Leimberg s Think About It

Transcription

1 Leimberg s Think About It Think About It is written by Stephan R. Leimberg, JD, CLU and edited by Eugenie DeRitter March 2007 #373 Diversity of opinion helps us to be more successful! Your Success Matters! Therefore, Prudential is pleased to provide you with material that offers different views and opinions on various subjects. Please note that these opinions are not necessarily those of Prudential. Leimberg s Think About It is distributed as a courtesy to our representatives at The Prudential Insurance Company of America. Prudential expressly disclaims responsibility for any content and has not approved other materials referenced. Clients should consult with their accountant, tax advisor and/or legal advisor to confirm the accuracy of these analyses and for advice concerning their particular circumstances. OVERVIEW SALES TO GRANTOR TRUSTS A grantor trust is an irrevocable trust in which the grantor, the party creating the trust, retains certain powers over, or interests in, the trust or the assets transferred to the trust. The trust falls under certain federal income tax provisions (known as "grantor trust" rules) that treat the grantor for income tax purposes only - as the "owner" of trust assets. Items of income, deductions, and credits of the trust are attributable to the grantor; therefore, the grantor is taxed on trust income and is entitled to trust deductions and credits. Many prominent estate planning authorities posit that the grantor and the trust will be considered as the "same taxpayer" for income tax purposes. A grantor trust variation of the typical irrevocable life insurance trust (ILIT) takes advantage of the significant differences between the federal income tax grantor trust rules and federal estate tax rules. This is achieved by inserting certain powers into an irrevocable trust to make it subject to grantor trust rules. The objective is to be able to treat the grantor as the owner, for income tax purposes only, of all trust principal and income, yet keep the trust assets outside the grantor s taxable estate. The commonly used provisions to establish grantor trust status yet avoid estate tax inclusion are: (a) the power by the grantor or his/her spouse to borrow from the trust without adequate interest or security, (b) the grantor s power to reacquire or substitute trust property with assets of equivalent value, and (c) the use of trust income to pay premiums insuring the life of the grantor and/or the grantor s spouse.

2 2 [NOTE: This discussion is intended only as a brief overview. These provisions must be drafted by a highly competent tax attorney and tailored to meet the client s goals. These grantor trusts are sometimes called "intentionally defective" irrevocable trusts.) SALE TO A GRANTOR TRUST A typical objective of claiming grantor trust status is to assure that a sale or other transaction between the grantor and the trust will not result in any capital gain (or loss) and that, for all income tax purposes, transactions between the grantor and his/her trust will be"non-events" for income tax purposes. According to the authorities that support this position, a sale by the grantor to the trust is treated as though the grantor moved cash or other assets from one pocket to another, that is, as if there were no reportable transactions. This enables the grantor to shift wealth and yet minimize gift tax consequences, or avoid out-of-pocket gift tax cost. For example, a grantor could sell property he or she owns with built-in capital gain to the trust and, since the transaction is considered a non-event for income tax purposes, there will be no reportable gain for federal tax purposes. (Note that state law may differ!) Although the grantor must recognize all trust income, he/she receives the benefits of all tax deductions and credits attributable to the trust as well. The amount of tax the grantor pays is removed from his/her estate and yet the grantor s payments of income tax are not deemed as gifts to the trust or its beneficiaries. The net effect is that the grantor is able to reduce his/her taxable estate, while essentially making additional indirect gift-tax free gifts to his/her trust beneficiaries. CLIENT PROFILE The ideal candidate for this "sale to a grantor trust" technique is a high-net-worth client who owns highly appreciating and/or income-producing assets that he/she wants to transfer to the next (or a lower) generation. Perhaps the client is already considering a Dynasty trust or other multi-generational wealth transfer device. Even if the client is willing to relinquish control over the transferred property, there s always the issue of taxes associated with the transfer. Preferably, the client has not exhausted his or her lifetime gift exemption, so that it can be used to shelter a gift of "seed money." For clients who are already using their available annual gift tax exclusions, a sale to a grantor trust may be another planning technique to shift wealth to their intended beneficiaries.

