Estate planning with S corporations after 1997 using GRITS, GRATS and GRUTS.
Changes in the tax code have made S Corporations (S Corps) the entity of choice for most small businesses. S Corps provide limited liability not generally available to partnerships and do not result in double taxation as with the standard C Corporation (C Corp). The 1996 tax legislation(1) liberalized several restrictions on the use of S Corps, including increasing the maximum number of shareholders from 35 to 75; permitting additional trusts and certain charitable organizations as shareholders; and allowing S Corps to hold subsidiaries, including foreign subsidiaries. The number of S Corps has more than tripled during the past ten years from 737 thousand in 1986 to a projected 2.3 million in 1996.(2) During the same period the number of C Corps declined from 2.6 million to 2.5 million.(3)
The 1997 tax legislation(4) has been incorrectly touted as providing substantial estate tax relief for small business owners. The general estate exemption increases from $600 thousand to one million dollars, but is phased in over ten years. The average annualized rate of increase is 5.24 percent. Therefore, inflation will eat away a significant portion of the increase. The estate tax exemption does increase up to $1.3 million for small business owners effective in 1998. However, there are substantial limitations on the use of the exemption. For example, the business must be more than 50% of the adjusted gross estate (as defined(5)). In addition, if family members do not continue to own and materially participate in the business for at least 10 years, the estate tax savings are recaptured with interest. Therefore, the need for more sophisticated estate planning still exists.
The use of Grantor Retained Income Trusts (GRITs), Grantor Retained Annuity Trusts (GRATs) and Grantor Retained Unitrusts (GRUTs) can be used as effective tools in estate planning for S Corp shareholders. These tools can reduce the amount of gifts subject to gift tax. However, a variety of factors can impact the desirability of each, including the S Corp's expected return, the discount rate used, and the relationship between grantor and grantee. In each case, the grantor funds a trust and retains some type of income interest for a specified term of years. With a GRIT.the grantor receives all the income from the trust; with a GRAT, the grantor receives a fixed dollar annuity from the trust; and with a GRUT, the grantor receives a fixed percentage of the remaining value of the trust. In each case, the remainder interest in the trust constitutes a gift for gift tax purposes. Since the interest constitutes a future interest, the $10,000 annual gift tax exclusion is not available, but the exclusion may be used for other gifts.(6)
If the trust is set up as a GRAT or a GRUT only the remainder is subject to gift tax without regard to the remainderman's identity. With a GRIT the full value of the transfer, including the retained income interest, is subject to gift tax unless the remainderman is not a "member of the family" of the grantor (see below). If the grantor survives the term, the trust fund is not included in the grantor's estate. Should the grantor die before the present interest expires, nothing but transaction costs have been lost since the entire value of the stock must be included in the grantor's estate,(7) a result which would have occurred in the absence of the deferred gift.
Trusts as S Corp Shareholders
Several classes of trusts are eligible to be S Corp shareholders, some for only 60 days, others for years, generations or even [TABULAR DATA OMITTED] indefinitely. These include:
* Voting Trusts which are allowable indefinitely.(8)
* Testamentary Trusts which are allowable for up to two years (60 days for taxable years beginning before 1997) after the transfer of the stock to the trust.(9)
* Qualified Subchapter S Trusts (QSSTs) which are allowable for a term of years or for the duration of one or more life estates.(10) A QSST is a grantor trust with respect to the current income beneficiary via Section 678.
* Electing Small Business Trusts (ESBTs), effective for taxable years after December 31, 1996.(11) An ESBT is taxable on its S Corp income.
* Grantor Trusts are allowable indefinitely. 12 However, at the death of the grantor the trust is an eligible shareholder for a maximum of two more years (prior to 1997, the period was limited to 60 days if the trust assets were not includible in the grantor's gross estate).(13)
GRITs, GRATs and GRUTs are grantor trusts(14) and thus are eligible S Corp shareholders (unless the grantor is a nonresidential alien). Since the objective is for the grantor to survive the retained income interest the trust instrument will either require a termination distribution or a conversion to a QSST or ESBT within 2 years of the cessation of the grantor's term interest.
