are imposed on CLTs by Sec. 4947(a)(2), must either be contained in the trust document or imposed by local law, according to Kegs. Sec. 1.508-3(d)(1). Under these rules, the trust must be prohibited from: (1) engaging in any act of self-dealing (within the meaning of Sec. 4941(d));. (2) retaining any excess business holdings (within the meaning of Sec. 4943(c)); (3) investing in any assets that would jeopardize carrying out the trust's charitable purposes (within the meaning of Sec. 4944); and (4) making any taxable expenditures (within the meaning of Sec. 4945(d)).

The private foundation rules and Sec. 508(e) apply to a split-interest trust, except that the excess business holdings and the jeopardy investment rules do not apply if, generally, the charitable portion for which a deduction was allowed is not worth more than 60% of the trust's value.(36)

Income Tax Treatment

Grantor trust: A grantor is entitled to an income tax charitable deduction for the value of the charitable lead interest in a CLT that satisfies the requirements for a gift and estate tax deduction. According to Sec. 170 (f) (2) (B), the grantor is entitled to the deduction at the time of the transfer to the trust if the CLT is a grantor trust for income tax purposes under subchapter J at that time. The grantor will be required to include trust income under Sec. 671 in all subsequent years the trust continues to be a grantor trust, as it is earned, with no deduction for amounts paid to the charity, according to Sec. 170 (f) (2) (C).

Trust as taxpayer: A CLT, unlike a charitable remainder trust (CRT), is not a tax-exempt entity. Thus, if the grantor trust rules do not apply to tax the grantor on the CLT's income and gain, the CLT is taxed as a separate taxpayer. Because all income is not required to be distributed currently and amounts are paid for charitable purposes, the complex trust rules apply. The grantor will not receive an income tax charitable deduction in the year of transfer to the trust, but the trust (unlike in the grantor trust scenario) will receive an income tax charitable deduction for payments of income to charity pursuant to the trust terms, under Sec. 642(c).

Carryover basis: Both the trust and its eventual remainder beneficiaries will receive a carryover basis in the trust assets from the donor. Accordingly, the trust would best be funded with cash or high-basis assets.

Suitable Clients

Nontax benefits: A CLT can provide a grantor with significant nontax benefits. For example, the creation of a CLT allows a grantor to satisfy charitable-giving objectives, whether during life or at death. A grantor can also use a CLT to involve family members in charitable giving. The charitable beneficiary can be a private foundation, perhaps run by members of the grantor's family, as a means of funding longterm charitable-giving objectives. Because some or all of the property and its income will be devoted to charitable purposes, a CLT works best when the grantor has both charitable and noncharitable objectives that can be satisfied simultaneously.

Appreciation potential: If the trust investments can be expected to outperform the IRS discount rate (which may be a realistic assumption in the recent economic environment), the amount of the gift will have been understated by the tables. Assets will pass to heirs at trust termination, without additional estate or gift tax.

Shortened life expectancy: If the grantor or the grantor's spouse is named as the CLT measuring life, but is not in good health (and, thus, not expected to live for the predicted IRS life expectancy), the CLT will terminate earlier than anticipated, resulting in a greater amount passing to the heirs than originally expected, at a decreased gift tax cost. Under Regs. Sec. 25.7520-3(b)(3), to receive the benefit of the use of the IRS tables, the measuring life must have a greater-than-50% possibility of surviving for one year from the gift date. If the measuring life lives for 18 months, this possibility will be presumed to have existed at trust creation, unless the contrary is established by clear and convincing evidence.

Planning Considerations

Charitable deduction used to offset high-income year: If a grantor has high income in one year, so that the Sec. 170(b) contribution limits are not reached by the grantor's other charitable contributions, and anticipates lower income in subsequent years, it may be advantageous to use the income tax charitable deduction in the early year, when the grantor can benefit from the income tax deduction. This essentially serves as a deferral technique, allowing the grantor to pay the income tax in later years (perhaps when the grantor has less income or is in a lower bracket).

For example, if a grantor anticipates a large bonus in one year, or plans to sell a business and recognize a significant capital gain, the grantor may decide to make a significant charitable contribution (including through a CLT) in that year, to take advantage of higher contribution limits.

