Spring 2011 Issue # 2. Introduction. Grantor Trusts & Intentionally Defective Irrevocable Trusts (IDITs) Issues & Uses in Estate Planning

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1 Spring 2011 Issue # 2 Grantor Trusts & Intentionally Defective Irrevocable Trusts (IDITs) Issues & Uses in Estate Planning I. INTRODUCTION II. USING GRANTOR TRUSTS III. REQUIREMENTS FOR GRANTOR TRUST STATUS IV. ISSUES AND LIMITATIONS V. CONCLUSION Introduction Irrevocable trusts have long been one of the cornerstones of estate planning. They offer a combination of administrative, spendthrift, and estate tax benefits that prove attractive to many clients who are concerned with passing on wealth to their heirs. Furthermore, they offer these benefits in a framework of laws that admits of little uncertainty, often making irrevocable trusts preferable to other vehicles whose use may bring IRS scrutiny or whose long-term viability may be in doubt. 1 In order to better use this popular planning vehicle, grantors should understand not only the general scheme for taxing trusts, but should also be aware of the advantages and disadvantages of grantor trust status for federal income tax purposes. By making the grantor responsible for income tax on trust income, grantor trust status can have a significant impact on trust accumulations, as well as the personal income tax obligations of the grantor and the trust beneficiaries. This article will define the term grantor trust, outline the technical requirements and limitations of grantor trusts, and explore how the grantor trust may be used in a number of estate planning circumstances. Specifically, it will examine how to use a grantor trust (1) to create gift tax leverage and maximize trust returns; (2) to transfer an existing life insurance policy to an irrevocable trust without violating the three year rule or the transfer for value rule; and (3) to execute an estate freeze using a sale to a grantor trust in exchange for an installment note.

2 A. Income Tax Effect of Grantor Trust Status In general, when the grantor trust rules apply, the grantor is treated as the owner of the trust property for income tax purposes. That is, the rules apply as if the grantor earned the income, received the credit, etc. Whereas a non-grantor trust reports income on its own return and pays its own taxes, the grantor trust in effect transfers the tax obligation to the grantor, who reports the income on his or her personal tax return. Although income-shifting is often the most important consequence of grantor trust status, other tax items are affected as well. Internal Revenue Code ( IRC ) 671 describes the income tax treatment that applies when a trust is considered a grantor trust. This section includes in the income and credits of the grantor those items of income, deductions, and credits against tax of the trust. 2 For income tax purposes, the grantor will be treated as the owner of the trust and all of its assets, income, credits, and other items relevant to computing income tax. 3 For example, assume that Xiao creates an irrevocable trust, taxable as a grantor trust. The trust owns stock in publicly traded company, BettorMart. In 2011, BettorMart distributes a dividend to Xiao s trust of $100. As a result of grantor trust status, Xiao must report the $100 on his income tax return and pay the associated income tax. 4 The trust keeps the $100 dividend to be accumulated for or distributed to the trust beneficiaries. IRC 671 provides that if the whole trust is not treated as a grantor trust, then the tax items treated as the grantor s must be determined proportionally. That is, they must correspond to the portion of the trust treated as a grantor trust. For example, assume that Tom creates an irrevocable trust taxable as a grantor trust for income tax purposes. He contributes 20 shares of XYZ stock to the trust. Sometime later, assume the trustee accepts a gift from Tom s sister, Barbara, of 20 more shares and that this gift causes her also to be treated as grantor for income tax purposes. In 2008, the trust receives a dividend of $400 on its 40 shares of XYZ stock. Tom and Barbara each will report on their respective income tax returns 50% (i.e., $200) of the trust s income. The trust retains the $400. B. Statutory Basis for the Term Grantor Trust. 1 Compare, for example, the family limited partnership (FLP), which has enjoyed popularity amongst clients and advisors alike for years, but which has been the subject of continuing IRS scrutiny and recently successful IRS challenge. 2 IRC 671 clarifies that the items to be treated as the grantor s include any items applicable to an individual s tax computations, even if such items are irrelevant to computing a trust s income. 3 IRC The IRS Instructions for Form 1041 outlines a number of methods by which the trust can satisfy its reporting requirement where the grantor is treated as owner of all or a portion of the trust. 2