3 3 Other ideal candidates for sales to grantor trusts are clients who need large amounts of life insurance but may not have enough "Crummey" beneficiaries for annual exclusion gifts, or the premiums are too large to fall within the exclusion. Instead of exhausting the lifetime gift exemption for gifts of annual premiums, a sale to a grantor trust can be a more viable and efficient solution. HOW DOES A SALE TO A GRANTOR TRUST WORK? AN EXAMPLE Marlee Ford creates an irrevocable trust for her children with terms that cause her to be considered the owner of the trust assets. She names her friend, Douglas Mellor, as trustee. Marlee contributes $200,000 of cash as "seed money" to the trust but pays no gift tax because she uses her applicable annual exclusion and lifetime gift exemption to shelter the gift. Marlee Ford owns income-producing real property that she bought for $300,000, which is now worth $1,000,000. Douglas, as trustee of Marlee's Grantor trust, purchases the property from Marlee for $1,000,000. Instead of paying a lump sum, the trust agrees to give Marlee a promissory note. The note requires ten payments of $100,000 each plus interest on the unpaid balance. The interest is based on the long term applicable federal rate determined once during the month of the sale. The AFRs are published by the IRS monthly and available at under "Free Resources." Aside from the $200,000 of "seed money" contributed to the trust as a (taxable) gift, there is no other gift involved in the transaction. The trust pays full fair market value for the property, which was appraised by an independent full-time highly experienced professional real estate appraiser. The trust uses the growth from the seed money and income from the trust asset to make payments to Marlee. Because Marlee is responsible for the tax on all trust income, all unspent income and growth in the asset's value accumulate inside the trust for ultimate distribution to the trust's beneficiaries. At the end of the agreed-upon term, the debt is paid off. As stipulated by the trust provisions, the assets may be distributed to the beneficiaries at that time, or held and managed by the trustee until the beneficiaries reach a specified age (e.g., 35 and 40) or until a triggering event (e.g., marriage of, or start of business venture by, a beneficiary) signals a time to distribute some, or all, of the assets. Assuming the authorities are correct, Marlee doesn t recognize any gain either at the time she sells the appreciated property to the trust or when she receives installment payments even though there was $700,000 of appreciation built into the transferred property. Nor does Marlee report any income on the interest paid by the trust to her on the unpaid balance.

4 4 Now, assume that 5 years after the installment payments ended, the property is still in the trust and has grown to $4,000,000 in value. The trust s basis in that property was carried over from Marlee and remains at $300,000. Marlee, flush with cash (perhaps because one of her tax-free bonds just matured), offers the trust full value, $4,000,000, to reacquire the property. The trust accepts the offer and turns over the property in return for a check for $4,000,000. Marlee has made no taxable gift because there is no gift. Marlee paid and the trust received full and adequate consideration (assuming again an appraisal from a independent qualified full-time appraiser). Nor does the trust pay income tax on its gain because the sale was "to itself," that is, the trust is deemed to be the same taxpayer as the grantor. This puts $4,000,000 of cash in the trust and gives Marlee, the grantor $4,000,000 in property - with a $300,000 basis. But if Marlee holds the property until she dies, the property will - at that time - receive a step-up in basis to its fair market value. LEVERAGING THE CONCEPT Instead of directly selling the property to the trust, let s assume Marlee first creates and contributes the property to an FLP (family limited partnership), she then takes back both general and limited partnership (LP) interests. Assume she keeps the general partnership units (e.g., 2%) and sells 98% LP units to the trust at a reasonable discount (e.g., 30%) that reflects the lack of marketability, and minority interest or lack of control. She has "packed" the trust with $400,000 of seed money and LP units and shifted the property interest (in the form of LP units) worth $980,000 at a much lower cost of $686,000 (70% of $980,000) to the trust. If the growth in the trust-owned LP units plus the trust s share of the FLP income exceeds the trust s payments (principal and interest) on the note, Marlee has accomplished a successful estate freeze. Taking the example one step further, assume that instead of paying interest and principal yearly, the trust gives Marlee an interest-only promissory note with a "balloon payment" at the end of the term. This significantly reduces the amount the trust must come up with each year and leverages the amount that can be transferred. In fact, the impact of this technique is maximized by keeping the principal back from the grantor and not repaying the note in full until the grantor s death. ADVANTAGES OF AN SALE TO A GRANTOR TRUST Interest Rate and Valuation Discount Leveraging: Most practitioners are of the opinion that the appropriate rate for the sale to a grantor trust to pay to the grantor-seller on the unpaid balance of the installment note is the applicable federal rate (AFR) published monthly by the IRS. Since most installment periods will be more than nine years, the AFR long-term rate is typically used. This AFR rate is, by definition, considerably lower than the Section 7520 rate, which is 120 percent of the AFR mid-term rate. So, the trust's payments on the note to the seller may be lower than under alternative methods.