Valuation of GRITs, GRATs and GRUTs for Tax Purposes
GRITs: A GRIT is assumed to generate an income stream equal to the discount rate to be used to value it. Since May 1989, the "applicable federal rate" (AFR), the discount rate used to value private annuities, term interest, life estate, remainders and reversions equals 120% of the "Midterm Federal rate" pursuant to Section 7520. The rate is recalculated monthly and rounded off, up or down, to the nearest two-tenth of one percentage point. At 10%, for example, Regulation Section 20.2031-7, Table B reveals the following remainder factors (the term interest is computed at one less the remainder factor):
Duration of Term Interest 5 10 15 20 Remainder Factor .621 .386 .239 .149 Term Interest Factor .379 .614 .761 .851
Thus, the value for tax purposes of a retained income interest for 15 years is 76.1% of the value of the property used to fund the trust and the gift of the remainder is worth 23.9% of the property at a discount rate of 10 percent. However, a retained interest which is not a right to receive a fixed amount or a fixed percentage of the fair market value of the property in trust at least annually is disregarded, but only if the remainderman is a "member of the transferor's family."(15) A "member of the family" includes the transferor's spouse, an ancestor or lineal descendant of the transferor or the transferor's spouse, a sibling of the transferor, or a spouse of such ancestor, lineal descendant or sibling.(16)
Example of GRIT
G transfers $100,000 worth of S, Inc. stock to a trust for A, retaining a 15-year income interest. If the discount rate in the month of transfer is 10%, G has made a gift of $100,000 if A is a "member of G's family" and a gift of only $23,939 if A is not a family member, e.g., a niece or nephew. In any event, if G does not survive the 15-year term, the trust assets would be includible in G's gross estate (the adjusted taxable gift of $100,000 or $23,939 would be removed and a credit against the estate tax for the gift tax paid, if any, would be available).
Since GRITs, GRATs and GRUTs are all grantor trusts the grantor is taxed on the actual income from the trust whether distributed or not. In a GRIT all income is distributed, while GRATs and GRUTs may distribute more or less than their income.
For asset classes other than S Corps, if the remainderman is not a "member of the family" a GRIT is likely to be preferable to a GRAT or GRUT for the following reasons:
1. The grantor's gift of the remainder is reduced by the present value of an assumed income stream equal to 120% of the "applicable federal rate," e.g., 10%, even though the actual income may be substantially less.
2. Only the actual income, e.g., 4% one year and 3% the next, must be distributed to the grantor. Thus, there is never a need to invade corpus since no minimum percentage of the initial or annual value must be withdrawn.
3. Because of 1 and 2 both gift and estate taxes are reduced, the former because of the income assumption, the latter since all assets in the trust, including appreciation, remain in the trust.
GRATs: A Grantor Retained Annuity Trust is assumed to generate an income stream equal to the fixed dollar amount to be paid. The AFR is used to value the annuity. Regulation Section 20.2031 reports only the remainder factor. To arrive at the annuity factor, the reciprocal of the remainder factor (the term interest factor) is divided by the discount rate.
(1 - R)/I where
R = Remainder factor
I = Discount rate, i.e. .10
At 10% all that is needed is to divide the term interest factor by .10:
Duration of Term Interest 5 10 15 20 Term Interest Factor .379 .614 .761 .851 Annuity Factor 3.79 6.14 7.61 8.51
The annual payment must be multiplied by the annuity factor to arrive at the present value of the annuity. The remainder equals the total asset value less this present value.
Example of GRUT
G, transfers $100,000 worth of stock in S, Inc. to a trust for his daughter, D. G retains a 6% income interest for 15 years computed on the initial fair market value of trust assets, i.e., G will receive a flat $6,000 a year. The tax consequences are the same as for a GRUT (see below) except for the following:
1. The discount rate used is the AFR, here assumed to be 10 percent.
2. The remainder factor for a 10% income interest may be found in Regulation Section 20.2031-7, Table B. For a term certain it is .239392.