3 Congress enacted the grantor trust rules as part of the 1954 Code to curtail the use of trusts in certain arrangements designed to reduce the grantor s income taxes. Prior to 1954, taxpayers could use trusts to reduce income taxes by diverting some personal income to a trust. 5 The income earned by the trust would be taxed in the trust s marginal tax brackets (beginning with the lowest) instead of in the grantor s tax bracket, where presumably it would have been exposed to tax at a higher marginal bracket. Divided between two taxpayers (i.e., the grantor and the trust), the grantor s income could take advantage of two runs up the brackets instead of one. The Treasury persuaded Congress to close this loophole by treating the trust income of certain trusts as being owned by and taxed to the grantor, even where the trusts were irrevocable. 6 Under the grantor trust rules, the income could no longer be divided amongst the grantor and the trust all income would be aggregated, ensuring progress into the higher tax brackets. The rules enactment largely curtailed the ability of taxpayers to use irrevocable trusts for income shifting, at least where the grantor retained any control over the trust. Since 1986, the underlying income tax reason for attempting to redirect income to a trust has also largely been eliminated. Beginning with the Tax Reform Act of 1986, the federal income tax rate structure for trust income was dramatically compressed. For example, trust income in 2011 in excess of $11,200 is taxed at the maximum federal income tax bracket of 35%, where single individuals are subject to that rate only after reporting taxable income of $373,650. Grantors now have little income tax incentive for implementing stand-alone trusts. Today grantor trusts indeed most trusts are not used to shift income to the trust. Instead, high effective rates for gift and estate taxes have encouraged grantors to explore methods for exploiting the consequences of grantor trust taxation in the context of transfer tax planning. 7 C. Estate Tax Effect of Grantor Trust Status Grantor trust status does not affect how the estate tax applies to a trust the trust s estate taxability, as it were. The income tax and the estate, being separate, affect trusts independently of each other. While certain powers retained 5 Though nominally irrevocable, these trusts often gave the grantor ability to receive back the trust principal after periods as short as a year and a day. At this time trust income tax rates and marginal brackets more closely resembled those applicable to individuals. 6 Compare the kiddie tax, which similarly adds income earned by certain children to their parents return to prevent income shifting. IRC 1(g). For example, children under age 18 must pay tax on their unearned income (above $1,900 in 2011) at their parents marginal rate. 7 For , the first effective marginal gift tax bracket is 35%. Although the gift tax applies marginal rates, the lifetime applicable credit amount offsets (i.e., covers ) the tax on the first taxable gifts made (up to a certain amount). In 2011 and 2012, that lifetime amount is $5,000,000. For years 2013 and following the lifetime gift exemption is scheduled to return to $1,000,000. Thus a gift in 2012 is taxable only if the sum of the gift plus the donor s other lifetime taxable exceed of $5,000,000. See IRC 2502, 2001(c),

4 by the grantor (or the grantor s spouse) may result in a trust being both (1) included in the grantor s estate and (2) treated as owned by the grantor for income tax purposes, the two conclusions follow from an examination of the trust from each tax perspective, not simply because of one. As discussed below, a trust is characterized as a grantor trust for income tax purposes if any one of a number of powers are reserved by the grantor. Section 674 provides, for example, that the grantor of a trust will be treated as the owner of any portion of a trust over which he or she has a power to control disposition of income or corpus. Thus, all revocable trusts, where the grantor has the power to amend the trust s terms and to make distributions, are treated as grantor trusts. The entire corpus of a revocable trust will also be included in the grantor s gross estate; not because it is a grantor trust, but because 2038 of the estate tax provisions require inclusion. A blanket conclusion may not be made about irrevocable trusts. In the estate planning context, a properly drafted irrevocable trust almost always will be written to avoid estate tax inclusion. That is, the trust s value will not be brought back into the grantor s gross estate. However, the same irrevocable trust may or may not be a grantor trust, depending on its terms. Each document s language must be examined on a case-by-case basis in order to determine the extent to which it may be taxable as a grantor trust for income tax purposes. A client may create an irrevocable trust that is effective for the estate tax purposes (i.e., not includible in the grantor s estate) and effective for income tax purposes (i.e., a stand-alone income tax entity). Alternatively, a client may create an irrevocable trust that is effective for the estate tax purposes but defective or ineffective for income tax purposes (i.e., ignored for income tax purposes). As illustrated below, the ability for an attorney to draft a client s irrevocable trust as a grantor trust creates a welcome flexibility in the estate planning process. These so-called intentionally defective irrevocable trusts (IDIT) or intentionally defective grantor trusts (IDGT) offer a useful combination of income and estate tax attributes. 8 II. USING GRANTOR TRUSTS The following discussion sets out the various uses of an intentionally defective irrevocable life insurance trust. The benefits of being able to ignore the existence of the trust for income tax purposes range from gift tax leverage to being able to avoid the three-year rule when transferring an existing policy to the trust. A grantor trust can also purchase assets from the grantor for a balloon note and thereby freeze the value of the property. Future appreciation will be removed 8 For purposes of this discussion, the terms IDIT, IDGT, defective trust, intentionally defective ILIT, and grantor ILIT all refer to the same type of trust: an irrevocable trust taxed as a grantor trust for income tax purposes and designed to hold life insurance and other assets. The terms stand-alone ILIT, tax-paying ILIT, or ILIT taxed as a separate entity refer to irrevocable trusts that are not grantor trusts. 4