5 This has two positive planning implications: 5 First, a lower interest rate translates into lower interest payments, which, in turn, makes it easier for the trust to fulfill its obligation under the terms of the installment sale. Second, the less paid to the grantor, the less is includible in his/her estate and the more is shifted to the trust beneficiaries, thus increasing the spread between what the grantor receives from the sale to the grantor trust and the size of the wealth transferred, enhancing the "estate freezing" leverage of this technique. It is relatively easy to achieve the advantages that result from a valuation discount when the sale involves an interest in a closely held business. This is because the interest rate is applied against the face value of the promissory note, which is the discounted value of the business interest sold. On the other hand, the available cash flow to the trust is the pro rata share of gross distributable cash flow, based on the fair market value of the business interest the trust holds. As an example, assuming the asset transferred is allowed a 40% valuation discount, an entity that has a cash flow of 10 percent of its value will yield an equivalent of percent cash flow for the transferee (that is, 10% divided by 0.06). Time Leveraging: If a grantor who creates a GRAT dies during the trust term, the current value of all or a portion of the GRAT asset is includible in the grantor s taxable estate. With a sale to a grantor trust, the grantor s death during the term will result in the inclusion of only the present value of any unpaid balance. This makes it more feasible for the parties to stretch the payments out over a longer period of time. "Packing" Potential: If the asset sold is an interest in a family limited partnership, a limited liability company, or even a minority interest in closely-held stock or fractionalized income-producing real estate, because the minority interest represents a significant reduction from the proportionate share of the underlying business or assets owned by the entity, the income from the interest sold to the trust should be greater than would be expected from another asset with the same fair market value. In essence, this allows "packing" of the trust with assets that "expand" in value, which increases its income-producing power. This, in turn, helps increase the spread between the trust s income and the interest payments the trust must make on the promissory note. Enjoyment of Trust Income and Property: With a GRAT, remainder beneficiaries must wait until the trust terminates before they can enjoy any of the trust property or its income. With an installment sale to a grantor trust, enjoyment can begin much sooner. All or some of the cash flow of the trust can be held and accumulated in the trust or, if there is sufficient income, a significant amount can be distributed currently to trust beneficiaries. "Gift-Tax-Free Gifts": It is the position of many well-known and highly respected planners that when the grantor pays income tax on trust income, in essence he/she is making the equivalent of a gift-tax-free gift to the trust (i.e., shifting the money the trust

6 or its beneficiaries would otherwise have had to pay to the beneficiaries) to the extent no reimbursement is made (unless the trust instrument or state law requires reimbursement to the grantor from the trust). 6 For example, assume a grantor is in a 40% combined state and federal tax bracket. He transfers $500,000 in assets producing an 8% annual return to a grantor trust. That produces $40,000 of before-tax income. At a 40% combined bracket, the tax is $16,000. In essence, this means the grantor has made an indirect $16,000 gift to the trust beneficiaries. It is true, of course, that had the beneficiaries paid the tax, it might have been lower than the tax at the grantor s 40% bracket. The trade-off must be measured by the grantor s gift and estate tax brackets. Furthermore, once the sale is made, all future appreciation in the value of the assets in the grantor trust is excluded from the grantor s taxable estate at no gift, estate, or generation-skipping transfer (GST) tax cost. Creditor Protection: Once an asset has been sold for full and fair consideration to an irrevocable trust, the grantor s creditors cannot reach that asset. Nor can the creditors of the beneficiaries of the trust reach the principal assuming the appropriate spendthrift language is inserted in the trust instrument. (Of course, any interest or principal paid out is subject to claims by the recipient s creditors.) An S Corporation Stock Planning Vehicle: Few types of trusts can safely hold S corporation stock without causing a loss of S corporation status. But a grantor trust should be able to hold S corporation stock without fear of a loss of its status and without having to meet more onerous requirements. Structural Flexibility: The grantor trust adds considerable flexibility to the planning process because the promissory note can be structured in the form of an "interest-only" note (with a balloon payment at the end of the term) or as payments of principal and interest according to an amortization schedule. An interest-only arrangement makes it possible to build wealth within the trust more quickly and reduces the potential that the need to make fixed payments will result in a payment "in kind" to the grantor-seller, or the liquidation of an asset to make required payments. Compare This to a GRAT. Under Code Section 2702 rules, the annuity payments from a GRAT cannot vary by more than 20% from year to year, and there is no provision allowing "interest-only" payments followed by balloon payments. Estate Tax Savings: Assuming the grantor lives beyond the term of the promissory note, the value of the asset and its growth from the date it was purchased is removed from his/her estate. If death occurs during this period of time, only the value of remaining payments is includible in the grantor s estate. (Many commentators believe that the present value of the remaining payments would be includible, and even that may be advantageously valued. It could be argued that the low interest rate, long term, and questionable ability of the trust to pay the remaining amounts should entitle the estate to some valuation discount.)