If a grantor anticipates that marginal rates will decrease, a CLT can be used to obtain an immediate deduction. When individual income tax rates were set to decrease significantly as a result of the Tax Reform Act of 1986, many individuals created CLTs to take advantage of the deduction in that year, and pay income tax at lower rates in subsequent years.

Zeroed-out CLAT: One planning technique useful for grantors with charitable-giving objectives is the "zeroed-out" CLAT. This technique involves transferring assets to a CLAT, and setting the charitable payment sufficiently high and the trust term sufficiently long, such that the value of the charitable gift equals (or almost equals) the entire value of the property transferred to the trust. As a result, the value of the remainder interest (the taxable gift portion of the transfer) is zero.

Example 5: B funds a 10-year CLAT with $1,000,000. The annuity is paid annually at the end of the year, with the remainder after 10 years payable to B's children. If the Sec. 7520 rate is 7%, a 14.2377% annuity (i.e., $142,377 per year) produces a zero taxable gift.

If the trust corpus actually grows at 7%, there will be nothing to pass to the remainder beneficiaries. To the extent, however, that the CLAT grows at a rate greater than the Sec. 7520 rate, the excess earnings will pass to the remainder beneficiaries gift tax-free. If the CLAT actually grew at 10% annually, $324,620 would pass to B's remainder beneficiaries gift tax-free.

A zeroed-out CLAT works best when a grantor combines it with existing charitable-giving goals. In Example 5 above, if B were already making annual charitable gifts of approximately $150,000, substituting a charitable-giving program through a CLAT triggers no additional cost and also achieves noncharitable-giving objectives.

This technique does completely eliminate gift tax when the CLAT term is measured by a life or lives. Regs. Sec. 25.7520-3(b)(2)(i) requires that calculations consider the possibility that the funds will be exhausted before all the annuity payments are made.

Shortened life expectancy: If a charitably minded client has a shortened life expectancy, but a better-than-50% chance of surviving for one year, certain planning opportunities arise using the Sec. 7520 actuarial tables.(37) Under these circumstances, a CLT is a valuable technique that can yield benefits for a client not likely to live to actuarial life expectancy, yet long enough to take advantage of the tables.

Example 6: Z, a parent, age 55, transfers a $5,000,000 asset to a CLAT. The trust specifies an 8.776% annual payout ($438,800) to a charity for Z's life; the remainder passes to Z's child. If Z dies after two years, the charity will have received $877,600. Assuming a 7% growth rate, Z's child will receive $4,816,184 at the end of the two years.

Using the Sec. 7520 tables, the 8.776% annuity should approximately equal the $5,000,000 transferred to the trust. Because the annuity interest qualifies for the Sec. 2522 gift tax charitable deduction,(38) one would ordinarily expect that the taxable gift (i.e., the remainder after subtraction of the CLT) would be roughly zero.

The Sec. 7520 regulations do not, however, allow for the zeroing-out of an annuity payable from a trust or other limited fund for the duration of an individual's life, if the payout rate is greater than the Sec. 7520 rate. Regs. Sec. 25.2520-3(b)(2)(i) requires that the calculations consider the possibility that the fund will be exhausted before all the annuity payments are made. For these purposes, it is assumed that the measuring life could live to age 110. Therefore, based on the regulation, it is impossible to zero-out the charitable interest in a CLAT when the term is based on a life.

Example 7: The facts are the same as in Example 6. The Sec. 7520 rate is 6.4% and Regs. Sec. 25.2520-3(b)(2)(i) is taken into account. The gift would be $520,989. If the donor is in the 55% marginal gift tax bracket and dies after two years, the donor paid $444,143 ($286,544 + $157,599 (gift taxes paid within three years of death are subject to estate tax)) in transfer tax to transfer $4,816,184 to the child, an estate tax savings of $2,204,758.

The risk with this scenario is that if the grantor outlives the anticipated life expectancy, the benefits of the transaction are reduced and the charity receives more than anticipated.