5 from the grantor s estate to the extent this growth exceeds the interest payments on the note. A. Basic Use Transferring the Income Tax Burden in Funded ILITs For many irrevocable life insurance trusts (ILITs) a life insurance policy insuring the client(s) is the only trust asset. The trust must rely on gifts of cash in order to pay the premium since the trust is (apart from the policy) unfunded. Funded ILITs, on the other hand, hold other assets in addition to the policy. A client can use his or her annual gift tax exclusions and his or her lifetime exemption ($5,000,000 in 2011 and 2012) to shelter from gift tax transfers of appreciating assets. The trust can also use cash flow from the transferred assets to fund the insurance premiums. While the funded ILIT has certain advantages over the unfunded ILIT, the income generated from trusts taxed as stand-alone entities will sometimes suffer from the compressed trust income tax brackets. 9 By creating an ILIT that is a grantor trust, the grantor insured can both A) use his or her marginal tax brackets, and B) relieve the trust of the obligation to spend any of its earnings to pay income taxes. Consider the following examples, which illustrate the difference between a grantor ILIT and a stand-alone ILIT. A grantor with adjusted gross income (AGI) of $120,000 makes a gift of $1,000,000 to an irrevocable life insurance trust, which will invest in a commercial building generating rental income of $100,000 per year. In the first scenario, where the donor uses a grantor ILIT, the income tax obligation for the rental income is imposed on the grantor. As a result, the grantor will pay an additional $30,242 of income tax (in 2011). 10 The trust retains the $100,000, which it may use to invest, to pay premiums on a life insurance policy, to distribute to beneficiaries, etc. In the second scenario, using a standalone ILIT, the income tax obligation remains with the trust. Using the trust s graduated rates, the tax on $100,000 is $33,976 (in 2011), leaving the trust with $66,024 to spend, invest, or distribute. 11 Use of the compressed trust brackets causes the stand-alone trust scenario to have $3,734 more in income tax. 12 B. Basic Use Gift Tax Leverage 9 While important for providing liquidity, the unfunded or bare ILIT treats only the symptom (i.e., the estate tax exposure), and not the root cause of the problem (i.e., appreciating assets in the estate). The funded ILIT attempts also to address the cause of the problem by shifting future growth outside the estate. 10 The grantor s tax without the trust income is $27,474 (single return). The grantor s tax with the trust income is $57,716. The trust s portion equals $57,716 less $27,474, or $30,242. Thus, the effective marginal rate for the trust income is about 30.2%. 11 The trust tax brackets reach 35% after $11,200 in income. The tax on the first $11,200 of income is $2, Please note that for taxpayers with large AGI, the income tax advantage of such a shift will diminish and ultimately will be lost. In 2011, single taxpayers with AGI of $373,650 will pay tax on any additional income at the highest marginal rate, 35%. A tax-paying ILIT gains a small advantage ($1024) over a grantor ILIT if the grantor is in the highest marginal tax bracket, since its tax uses lower rates on the first $11,200. 5

6 An intentionally defective irrevocable trust can take advantage of the grantor s income tax obligation to increase the value of gifts made to the trust. Each time the grantor pays a tax that otherwise be imposed on the trust, the grantor has in effect made a gift of the income tax payment, but without the gift tax consequences of actually making a gift. 13 This leverage may be used to maximize the benefit of each gift. Assume the same facts as in the previous example, and in addition that the grantor would like the trust to have $100,000 available to the trust each year. If the grantor uses a stand-alone irrevocable trust, the trust must use $33,976 of its $100,000 income on income tax, netting $64,024. In order for the trust to have $100,000 available for trust purposes, the grantor must give to it an additional $33,976. Using an IDGT, the income tax obligation on the trust s $100,000 of income lies with the grantor, who pays $30,242 in additional income tax. However, no gift is necessary since the trust keeps the $100,000 it earned. In both cases the trusts end up with $100,000 available for trust purposes: the stand-alone trust requires the grantor to give $33,976 to the trust; the IDGT requires the grantor to give $30,019 to the IRS. While similar in effect, in the IDGT scenario the grantor has not used any additional annual exclusion or lifetime gift exemption to accomplish the goal of providing $100,000 to the trust. The grantor trust provides gift tax leverage to the original gift. In contrast, the stand-alone trust scenario requires use of $33,976 in annual gift tax exclusions or exemption. Seen another way, the result for a grantor trust is the same as if the grantor had made a gift to the trust of the income tax on trust earnings. While normally the IRS could put forward a substance-over-form argument to recharacterize the grantor s payment as an actual gift, taxpayers have found a credible defense in the fact that the IRC itself imposes this obligation. 14 C. Avoiding the Three-Year Rule for Transfers of Existing Policies Changing financial situations affect life insurance needs. For example, the need to provide survivor income protection may be eclipsed by the need to fund an estate planning solution as a person accumulates more wealth. While in many 13 See Rev. Rul , IRB 7. This ruling makes clear that in the context of a grantor trust, the grantor s payment of income tax on trust income is not a gift to the trust or its beneficiaries 14 The IRS in PLR took the position that absent a reimbursement provision in the trust requiring the trust to reimburse the grantor for the payment of any taxes, the grantor will be deemed to have made a gift to the trust equal to the taxes paid. This ruling was modified in PLR and the language regarding the reimbursement requirement and the resulting gift tax consequences was omitted. In Rev. Rul ( CB 7) the IRS confirmed that the payment of income tax by the grantor would not be treated as a gift for gift tax purposes. 6