3. The present value of an annuity of $1 for 15 years is the reciprocal of the remainder factor divided by the interest rate, i.e., (1-239392)/.10, or $7.60608. The present value of a $6,000 annuity is therefore $6,000 x 7.60608 or $45,636. The value of the income interest is multiplied by the frequency of payment factor in Schedule K of the Regulation. For example, if the payments are to be made monthly, the present value of the income interest is $45, 636 x 1.045 (monthly value in Schedule K at 10%) or $47,690.
4. The gift of the remainder is therefore valued at $52,310 ($100,000-$47,690).
5. The gift is higher with an annuity trust when the AFR exceeds the retained income percentage. The higher the discount rate used, the lower the present value of the income stream and the higher the value of the remainder. This is consistent with reality since the distributions to G will increase with the value of trust assets in a unitrust reducing the actual value of the remainder.
GRUTs: A GRUT pays the grantor a fixed percentage of the annual value of the trust assets each year. Thus, the dollar amount paid out fluctuates with the fair market value of the stock in the trust. Furthermore, being a fixed percentage, the payout may be more or less than actual income generated each year. The discount rate used to value the retained interest (and therefore the remainder) is the payout rate itself, e.g., 6% and is independent of the AFR (except for an adjustment to reflect the timing and frequency of distributions). The remainder factor for a term certain are to be found in Regulation Section 1.664-4 Table D. If the payout rate is less than the AFR, the present value of the retained income interest is higher than in an annuity trust with a corresponding decrease in the value of the remainder (and the gift tax payable). As a practical matter, a GRUT is generally not practical for small business interests, because it requires the business to be re-appraised for each payment.
Example of GROT
G, transfers $100,000 worth of stock in S, Inc. to a trust for his daughter, D. G retains a 6% income interest for 15 years computed on the annual fair market value of trust assets at the beginning of each year. The remainder factor for a fifteen-year term interest in a unitrust with an adjusted payout rate of 6% is .395292.(17) The 6% payout would be reduced by the appropriate factor in Table F of the Regulation if the payment is either delayed or more frequent. The tax consequences are:
1. The trust is a grantor trust and therefore an eligible S Corp shareholder for 15 years.
2. Since G may receive all income from the trust and more, G is taxed on the trust income whether more or less than 6 percent.
3. G has made a gift of $39,529 (.395292 x $100,000). No exclusion is available since the gift is of a future interest.
4. If G survives the 15 years the trust assets are not included in his gross estate.
5. If G dies within 15 years all trust assets are included in his estate under Section 2036(a).
6. After 15 years the trust terminates and distributes its assets to D who becomes a shareholder in S, Inc. directly.
7. The trustee's basis in the stock carries over to D under Section 643 (e). (4-7 are equally applicable to GRITs and GRATs).
Grantor's Income Tax Liability
Whether the trust employed is a GRIT, GRAT or GRUT the grantor is taxed only on the income generated by the trust. With GRATs and GRUTs the grantor's distribution in a given year may exceed trust income. If so, only the latter is taxable, the excess is a tax-free corpus distribution. However, the trust is taxable on any appreciation in trust assets used distributed in kind to pay the grantor the required annuity? Should the grantor gift the in kind distribution back to the trust (or anyone else) the trust (or donee) will receive the grantor's fair market value basis in such gifts.(19)
Leveraging the S Corp Gift with GRATs and GRUTs
Only the value of the remainder portion of a GRAT or GRUT is treated as a taxable gift. Therefore, by making an advance gift, the donor can reduce the value of the gift for transfer tax purposes. This becomes significant when one considers the valuation of small business interests (and particularly minority interests) for estate tax purposes. After taking into account discounts for lack of marketability and for minority ownership, it is not uncommon for the capitalization rate of S Corp stock to exceed 20% of expected net income. Since the donor is taxable on the entire income from the stock in any case (as a grantor trust), a very high interest rate may be applied for the retained interest. For example, assume S Corp stock worth $100,000, after taking into account all available discounts allowed for estate and gift taxes, is expected to produce taxable income of $20,000 per year. The donor gives the stock to a GRAT, retaining an annual income payment of $15,000 for a period of 8 years. Assuming that the AFR at the time of the gift is 7%, the remainder value in Table B of Regulation Section 20.2031-7 is .582009, which means a .417991 value for the income interest. The value of the retained portion of the gift is $89,570 (.417991/.07 x $15,000). The value of the deferred gift subject to gift tax is only $10,430 ($100,000-$89,570). Using this methodology, the donor could give stock worth almost $6 million before exhausting the unified credit (of $600,000 in taxable gifts). The donor would be subject to gift tax of $20,000 (assuming gift tax assumptions are correct), but would be receiving enough income to pay all taxes due, but not so much income as to cause a problem for the trust in a bad year. Naturally the discount would be greater if a larger portion of the expected income were used. Note that the goal should be to use as large an income interest as possible without endangering the assets of the trust. When using a relatively low retained income portion of the trust, there is a danger that the donor's distribution may be less than the tax imposed on the trust.