Nonqualifying CLT: Occasionally, it may be beneficial for a grantor to create a CLT that deliberately does not meet the rules to qualify for a gift, estate or income tax charitable deduction.

Example 8: M creates a CLT with $500,000. The trust will pay income (rather than an annuity or unitrust payment) to 14 different named charities for five years; at the end of that time, it will pay the remainder to M's children. Using a 6.4% Sec. 7520 rate, the actuarial present value of the right to receive one-fourteenth of the income from $500,000 for five years is $9,524. Because $9,524 is less than $10,000, the 14 charitable income interests will each qualify for the annual exclusion; only the value of the remainder interest to M's children, or $366,664 ($500,000 -- ($9,524 x 14))is subject to gift tax.

If the trust does not earn the projected rate of return in income, the charity's interest has been overstated for gift tax purposes. If the principal appreciates, the value of the gift to the children has been understated, resulting in property passing to them at a lower gift tax cost. For example, if the property transferred to the trust earns 2% income annually and appreciates 7%, the present value of the remainder interest to M's children is $502,820 (using a 6.4% discount rate) rather than $366,664; thus, M has transferred an additional $136,156 to his children gift tax-free.

Control of designation of charity: If a grantor retains control of designating the charity to receive the lead payments directly (or indirectly, through controlling the distributions from a private foundation to which the lead trust payments are made), numerous issues arise: (1) whether the grantor has made a completed gift, (2) whether (and when) the grantor is entitled to an income tax deduction and (3) whether the CLT is included in the grantor's gross estate. However, in the case of a private foundation, the grantor may avoid the control issue by directing that any proceeds that the private foundation receives from the CLT be placed in a separate account within the foundation, and that the grantor have no control over the disposition of those assets.(39)

GST planning: When allocating the GST exemption to a CLT, different rules will apply (and different results will be obtained) depending on whether the trust is a CLAT or a CLUT. A special rule applies to the allocation of GST exemption to a CLAT (but not to a CLUT), under Sec. 2642 (e). The effect of this rule is to disfavor CLATs as a means of transferring appreciating property to grandchildren or other skip persons. No special rules apply to the allocation of GST exemption to a CLUT The value of the charitable deduction allowed under Sec. 2055 or 2522 may be subtracted from the total value of the property transferred to the CLUT when allocating GST exemption, according to Sec. 2642 (a) (2) (B) (ii) (II).

Nine: CRTs

A charitable remainder mast (CRT) provides benefits for the charitably minded donor. A CRT effectively allows a donor to (1) avoid paying tax currently on the disposition of appreciated assets and (2) invest the sale proceeds to generate a future income stream, while (3) receiving a charitable deduction for the net present value of the amount that will eventually pass to charity.

How They Work

A donor forms a CRT and contributes assets (such as appreciated stock) to it. The CRT sells the stock, but does not pay tax on the gain, because it is generally a tax-exempt entity under Sec. 664(c). It then invests the proceeds and pays the donor an income stream for a fixed term of years (or over the course of a life or lives). On completion of the term, the CRT distributes the remaining assets to a charity, which can include a private foundation established by the donor. The longer the CRT is in existence, the larger the income benefit it can generate for the income recipient; consequently, the smaller the amount that will eventually be contributed to charity.

The donor receives an income tax charitable deduction (as well as a gift or estate tax charitable deduction) on mast creation, measured by the actuarial present value of the charity's right to receive the corpus on termination of the noncharitable interest.

Technical Considerations

To qualify as a CRT, a mast must satisfy Sec. 664 and the regulations thereunder at the time of creation, and is subject to specific rules during its operation.

There are two primary types of CRTs. A charitable remainder annuity trust (CRAT) pays a certain percentage of the value of the initial contribution each year to the beneficiary (at least 5%, but not more than 50%). Under a CRAT, the dollar amount of the payment must remain constant throughout the term, regardless of interest rate changes, performance of trust investments or reduction in the trust principal's value. A charitable remainder unimast (CRUT) requires that the payment to the income beneficiary be a fixed percentage (between 5% and 50%) of the net FMV of the mast assets, valued on an annual basis (as opposed to a CRAT, which provides for a fixed percentage payout of the initial FMV of the assets contributed to the trust, measured at the date of contribution).