7 cases a new policy may be appropriate to address the new concern, in others the existing policy owned differently may satisfy the new insurance needs. 15 The transfer of an existing policy may create an unwanted estate tax liability due to application of the three-year rule. The three-year rule as it applies to life insurance provides that where an insured gives away or releases any incident of ownership in a policy to an irrevocable insurance trust or other donee, the entire death benefit will be pulled back into the insured s taxable gross estate if he or she dies within three years of making the transfer. 16 For example, assume the insured owns a policy with a $500,000 death benefit on her own life, naming her child as beneficiary. The insured gives the policy to her child in May The insured subsequently dies in May Although the insured did not own the policy at the time of her death, nevertheless, the three-year rule requires her executor to include the $500,000 policy death benefit in the insured s gross estate. The three-year rule most often impacts planning in cases where either (a) the insured would like to change the use of an existing policy, and so intends to give it to a third party or trust, or (b) where an insured herself enters into a new life insurance contract as owner because an irrevocable trust has not yet been created. The three-year rule does not affect planning where the gift of a policy will be made by someone other than the insured, as where a noninsured spouse gives a policy to an irrevocable trust. 17 In the case of survivorship policies, the death benefit will not be included in the estate of the first to die because there is no death benefit to include. In effect, the death benefit risk created by the threeyear rule in survivorship policies lies with the survivor. Internal Revenue Code 2035(d) grants an important exception for transfers made for consideration (i.e., as part of a sale). It provides, in part, that the three-year rule shall not apply to any bona fide sale for an adequate and full 15 For example, although joint and survivor life insurance continues to be a cornerstone of estate tax planning, the client s concern to have liquidity to pay estate taxes does not automatically signal replacement of a single-life policy with survivorship insurance. In some cases, questions of insurability may affect the individual s ability to buy a new policy. In other cases, the insureds simply may appreciate the planning flexibility that a funded single life insurance policy gives them. The plan creates flexibility in that the noninsured spouse as trustee may access the death benefit for income needs, or invest the proceeds so that a large liquid reserve will be available at his or her subsequent death. Though the powers must be exercised in a fiduciary capacity and are restricted by certain ascertainable standards, the noninsured spouse may access cash values and death proceeds through distributions of trust income and principal, and may have a special power of appointment over the trust s remainder. 16 The three-year rule results from the combined application of IRC 2035 ( Adjustments for certain gifts made within 3 years of decedent s death ) and 2042 ( Proceeds of Life Insurance). The latter provision includes in the gross estate of an insured decedent the death benefit of any life insurance policy insuring his or her own life in which the decedent possessed any incident of ownership, such as the right to change the beneficiary, to borrow from the cash value, etc. The insured need only have a single incident of ownership for 2042 to apply. Consequently, the insured need only give away or release a single incident of ownership within three years of death for 2035 to apply. 17 The IRS may apply a step transaction argument to defeat attempts by insured taxpayers to avoid the three-year rule by giving the policy to an intermediary (e.g., the noninsured spouse) who then gives the policy to the trust. 7

8 consideration in money or money's worth. 18 Thus, where an insured sells a policy to a trust instead of giving it to the trust, the policy proceeds will not be included in the insured s estate even if the insured dies within three years of the transfer. As explored in detail below, however, the sale of a policy comes with its own problem the transfer for value rule. D. Avoiding the Dreaded Transfer for Value Rule Under the general rule of 101, life insurance death proceeds are usually received income tax free to the beneficiary. 19 An exception applies, however, whenever a transferee acquires the policy in a sale. More precisely, 101(a)(2) provides: In the case of a transfer for valuable consideration, by assignment or otherwise, of a life insurance contract or any interest therein, the amount excluded from gross income by [the general rule] shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee. The transfer for value rule can taint (i.e., make partially taxable) the death benefit where only part of the policy is assigned or where the whole policy is sold. In the business continuation context, the exchange of policies by co-shareholders creates a transfer for value. Similarly, where a buy-sell agreement calls for the assignment to a co-shareholder of a portion of the policy proceeds, the assignment represents a transfer for value. In the estate planning arena the sale of a policy to a trust (as a opposed to a gift) creates a transfer for value. 20 Where the trust purchases the policy, the consideration will equal the purchase price paid for the policy plus premiums subsequently paid by the trustee. The death benefit in excess of this consideration will be taxed to the trust as ordinary income. Section 101(a)(2)(B) provides a number of exceptions to the transfer for value rule. The exceptions apply to transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the (the Three-Year Rule)provides, in part: (a) Inclusion of certain property in gross estate. If (1) the decedent made a transfer (by trust or otherwise) of an interest in any property, or relinquished a power with respect to any property, during the 3-year period ending on the date of the decedent's death, and (2) the value of such property (or an interest therein) would have been included in the decedent's gross estate under section 2036, 2037, 2038, or 2042 if such transferred interest or relinquished power had been retained by the decedent on the date of his death, the value of the gross estate shall include the value of any property (or interest therein) which would have been so included. (d) Exception. Subsection (a) and paragraph (1) of subsection (c) shall not apply to any bona fide sale for an adequate and full consideration in money or money's worth. 19 The general rule applicable to employer-owned contracts differs substantially: in the case of an employerowned life insurance contract, the amount excluded from income is not more than the excess of the death benefit over the amount paid by the employer for the contract. See 101(j). 20 Thus the mechanism for avoiding the three-year rule may cause a transfer for value problem. 8