7 7 Not "Discount Dependent": The benefits of the sale to a grantor trust technique are enhanced by but not dependent on the allowance of valuation discounts applied to the property sold. Some planners believe this leaves the technique less likely to be the subject of IRS or Congressional scrutiny than say FLPs but this is, of course, not a certainty or guarantee. Income-Tax-Free Transfers: Many highly prominent estate-planning authorities have stated that grantor trust status makes transactions between the grantor and the trust "nonevents" for income tax purposes. This makes it possible for the trust to pay off an interest-only note at maturity by transferring to the grantor highly appreciated assets with a fair market value equal to the face amount of the note without any recognition of capital gain. GSTT Friendly: A GRAT is not suitable for gifts to grandchildren because the annuity retained by the grantor causes an "estate tax inclusion period" (ETIP) that prevents the application of the generation-skipping transfer exemption until the end of the trust term (after all the appreciation has occurred and the exemption is least effective). An installment sale to a grantor trust should not cause an estate tax inclusion period. DOWNSIDES OF A SALE TO A GRANTOR TRUST Uncertainty: To my knowledge, although many very brilliant minds have blessed this concept, there is no statutory road map and not a single Code Section, regulation, or revenue ruling that provides absolute assurance that a sale to a grantor trust will work as proposed. Assuming the grantor dies before the "debt" is fully repaid, the IRS could make an argument for estate tax inclusion of the transferred property by: (1) claiming that the transaction is a transfer with a retained life estate and including it under Code Section 2036; or (2) claiming the transfer to the irrevocable trust coupled with a retained interest is a Section 2702 gift and that the transaction failed to comply with GRAT rules. Certainly, the client who engages in this transaction should be cautioned to start with highly competent legal and tax advice. Could the IRS argue that, if there is no gift, and the trust is a grantor trust, there is no completed transaction for income tax purposes and the estate freeze fails? Certainly, it could make that argument. But keep in mind that estate and gift tax laws are not in pari material (i.e., interpreted in the same way) with the income tax law. In my opinion the argument would fail. Phantom Income Real Tax: The grantor will be faced with paying tax on trust income he/she does not actually receive. All dividends, interest, rents, and other income actually accumulated by the trust or enjoyed by the trust beneficiaries is currently taxable to the grantor, who may or may not have sufficient cash flow to pay that tax in future years.