A CRUT is generally perceived as the more flexible of the two types of masts, because additional contributions can be made to it at a later date and flexible alternative payout mechanisms are available. In addition, a CRUT beneficiary can share in any appreciation in the value of trust assets, an important factor during times of economic expansion.

An important CRT requirement is that, under Sec. 664(d)(1)(D), the actuarial present value of the property remaining to pass to charity at the end of the trust term must equal at least 10% of the initial FMV of the property transferred to the trust.

In addition, Sec. 664(b) imposes "ordering rules" that dictate the income tax character of distributions from a CRT to a noncharitable beneficiary. Specifically, there are four tiers of income, which are maintained on a cumulative basis for the duration of the trust. The earlier tiers must be exhausted before the distributions can be deemed to come from the lower tiers. The tiers are ordinary income, capital gains, other income (e.g., tax-exempt income) and return of corpus.

Suitable Clients

Appreciated Assets

A CRT is particularly attractive for a donor with highly appreciated assets who would like to diversify them while retaining the income stream from their full value, unreduced by the tax.

Charitably Minded

After the changes made by the Taxpayer Relief Act of 1997 to the CRT rules, as well as the reduction of the capital gains rate to 20%, a CRT is most attractive to an individual who has charitable-giving objectives. In that case, a CRT yields the most benefits overall.

Planning Considerations

Trust Investments

If an appreciated asset is transferred to a CRT, its subsequent sale triggers a large capital gain. Under the tier system, it will probably take many years to exhaust such gain via distributions to the noncharitable beneficiaries. In that case, if the trust is invested in low-yielding tax-exempt securities, mast beneficiaries may not reap the benefits for many years to come, after the taxable tiers are completely exhausted. Accordingly, it might be better to invest in high-yield or high-growth securities instead.

Flip Unitrusts

If a donor would like to transfer an asset to a trust that does not currently yield income to pay an annuity or unitrust interest, but which the trust is expected to sell and convert to income-producing property, a CRUT can be created that "flips" from one required to pay a unitrust amount only when the trust has income, to one that pays a guaranteed percentage. Regs. Sec. 1.664-3(a)(1)(i)(c) and (d) now allow for such a flip if certain specified conditions are met.

Anti-abuse Rules

Many transactions using CRTs have little or no charitable motivation. The Service, on hearing of such transactions, acts quickly to try to end them, as exemplified in Prop. Regs. Sec. 1.643(a)-8. Thus, a tax adviser should be aware (and consider the risks) of entering into such transactions.

Ten: FLPs

A family limited partnership (FLP) is a vehicle in which family members maintain ownership of assets in partnership form. FLPs are frequently used in estate planning, enabling clients to remove property from an estate with a minimum of gift and estate taxes and administrative inconvenience.

How They Work

A client transfers assets to a limited partnership in exchange for both general and limited partnership units. Because the entity is a partnership, at least one other partner (such as a spouse or child) is required to contribute assets in exchange for partnership units.

Suppose a client transfers property worth $999,000 to a partnership in exchange for 9,980 limited partnership units and 10 general partnership units. Typically, general partner units are small, because the donor tends to retain them for control purposes. Accordingly, they are usually included in the donor's estate. The grantor's spouse then transfers $1,000 in exchange for 10 limited partnership units. The client then transfers 100 limited partnership units each year to each of his children as annual exclusion gifts.

Of course, once the client transfers a minority interest (100 units out of 10,000) in an unmarketable entity (the partnership), the client should be able to take advantage of minority interest and lack of marketability discounts for gift tax valuation purposes. For example, if the client is entitled to a 25% discount, each unit is worth $75 rather than $100. Thus, the client should be able to transfer 133 units (rather than 100) as an annual exclusion gift. Permitted combined discounts for lack of control and marketability have been as high as 35%(40) and even 50% percent and higher.(41)

Given how critical it is to substantiate discounts for gift tax purposes, any discount should be supported by an appraisal or valuation report by an appraiser qualified to value the property involved.