9 insured is an officer or shareholder. For example, an insured can buy an existing policy on his or her life without it being a transfer for value. The transaction, however, may create taxable income for the seller even if the transfer meets an exception to the transfer for value rule. Assume, for instance, that Tomas owns a permanent policy insuring his brother, Javier. Tomas basis in the policy is $8,000, equal to the cumulative premiums he has paid. Javier pays Tomas $14,000 for the policy, its fair market value at the time of the exchange. Javier is the insured, so his purchase of the policy on his own life will not cause the death benefit to be tainted when received by the beneficiary. However, Tomas will still recognize $6,000 in ordinary income upon the sale, an amount equal to the value received, $14,000, less his $8,000 basis. Javier, having paid $14,000 for the contract, has a basis of $14, Grantor trusts may (1) avoid the transfer for value rule or (2) take advantage of the rule s exceptions for transfers to an insured whenever the trust buys a policy. The purchase by a grantor trust of a policy on the grantor s life depends on the insured being treated as owner of the trust for income tax purposes. Revenue Ruling provides two examples to illustrate how 101 applies to sales involving grantor trusts. Example 1: Trust A and Trust B are both grantor trusts treated as wholly owned by grantor, G. Trust A owns a policy on G s life. Trust A sells the policy to Trust B for cash. Because G is treated as the owner of both A and B for federal income tax purposes, G is treated as the owner of all the assets of both trusts, including the life insurance and the cash, both before and after the exchange. Accordingly, since G is the owner of the insurance before and after the transaction, there has been no transfer within the meaning of 101(a)(2). Example 2: Trust C is not a grantor trust. Trust D is a grantor trust treated as wholly owned by grantor, G. Trust C owns a policy on G s life, which it sells to Trust D for cash. Because G is treated for federal income tax purposes as the owner of all of the assets of Trust D and none of the assets of Trust C, G is treated as the owner of the cash (but not the insurance policy) before the transaction, and as the owner of the life insurance (and not the cash) afterwards. Accordingly, there has been a transfer of the policy for valuable consideration. Nevertheless, the transfer for value limitations affecting the tax-free death benefit do not apply, because the transfer to Trust D is treated as a transfer to G, the insured, within the meaning of 101(a)(2)(B) Note that the insurer would still issue a 1099 income form to Javier if he surrendered the policy for $14,000 the day after acquiring it. Javier is responsible for tracking his basis in the contract and explaining to the IRS on his Form 1040 return why the taxable portion of any surrender proceeds should be reduced. 22 Prior to 2007, practitioners had suggested that sales to a grantor trust could meet the requirements of 101(a)(2)(A) to avoid the transfer for value problem. This section makes the transfer for value penalty 9

10 Thus, a grantor trust may be used in a number of circumstances to facilitate the transfer of a policy without endangering the policy s tax-free death benefit. E. Moving an Existing Policy to a New ILIT Where an insured grantor would like to move an existing life insurance policy to an ILIT of which she is the grantor, but wants also to avoid the risk of estate tax inclusion of the death benefit under the three-year rule, the grantor may use a grantor trust to accomplish both goals. The three-year rule also does not apply where a life insurance policy is sold for full and adequate consideration. 23 That is, it only applies to gifts. As a result, an insured wishing to avoid estate tax inclusion of the death proceeds may transfer the policy to an irrevocable trust in exchange for cash (or other property) instead of transferring the policy gratuitously. Stated another way, an insured policy owner may avoid the threeyear rule by selling the policy for full and adequate consideration instead of giving it away, as illustrated in the diagram, below. Insured 1. Gift(s) of cash or property $$$ Irrevocable (Grantor) Trust 2. Investment Life Insur. policy 3. Policy sold to trust in exchange for cash or property If structured as a sale, the transfer of the policy would not be a gift, and thus, the transfer would not be subject to the three-year rule. Further, under the logic of Revenue Ruling , the sale would avoid the transfer for value problem since the insured would be considered the owner of the policy both before and after the exchange. This techniques works only if the trustee may not be compelled to engage in this sale and that fiduciary principles must guide the trustee s decision on whether to buy the policy. inapplicable to transfers where the transferee s basis in the policy is determined in part (or in whole) by reference to the transferor s basis. Revenue Ruling has rendered such arguments unnecessary. 23 A discussion of a life insurance policy s fair market value is beyond the scope of this work. The Treasury Dept. has issued regulations governing the valuation of life insurance contracts in the income tax context (see (e)) and the gift tax context (see ). It has also provided a safe harbor formula for income tax purposes in Rev. Proc ( IRB 962): the greater of (a) the interpolated terminal reserve plus unearned premiums, plus a pro rata portion of expected dividends; or (b) the product of the socalled PERC amount (a calculation involving premiums, earnings, and reasonable charges) and the average surrender factor. 10