8 8 However, remember, the grantor does receive installment payments from the trust. Therefore, unless the interest rate is inordinately low (and the combined federal and state income tax rate is inordinately high) the grantor would have some cash flow from the trust at the very least the interest-only payment that can be used to pay tax on the "phantom" income. [Obviously, these transactions should only be created for those who reasonably anticipate the ability to bear that tax burden.] This disadvantage is actually a positive feature for grantors astute and wise enough to see it as it is: a gift in the amount of tax paid from the grantor to those who would otherwise be subjected to the tax, the trust or its beneficiaries. The net effect is a gift-tax-free shift in wealth from the grantor to his/her beneficiaries and to some extent a shift in disposition from the IRS to the trust beneficiaries. Necessity of "Seed Money": Most commentators feel that the grantor (or someone else) must "plant" substantial seed money (I suggest at least 10% to 15% or more of the price of the asset to be purchased) in the grantor trust before the installment sale is consummated in order to block an IRS attack that the grantor has retained an interest in the transferred assets that would cause estate tax inclusion. Certainly, it would be prudent to structure the terms of the note in such a way that they would not coincide with the exact timing and amount of the income generated by the asset sold to the trust. Part of the reasoning is that in an arm s length transaction between unrelated parties, the seller would most likely require collateral or at least a personal guarantee for the note from the buyer. Of course, this personal guarantee is not realistic in this context, and so the seed money idea is used. Death of Grantor During Term: Clearly, if the grantor dies when there is an unpaid balance on the note, the value of the remaining payments the trust owes the grantor will be in the grantor s taxable estate. [Some commentators believe that the estate tax inclusion is the present value of the remaining balance due the grantor.] But there is another potential problem. If the grantor dies before the end of the note term, some authorities feel that the grantor s death may trigger an income tax liability. Their rationale is that after the grantor s death the nature and status of the trust changes (i.e., it can no longer be a grantor trust after the grantor s death). Some authorities have expressed concern that the IRS will argue that the grantor s estate will be taxed - at that time - on any gain attributable to the unpaid portion of the note. It is likely that post-death payments on the note by the trust to the grantor s estate or named beneficiary are Section 691 income in respect of a decedent (IRD). This treatment is likely even though the authorities state they would have been income tax free had payments been received by the decedent during lifetime. If, for some reason, the sale does not qualify for installment sale treatment, the income would have to be reported on

9 9 the decedent s final income tax return with a counterbalancing estate tax reduction for the income tax owed by the estate. Loss of a Step-Up in Basis: Assets sold to (and retained by) the grantor trust will not receive a step-up in basis either at the date sold or at the grantor s death. If and when the asset is sold by the trust, capital gains will be recognized and taxes will be paid (unless the assets are repurchased by the grantor and held until death, as in the example above). Possible Gift on Payment of Income Tax: Some authorities have expressed concern that the IRS might treat the grantor s payment of the income tax as "on behalf of" the trust beneficiaries and therefore as a taxable gift. Specifically, the IRS has stated that such payments are not taxable gifts if the trust is specifically required to reimburse the grantor for the income taxes he or she has paid. The impact of such a reimbursement is negative; the grantor would be receiving additional money that if not consumed, given away, or paid in taxes prior to death would result in federal and state death tax inclusion. Those of us who believe the IRS will not be able to impose a gift tax base our beliefs on the fact that the grantor s payment of income tax is not "voluntary" because the grantor trust rules require that the grantor report trust income as his/her own. ENHANCING THE SALE TO A GRANTOR TRUST WITH LIFE INSURANCE Adding life insurance individual or survivorship insurance to a grantor trust enhances its effectiveness in achieving the following grantor s wealth transfer objectives in a costefficient manner: Repay the note at the grantor-seller s death (without having to sell low-basis assets) Provide a "cost recovery" method to repay funding of the note during lifetime Fund the grantor s federal and state death taxes and other estate settlement costs Provide for the grantor s other estate liquidity needs Provide cash to help secure and enhance the trust beneficiaries standard of living If the trustee of the grantor trust purchases life insurance, the excess trust income not used for payments (which are generally interest-only) to the grantor can be used to pay insurance premiums. The policy(ies) may be on the grantor s life, that of the grantor s spouse, or both. Unlike the unfunded ILIT, the net cash flow of the funded grantor trust is usually sufficient to pay all or a substantial portion of the entire premium due without the need for the grantor to make additional annual gifts. At the death of the grantor (or the survivor of the grantor and his/her spouse, if a survivorship policy is involved), the proceeds are payable to the grantor trust. The trustee can use the proceeds to purchase assets from the estate or make loans to the estate.