As stated previously, a GRUT is less desirable than a GRAT unless the retained interest percentage is less than the AFR and where re-appraisals are practical. Therefore, a GRUT would generally be considered only for an S Corp that either holds an investment portfolio or real estate. Because there is no gift tax reduction for the income interest, a GRIT should only be used for a non-family donee.
Assuming a non-family donee:
1. If the capitalization rate of the S Corp stock is substantially greater than the AFR, a GRAT would produce a lower gift tax than the GRIT.
2. If the earnings of the S Corp are such as to make consideration of a GRUT appropriate, a GRIT would still generally be more favorable than a GRUT because the AFR used to discount the remainder interest in the GRIT would be higher than the percentage of value used to discount the GRUT (i.e., due to its lower valuation, the GRIT will result in a smaller taxable gift than the GRUT). In addition, the GRIT does not require re-appraisals.
Based on the above analyses and examples, the following general conclusions may be stated:
1. GRITs, GRATs and GRUTs should only be used for estate planning purposes.
2. For corporations only holding investment assets, GRITs are generally superior to GRATs and GRUTs if the remainderman is not a member of the grantor's family. However, a GRIT funded with assets worth up to $600,000 ($1,200,000 with a split gift) may be considered even if the remainderman is a family member since no gift tax may be currently payable.
3. For corporations with high capitalization rates, a GRAT with a large distribution rate is superior to either a GRIT or a GRUT. Proper planning should be employed to assure that the valuation of the gifted stock as well as any stock held in the donor's estate is as low as possible (i.e., estate and gift tax valuation discounts should be maximized).
4. A GRUT should generally only be considered in family situations where the corporation produces low taxable income relative to stock value and the stock is easy to value (generally limited to portfolio or real estate holding companies).
5. Regardless of the type of trust used, the grantor may make a gift of the after-tax income received annually, e.g., to the remainderman or to the trust, thus reducing the grantor's gross estate further.
1. Public Law 104-188 (1996).
2. Internal Revenue Service, IRS Statistics of Income (1996).
4. Taxpayer Relief Act of 1997.
5. Code Section 2033A(c).
6. Code Section 2503(b).
7. Code Section 2036(a).
8. Code Section 1361(c)(2)(A)(iv).
9. Code Section 1361(c)(2)(A)(iii).
10. Code Section 1361(d).
11. Code Section 1361(e).
12. Code Section 1361(c)(2)(A)(I).
13. Code Section 1361(c)(2)(A)(ii) and (iii).
14. See Code Section 677.
15. Code Sections 2702(a)(2) and 2702(b).
16. Code Section 2704(c)(2).
17. Regulation Section 1.664-4, Table D.
18. Regulation 1.661(a)-2(f)(1).
19. Code Section 1015(a).
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|Title Annotation:||Grantor Retained Income Trusts; Grantor Retained Annuity Trusts; Grantor Retained Unitrusts|
|Author:||Auster, Rolf; Tyler, Michael L.; Cramer, Lowell|
|Publication:||The National Public Accountant|
|Date:||Jan 1, 1998|
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