11 F. Transferring a Life Insurance Policy from an Existing ILIT to a New ILIT Where the terms of the original ILIT no longer serve the purposes of the grantor, or where the new trust corrects drafting defects present in the older trust, a grantor may wish to have the insurance policies transferred from the existing trust to the new trust. While the need for change could have been anticipated and addressed through the use of a trust protector that is, by giving a third party who has no beneficial interest in the trust a right to amend the trust a new grantor trust can provide an alternative solution. This new trust could purchase the insurance policy from the old trust. Of course, this sale will constitute a transfer for valuable consideration. However, as in Revenue Ruling , the transfer for value rule may be avoided where both trusts are grantor trusts and the insured is the grantor of both. The trustees who have a fiduciary obligation to their respective beneficiaries and not the grantor, must independently decide to engage in the exchange. The grantor has no legal right to compel the trustees to buy or sell. The following diagram illustrates this concept: 1. Gifts of cash New Trust (a Grantor trust) Cash Existing ILIT (a Grantor trust) Life Insur. policy Insured 2. Existing ILIT sells policy to New Trust in exchange for cash 3. Existing ILIT retains or invests cash for its beneficiaries G. Third-Party Sales (to trusts) Often, the policy to be transferred to the irrevocable insurance trust is not owned by the insured. It could be owned by a corporation as key-person life insurance or by the insured s spouse. As discussed above, the challenge in this case is to avoid the transfer for value rule. For example, consider the situation where the insured s wife owns a policy, originally bought for income protection. As circumstances change, the estate tax problem of owning the policy within the combined estate may prompt the insured and his wife to change the policy 11

12 ownership; for example, to a spousal lifetime access trust (SLAT). 24 The insured s wife should not give the policy to a trust of which she is the beneficiary, as it will cause all or a portion of the trust assets to be included in her estate as a gift of a retained interest under The insured could give the policy to the trust (after his wife gives the policy to him), but in this case the gift will be subject to the three-year rule. Instead, the insured s wife could sell the policy to the SLAT. The sale of the insurance policy for full and adequate consideration on the grantor s life to a defective SLAT will not be a gift (thus avoiding the estate tax problem of the three-year rule) and will qualify as a transfer to the insured, an exception to the transfer for value rule. H. Installment Sales to IDITs (the GRAT alternative) Grantor trusts serve an important function in the estate planning technique known as the sale to an IDIT. This concept operates in some respects like a zeroed-out GRAT freezing the value of transferred property in the owner s estate while stripping out some portion of the appreciation. Typically the grantor of the trust sells assets (sometimes discounted) to the trust in exchange for a promissory note. 25 The trust pays interest on the note at the prescribed applicable federal rate (AFR) during the term of the arrangement, with a balloon payment of the principal at the note s maturity. Structured properly, the value of the note will equal the value of the property sold, so no gift (or generation-skipping transfer) will occur as a result of the exchange. 26 Further, the seller s estate will include only the remaining balance of the note, not the actual value of the sold property. 27 Please note, however, that it is not entirely clear what the income tax consequences would be if the grantor died while the note is outstanding. Some have argued that because the trust is no longer a grantor 24 This trust offers the spouse, serving as trustee, the opportunity to access policy values and distribute trust property to him or herself based upon an ascertainable standard during the insured s life, while still excluding the death benefit from both estates. 25 The ability to discount the sale price, though supported in various court decisions, is complex and will almost certainly be scrutinized by the IRS. Any such discount should be determined by a qualified appraiser. 26 This concept, unlike the GRAT, does not have safe harbor parameters for determining whether it is bona fide. However, some key elements should be considered. The trust should have independent significance. Commentators cite 10% as the minimum equity-to-debt ratio that should be used, based on informal IRS comments. See e.g., Bourland & Meyers, Grantor Trusts and FLPs in Estate Planning Great Wealth Migration Partners, See also Leimberg et al., Tools and Techniques of Estate Planning, National Underwriter 2010, at p.296. The tax court in Frazee v. Commissioner, 98 T.C. 554 (1992) held that (1) use of the appropriate AFR to determine interest and (2) a note equal in value to the property sold, would be an exchange of equivalent property, not a gift with a retained interest. See also PLR for an IDIT example favorable to the taxpayer. 27 It is important that the payments on the note not be tied to the income of the trust, lest the grantor be treated as having retained an interest in the transferred property. See PLR where the IRS concluded that the extension of credit to decedent s ILIT (which loans were documented with interest bearing promissory notes) did not create an incident of ownership. The IRS did not address the issue of whether the extension of credit between the decedent and the trust would be viewed in any way as a retention of the right to receive income from the trust causing the trust to be includible under 2036(a). 12