Suitable Clients

Difficult-to-transfer Assets

A FLP works well for a client whose assets are not easily capable of fractionalization. For example, real estate can be transferred to a FLP; thereafter, FLP units can be transferred to beneficiaries, as annual exclusion gifts or otherwise. Administratively, this is simpler than transferring undivided interests in the real estate, which would require deeds of the fractional interests, local recording requirements and fees.

Control

If a client would like to retain control of the disposition of the underlying assets (as well as the income flow therefrom), the client can retain the general partner units in the entity and transfer only the limited partner units to beneficiaries.

Creditor Protection

If a client is concerned about creditor protection (e.g., against a possible divorce), forming a FLP with other family members is a useful tool. Under most state laws, a creditor could not become a substituted partner, but merely an assignee, with no rights to force distributions or liquidation.

Combination with Other Vehicles

In addition to facilitating use of a client and spouse's annual exclusions and applicable exclusion amount, FLPs can be interposed between the asset transferred and another estate planning vehicle, such as a GRAT or an IDIT As is the case with facilitating direct transfers to beneficiaries, FLPs can be used to transfer hard-to-transfer assets back to the grantor in payment of the annuity amount, when assets might not generate sufficient other income to do so.

Planning Considerations

IRS Attack

FLPs have come trader serious attack by the IRS, particularly when the creator dies shortly after FLP formation.(42) In addition, proposals to eliminate valuation discounts in this area appeared in President Clinton's budget and other legislative proposals. Despite these attacks, however, taxpayers have recently won significant victories in Tax Court in two FLP cases.(43) The Service is quite likely, however, to appeal both of these cases. In addition, despite finding for the taxpayers, both courts significantly reduced the allowable lack of marketability and minority discounts. Finally, both courts were sharply divided, suggesting caution before undertaking a FLP for a client. Several of the main areas of IRS attack are discussed briefly below.(44)

Business Purpose

The Service has argued that there is no business purpose for the existence of a FLP, and that it should be ignored for estate and gift tax valuation purposes, thereby valuing underlying assets at full FMV for estate and gift tax purposes.(45)

It may be argued that a partnership being used merely to obtain minority discounts for investment assets (such as publicly traded securities) may not have the requisite business purpose. Therefore, it may make sense to place other assets, such as rental property, in the partnership to provide an additional business activity. Alternatively, if the assets consist mainly of passive investments (e.g., publicly traded stock), it may make sense to hire an independent investment adviser. Strangi(46) upheld a FLP against such a business-purpose attack. The majority in that case, however, allowed the IRS's lack of economic substance argument to go to the weight of the allowable discount.

Respecting Form

A corollary to the business purpose rule is that the partnership format must be respected. Personal assets, such as a residence, should not be transferred to a FLP. Similarly, commingling partnership assets with the general partner's personal assets is to be avoided. Otherwise, continued use and enjoyment of assets transferred to a FLP (particularly if they are used or enjoyed in the same way as before FLP creation) could cause the inclusion of all of the FLP assets in the transferor's estate under Sec. 2036 or 2038.(47) Nevertheless, the partnership form was respected for gift tax purposes in Knight(48) and for estate tax purposes in Strangi.

Single Testamentary Transaction

The Service has argued, based on Est. of Murphy,(49) that the formation of the partnership interest and the subsequent disposition constitute a single testamentary transaction, causing the partnership to be ignored for valuation purposes. It is questionable whether Murphy is good law; the argument is an obvious one when partnership formation is close in time to the creator's death.

Gift of Amount of Discount at Formation

Another argument that the Service uses when a parent has joined with children as limited partners to form a partnership (rather than creating the partnership and gifting partnership interests to the children) is that the value lost to the parent's partnership units (via discounts) is to be treated as an immediate gift to the children on partnership creation.(50) To avoid this (seemingly incorrect) argument, it would be preferable, when possible, to have the parent generation create the partnership and transfer or sell units to the children. The gift-on-formation theory was rejected by the majority in Strangi. At the same time, however, the case suggested that a transfer with retained control argument under Sec. 2036 might have been allowed by the court had it been raised in a timely manner by the Service.