10 10 THE MECHANICS OF USING LIFE INSURANCE WITH A SALE TO A GRANTOR TRUST After the grantor contributes seed money to the grantor trust, the grantor and the trustee enter into an agreement whereby the grantor sells an income-producing asset or business interest to the grantor trust in return for an installment note. The grantor trust buys life insurance on the grantor s life (or on the lives of the grantor and his/her spouse) and is the owner, premium payor, and beneficiary. The trustee uses the seed money and income from the trust assets to pay the premiums. There are potential growth opportunities using the technique of combining the sale to the grantor trust with trust-owned life insurance. Suppose a grantor seeds her trust with $400,000 of marketable securities and sells the trust $3,000,000 of a limited partnership interest at a 30% discount for an interest-only note with a balloon payment at death. The value of the note is $2,100,000, and the long term AFR for the month of the sale is 5.01% (long term AFR for March, 2007). Let s assume the trust asset appreciates at 4% and produces 6% annual income, and it is projected to be worth say $7,100,000 at the end of 20 years. The grantor trust receives annual income of $204,000 from trust assets (0.06 x $3,400,000 [$400,000 of seed money and $3,000,000 of LP interest]), and pays $105,210 in interest to the grantor ( x $2,100,000 [note principal]), the excess cash flow may be reinvested and used to repay the note principal later on. Alternatively, the trustee may use the growth from the seed money plus a portion of the trust income each year to purchase $7,500,000 of second-to-die coverage insuring the lives of the grantor and her husband boosting the projected net value of the SALE TO A GRANTOR TRUST (based on its assets alone) to about $12,500,000; that is, $7,100,000 trust assets plus $7,500,000 life insurance, less $2,100,000 of note principal. By using the trust s excess cash flow to fund life insurance premiums, the trustee essentially converts assets that are otherwise taxable (as ordinary income or capital gain) to tax free insurance proceeds. QUESTIONS & ANSWERS What kind of provision can thread the needle to cause a grantor trust status for income tax purposes yet not cause estate tax inclusion? Proponents of this idea use one or more of the grantor trust provisions of Internal Revenue Code Sections 673 to 679 (the "grantor trust" income tax rules) to achieve the goals described above. The three most commonly used ways to deliberately achieve the intended grantor trust status are to (a) include a power allowing the grantor to repurchase assets from the trust and, in return, substitute assets of equivalent value (the so-called "power of substitution"); (b) insert a power for the spouse of the grantor to take income

11 11 or affect the beneficial enjoyment of the corpus or income; and (c) include a power to use trust income to pay premiums on life insurance on the grantor or the grantor s spouse. The first of these, the power of substitution, is probably the most frequently used but is often used in combination with one or both of the other two. Who can (should) be the trustee? The Grantor should not be named trustee or co-trustee nor should he/she have the right to replace the trustee(s) and appoint a successor trustee (or trustees). But the grantor can name his or her spouse (who is not a grantor), a child, grandchild, or almost any other legally, emotionally, and intellectually competent adult. What types of property can be the subject of a sale? Almost any type of property can be the subject of the sale as long as it is likely to appreciate faster than the interest payable on the promissory note. So, the object of the sale could be stock in a C or an S corporation, an FLP or LLC interest, public-traded stock, or commercially viable real estate. (See below for more details.) Can the grantor trust be used to shift a life insurance policy out of the grantor s estate without triggering the Code Section 2035 transfers within 3 year of death rule? Yes, but it is true that Code Section 2035 applies only to gratuitous transfers. So a bona fide sale of a policy for full and adequate consideration should fall outside that trap. It is also true that the infamous "transfer-for-value rule" can be sidestepped when the basis of the transferee is determined in whole or in part by reference to the transferor s basis as it would be in the case of a sale to a grantor trust. Furthermore, the transfer falls within another "safe harbor" in that it is to a grantor trust, which is the alter ego of the grantor/insured for income tax purposes; hence, it can be argued that the transfer is to the insured an exempt party under the transfer-for-value rule. But there are two possible thorns in this seemingly beautiful rose. First, the question of what is "adequate and full consideration" is far from clear when it comes to valuation of life insurance. This issue is particularly thorny when the insured is in less than average health and there are life settlement companies willing to purchase the policy for amounts greater than the normal IRS measure of value. There is at least one PLR where the IRS refused to rule on whether the transfer-for-value rule applied to the sale of a life insurance policy to a grantor trust. Can the grantor trust be used in a business context? Yes. It can be used as the lifetime purchasing entity in a buy-sell arrangement. The advantages include:

12 12 A lifetime buy-out helps to dampen the purchase price early before expected escalation of value. This helps to significantly reduce the life insurance necessary to fund the buy-out. Since the trust, rather than the heirs/children, purchases the stock, it is not included in their taxable estates and, if desired (or necessary), the trust can be structured to avoid estate inclusion even for a further generation (or generations). Children who are working in the business can be named as trustees of the grantor trust, thus giving them a measure of control even if they are named as equal beneficiaries with their siblings who are not active in the business. It is even possible to accomplish all these objectives and still have the client maintain substantial control over the family business by selling to the grantor trust only interests that have no voting power. For example, the client could sell the trust non-voting C or S corporation stock, or a limited partnership unit in an FLP, or non-management units in an LLC. This technique will work particularly well if the client s business entity (or interest) is likely to be sold or go public at some future date but can presently be discounted. Will the technique work when the subject of the stock is an S corporation? Yes. As noted above, by definition, a grantor trust is deemed to be owned by the grantor for income tax purposes. The grantor is considered owner of all the assets of the trust for all purposes. But is important to should remember that the trust s eligibility to safely hold S stock terminates when the grantor dies. This means the draftsperson must be sure to empower the trust to automatically convert at that time to a QSST (Qualified Subchapter S Trust) or an ESBT (Electing Small Business Trust). If the trust has multiple potential current beneficiaries, the ESBT will probably be the form of choice. When is the sale to a grantor trust technique contra-indicated? First, the sale of an asset that is not likely to substantially appreciate over time both from an income and capital gain perspective will be counterproductive. The benchmark is a rate of income/growth that is measurably greater than the long-term AFR. If the combined income/appreciation is not significantly higher than the long-term AFR in effect at the time the sale is effected, this technique will not produce the desired results. Second, if a client or his family is dependent on the long-term stream of income produced by the assets in question, the use of this technique will be problematic. Likewise, if the stream of income produced by the transferred business interest or asset is likely to stop before the end of the installment payout period, the trust may have problems meeting the requirements of the sale.

13 13 Third, the technique will not be indicated if the income generated by the trust assets will be insufficient to reasonably make the interest payments under the installment sale. Insufficient cash flow may necessitate the return of some trust assets to the grantor-seller and, to that extent, will defeat the wealth-shifting ("intentional defunding") goal of the transaction. Of course, paying interest "in kind" will continue to work to the extent the assets substantially appreciate but the intended estate freeze would "leak," hence the term "leaky freeze." The most important contra-indication is where a client will be uncomfortable without the safety net of cases, regulations or rulings. In spite of the fact that some of the brightest minds in the legal profession are strong proponents of this technique, there are a number of issues that remain unsettled, so the concept has inherent risks that some clients are not willing to accept. CONCLUSION A sale to a grantor trust is an important estate and wealth transfer-planning alternative to discuss with clients. The pros, cons, and uses in various contexts should be considered. A properly structured grantor trust can enable the client to obtain significant gift and income tax benefits when transferring assets out of his/her taxable estate during lifetime. It can be particularly useful for high-net-worth clients who want to transfer large amounts of closely held stock, limited partnership interests, or other income-producing assets while minimizing their gift tax liabilities. In this case, a sale to a grantor trust may be a viable solution. It allows the client to transfer assets to the trust at low gift tax and income tax costs and, in certain situations, at a valuation discount. These trusts should be considered for clients who otherwise may be confronted with significant gift taxes when funding their life insurance needs. They may not have many "Crummey" beneficiaries, may have already used their annual exclusions, or the premiums may simply be too large to be sheltered by annual exclusions or without depleting their lifetime gift exemptions. A sale (or gift) of income-producing assets from the client to a grantor trust can facilitate the purchase of life insurance by the trust using trust income to fund large premiums in a cost efficient manner.

14 14 This material is for internal use only and is provided courtesy of The Prudential Insurance Company of America, Newark, NJ. The discussion of planning techniques does not imply a recommendation that a specific planning concept should be implemented. References to legal and tax considerations are made but are not meant to provide advice in this regard. Please remind clients that legal and tax advice, including the preparation of legal and tax documents, should come from an attorney and/or a tax advisor such as an accountant. These advisors can determine how best to utilize such product or technique. Prudential Financial Planners can prepare financial plans incorporating many of the planning techniques discussed above. Financial Services Associates and producers can work as knowledgeable members of clients professional teams to provide suitable products. Insurance is issued by The Prudential Insurance Company of America, Newark, NJ. Securities are offered by Pruco Securities, LLC. All are Prudential Financial companies located in Newark, NJ. Investment advisory services offered through Prudential Financial Planning Services, a division of Pruco Securities, LLC. Stephan R. Leimberg is not affiliated with Prudential and Prudential makes no representation as to the accuracy of the cites. Prudential and the Rock logo are registered service marks of The Prudential Insurance Company of America and its affiliates.