13 trust upon death, the income associated with the sale of the assets should be recognized. Such issues serve to point out the importance of seeking the guidance of professional tax and legal advisors. This arrangement creates an estate planning opportunity in that all of the appreciation and income of the acquired property in excess of the interest paid by the trust will accrue for the benefit of the trust without having been subject to transfer tax. In other words, the sale will operate as a freeze and a portion of the post-sale appreciation will not be included in the grantor s gross estate. For example, assume Li-Zhu owns rental real estate limited partnership interests with a fair market value of $1,000,000. The partnership interests generate $75,000 in rental income and are projected to appreciate at 3% each year. He sells the interests to an IDIT in August 2008 when the long-term AFR is 4.58%. 28 Prior to the sale, the IDIT owned $100,000 in cash and publicly traded securities. The terms of the sale call for interest only payments to him for 15 years, ending with a balloon payment of the principal. There is no gift upon transfer because the note equals the value of the property. Each year, the trust receives $75,000 from partnership distributions. As the trust is a grantor trust, Li-Zhu must pay the tax on these earnings (e.g., 35% of $75,000 or $26,250). Each year, the trust must pay him the interest on the note of $45,800 (equal to 4.58% of $1,000,000). As a result, the IDIT retains the difference of $29,200 each year, while Li-Zhu nets $19,550 ($45,800 received less the $26,250 paid in taxes). $26,250 tax payment IRS Li Zhu $45,800 annual interest payments LP Interests $1,000,000 principal payment (end of year 15) Promissory Note 4.58% AFR IDIT $75,000 LP profits distribution LP Interests $75,000 rental income At the end of fifteen years (prior to the balloon payment), the trust s value is expected to be about $2,722,000, assuming the income is retained and 3% appreciation. The trust repays the principal in cash or in limited partnership interests, leaving it with about 28 Taxpayers must use the AFR applicable to the term of the note: short-term for notes with a maturity of 3 years or less; mid-term for notes maturing more than 3 years and up to (and including) 9 years; long-term for obligations longer than 9 years. The AFR (published monthly) will be the rate in effect for the month of the contract or (if lower) the rate in effect for either of the two preceding months. 13

14 $1,722,000 to be distributed according to the trust s terms to Li-Zhu s descendents. Assuming he outlives the fifteen-year term, Li-Zhu will have removed over $1,700,000 of appreciation from his estate. If he does not outlive the term, then the fair market value of the note (but not the property s actual value) would be included in his estate. 29 In many cases the IDIT will buy a life insurance policy on the grantor as part of the estate plan. Continuing the example above, the IDIT might spend $20,000 of its annual net cash flow on premiums for a $1,000,000 life insurance policy on Li- Zhu, paying premiums for the fifteen years of the installment period. 30 The expected value of the trust at the end of the term (after repayment of note principal) will be reduced to about $1,087,000, but the trust will have balanced this with the risk protection represented by the policy s $1,000,000 death benefit. The grantor trust status is key to the income tax consequences of the sale. The grantor does not recognize gain on the sale to the IDIT because of the income tax relationship between the grantor and the trust. 31 Nor does the grantor recognize income on interest paid by the trust each year, because the grantor and the IDIT are treated as the same person for income tax purposes. However, after the grantor s death, the trust will cease to be treated as a grantor trust for income tax purposes. Thus, any payment of interest by the trust to the grantor s estate as regarding the repayment of the loans will result in taxable income to the grantor s estate. 32 Advantages Over a GRAT A sale to a grantor trust serves the same estate planning function as a GRAT, namely to freeze the value of certain property in the estate, while transferring (at low gift tax cost) the property s appreciation over a given period. As a result, GRATs and IDIT sales should both be considered in a given situation. The IDIT sale compares favorably to a GRAT in a number of respects: interest rate available, GSTT sensitivity, and payment structure/timing. While GRATs and IDIT sales use similar present value formulae under 1274 to calculate their respective remainder values, the interest rates differ. GRATs require the use of the 7520 rate. As a result, the gift tax (remainder) element of the GRAT will be based (in part) on a rate equal to 120% of the midterm 1274 rate. In contrast, IDIT sales must use the applicable federal rate (AFR) shortterm, mid-term, or long-term as determined by the duration of the promissory 29 The note s value will depend in part on the then applicable present value rate. For example, if he dies at the beginning of the eleventh year, the amount included in his estate will be equal to (a) the then fair market present value of the remaining five payments of $45,800 plus (b) the then fair market present value of the $1,000,000 principal payment. In this case, the note s value would be $1,104,530 if the present value rate were 3%, but $927,951 if the present value rate is 5%. 30 Policy costs obviously depend on the specific situation, including age and insurability. This example assumes a fifteen-year premium obligation on a preferred risk male non-smoker age See e.g., PLR The grantor is still taxed on all income earned by the grantor trust, whether or not that income is paid to the grantor. 32 See Estates, Gifts and Trusts, BNA Portfolio st, Personal Life Insurance Trusts 14