Sec. 2703

Attacking on the Chapter 14 front, the Service has argued that the partnership entity itself imposes a restriction on the right to sell or use the underlying property and should be ignored for valuation purposes under Sec. 2703(a) (2). This argument seems misguided, however, because discounts have frequently been granted for transfers of closely held corporate interests. In fact, the Tax Court in Strangi rejected this argument.

Sec. 2704(b)

Using Sec. 2704(b), the Service has also argued that a provision in a partnership agreement limiting withdrawal rights of limited partners is an "applicable restriction" that has no effect for gift tax valuation purposes. An applicable restriction would include a limit on the ability to liquidate a partnership that is more restrictive than applicable local law.(51) To avoid this provision, many states have amended their partnership laws to limit the withdrawal rights of limited partners. Similarly, under many limited partnership acts, a transferee of a limited partnership interest is merely an assignee rather than a partner, thereby further limiting the rights (and the value) of the limited partnership interests. Thus, it is advisable to choose a state having a partnership law with the appropriate restrictions in place, rather than including such provisions in the partnership document. Nevertheless, it is encouraging that this argument has been rejected in at least two Tax Court cases so far, including Kerr(52) and Strangi.

Sec. 2704(a)

Under Sec. 2704(a), the Service has attempted to eliminate valuation discounts for limited partnership units on the death of a general partner who owns both general and limited partnership units by arguing that death causes a lapse of the withdrawal right and, thus, the right to terminate the partnership and liquidate the partner's interests in both general and limited partnership units. As a result, the value of the lapsed right to liquidate and withdraw the value of both the general and the limited partnership units should be included in the gross estate under Sec. 2704(a).(53)

No Annual Exclusion

Finally, the Service has held that, when a general partner's controls over the partnership are too tight (e.g., when the general partner has unfettered control over decisions or the limited partners cannot sell, transfer or pledge their interests), the gift of limited partnership interests is not a gift of a present interest; thus, no annual exclusion is available.(54) When use of the annual exclusion is desired, this argument is avoided by not restricting transferability, and requiring that the general partner exercise powers only in a fiduciary capacity. The latter provision might also be helpful in avoiding a Sec. 2036 or 2038 inclusion argument.

Conclusion

There is an abundance of ideas available or clients in need of estate planning: this article discusses merely 10 of them. Out of this top 10 list, there should be something of interest for each client.

(19) Part I of this article, in the January 2001 issue, discussed certain exclusions and exemptions indexed for inflation. The Service has since issued Rev. Proc. 2001-13, IRB 2001-3, which contains the indexing for 2001 and provides that the annual exclusion under Sec. 2503(b) remains at $10,000; the GST exemption under Sec. 2631 increases to $1,060,000.

(20) Rev. Rul. 85-13, 1985-1 CB 184; but sec Harold Rothstein, 735 F2d 704 (2d Cir. 1984).

(21) See Frederic W. Procter, 142 F2d 824 (4th Cir. 1944), cert. den.

(22) If the Service argues a transfer with a retained interest, Sec. 2702 may apply for gift tax purposes, which could cause the entire value of the property sold to the mast to be a taxable gift.

(23) See Bernard Madorin, 84 TC 667 (1985), Keg,s. Sec. 1.1001-2(c), Example 5 and Rev. RuE 77-402, 1977-2 CB 222.

(24) IRS Letter Ruling (TAM) 200011005 (11/23/99).

(25) See Est. of Suzanne IV. Cullison, TC Memo 1998-216, for a discussion of the method for valuing the gift.

(26) To ensure this result and avoid the application of Regs. Sec. 25.7520-3(b)(2)(i), the annuity should not be made payable from a trust or other limited fund.

(27) See, e.g., Est. of Alma W. Mitchell, TC Memo 1982-185, aff'd, 734 F2d 15 (6th Cir. 1984); Simon M. Lazarus, 58 TC 854 (1972), aff'd, 513 F2d 824 (9th Cir. 1975).

(28) See Est. of Lloyd G. Bell, 60 TC 469 (1973).

(29) Rev. Rul. 69-74, 1969-1 CB 43.

(30) See Hams, "Even the Blackest Cloud Has a Silver Lining: Wealth Transfer Planning for the Terminally Ill Client," 32A U. Miami Philip E. Heckerling Inst. on Est. Plan (1998), Ch. 5.

(31) See Est. of Janet M. Frane, 998 F2d 567 (8th Cir. 1993).

(32) For a broader discussion of CLTs, see Capassakis, "Estate Planning with Charitable Lead Trusts," 22d Annual AICPA Advanced Estate Planning Conference (1999).

(33) See kegs. Secs. 20.2055-2(e)(2)(vi)(a) and 25.2522(c)-3(c)(2)(vi)(a).

(34) The Service has recently issued proposed regulations that limit the CLT term under certain circumstances, effective for trusts created on or after April 4, 2000. See Prop. Regs. Secs. 1.170A-6, 20.2055-2 and 25.2522(c)-3. Generally, under the new provisions, an individual may be used as a CLT measuring life only if that individual is the donor, the donor's spouse or a lineal ancestor of all the remainder beneficiaries.

(35) See Regs. Sec. 1.508-2(b)(1)(i)(a).

(36) Sec. 4947(a)(2); see also Regs. Sec. 1.508-2(b)(1)(vi)(a)

(37) See Regs. Secs. 25.2512-5(a), (d) and 25.7520-3(b)(3).

(38) See Regs. Sec. 25.2522(c)-3(c)(2)(vi).

(39) See IRS Letter Ruling 9908002 (11/5/98).

(40) John R. Moore, TC Memo 1991-546.

(41) Virginia Z. Harwood, 82 TC 239 (1984); see also Est. of Etta H. Weinberg, TC Memo 2000-51 (court applied combined discounts under different valuation approaches, resulting in overall discount of 49.77%); Est. of Richard R. Simplot, 112 TC 130 (1999) (court allowed 35%-40% lack of marketability discount for interests in a closely held corporation, applying a 3% control premium for voting privileges).

(42) See, e.g., IRS Letter Rulings (TAMs) 9719006 (1/14/97), 9723009 (2/24/97), 9725002 (3/3/97), 9730(X)4 (4/3/97), 9735003 (5/8/97) and 9842003 (7/2/98).

(43) Est. of Albert Strangi, 115 TC No. 35 (2000) and Est. trina F. Knight, 115 TC No. 36 (2000).

(44) For a comprehensive discussion of the possible pitfalls and areas of IRS attack involving FLPs, see Eastland, "The Art of Making Uncle Sam Your Assignee Instead of Your Senior Partner: The Use of Partnerships in Estate Planning," 22d Annual AICPA Advanced Estate Planning Conference (1999).

(45) But see Est. of Daniel J. Harrison, TC Memo 1987-8, in which the Service lost a similar argument.

(46) Est. of Strangi, note 43 supra.

(47) Est. of Charles E. Reichardt, 114 TC 144 (2000); Est. of Dorothy Morganson Schauerhamer, TC Memo 1997-242.

(48) Est. of Knight, note 43 supra.

(49) Est. of Elizabeth B. Murphy, TC Memo 1990-472.

(50) See IRS Letter Ruling (TAM) 9842003, note 42 supra.

(51) See Sec. 2704(b)(3)(B); Regs. Sec. 25.2704-2(b).

(52) Blaine P, Kerr, 113 TC 449 (1999).

(53) IRS Letter Ruling (TAM) 9804001 (9/30/97),

(54) IRS Letter Ruling (TAM) 9751003 (8/28/97),

Editor's note: Ms. Capassakis is the Chair of the AICPA Tax Division's Trust, Estate and Gift Tax Technical Resource Panel. This article was originally presented at the 23rd Annual AICPA Advanced Estate Planning Conference.

Author's note: The author expresses her thanks to Michael Josephs and Lisa Barbieri, of PricewaterhouseCoopers, LLP, for their invaluable assistance in the preparation of this article.

Evelyn M. Capassakis Wealth Transfer Solutions Partner PricewaterhouseCoopers, LLP New York, NY