15 note. 33 For IDIT sales, this produces a lower interest rate for short and mid-term loans (and often for long-term loans). These lower rate assumptions in turn increase the chances that the actual return on investment will exceed the AFR. 34 This is important since this excess passes to the trust beneficiaries free of gift and estate tax. GRATs are at a significant disadvantage regarding the generation-skipping transfer (GST) tax. If a person s estate plan calls for a GST sensitive trust, the sale to an IDIT will be preferable to a GRAT. Under 2642, donors are prohibited from allocating GST exemption during any so-called estate tax inclusion period (ETIP). If the grantor dies during the trust s term, some (or all) of the trust s value will be included in the grantor s estate. 35 The term of the GRAT is an example of an ETIP a period during which the grantor cannot allocate GST exemption because the property is still includible in the grantor s estate. Instead, the GST exemption must be allocated when the grantor dies, or when the GRAT reaches the end of its term. In short, the value for GST purposes cannot be frozen at the initial value as it can for gift tax purposes, but must be applied after the property has (presumably) grown in value. 36 Installment sales do not suffer from a similar GST allocation problem. The ETIP rule does not apply because the seller has not retained an interest in the IDIT, but only in the promissory note. As a result, the GST consequences of a sale can be settled initially, with allocation of GST exemption necessary only where the arrangement is part-gift/part sale. Installment arrangements permit a good deal of flexibility in structuring the payment of the note 37. For example, an agreement could call for (i) equal payments over time, (ii) equal payments of principal, or (iii) interest only payments with a balloon payment at termination. Where the property s return exceeds the AFR, delaying payments of principal will allow the IDIT to hold the principal property longer and thus, receive more of the property s return. In contrast, a GRAT may not be end-loaded to produce a payment that is more than 33 Please keep in mind that the calculations for GRATs and promissory notes include other adjustments not addressed here, such as frequency adjustments for quarterly or monthly payments and interpolations for end-of-year payments. 34 Although the long-term rate is not determined by direct ratio, examination of the rates over the past 8 years shows that the long-term rate generally exceeds the 7520 rate only when the mid-term rate moves below 4%. For example, in August 2008 the mid-term rate of 3.55% corresponded to a 7520 rate of 4.26% and a long-term rate of 4.58%. In other words, for August 2008 the 7520 rate was (as always) 120% of the mid-term rate while long-term rate was 129% of the mid-term rate. The January 2011 long-term rate of 3.88% the mid-term rate 1.95% the 7520 rate 2.4%. 35 For most zeroed-out GRATs, the value included in the grantor s estate under 2036 will be 100% of the GRAT s then current value (i.e., value at death or the alternate valuation date). The value may be less, however. The Regulations provide that the value to be included is that portion of the trust corpus necessary to provide the decedent's retained use or retained annuity, unitrust, or other payment (without reducing or invading principal) using the then current 7520 rate. See Regulations at (c). 36 Note that this GST allocation problem exists even when the gift tax value is zero, as with a zeroed-out GRAT. 37 With respect to an installment sale to an intentionally defective grantor trust, it is imperative to observe all formalities of the transaction in an arms length, businesslike fashion else the transaction may not be respected by the IRS. See Pierre v. Commissioner, T.C. Memo (May 13, 2010). 15

16 120% of the payment made during the prior year. 38 This limits the GRAT s ability to shift appreciation to the GRAT beneficiary. I. S Corporation Shareholder A grantor trust may hold S corporation shares without jeopardizing the S corporation s tax-free character as a small business corporation. 39 The ability to restrict access to shares through the use of a trust is a powerful tool for achieving long-term distribution objectives. Combined with the flow-through taxation permitted under 1361 to S corporations, a grantor may accomplish several goals using the grantor trust to own S corporation shares. A planning impediment exists for S corporation shareholders an S election will terminate automatically if shares pass to an ineligible shareholder (or are transferred to too many eligible ones). The general rule of 1361(b)(1)(B) states that only individual persons are eligible shareholders. Fortunately, the Code provides an exception for certain trusts, including an Electing Small Business Trusts (ESBT), a Qualified Subchapter S Trust (QSST) and grantor trusts. 40 Both QSSTs and ESBTs have substantial drawbacks. A QSST may hold S stock, but the trust s distributions may benefit only one person. That is, during the life of the income beneficiary, only the beneficiary may receive distributions of income or corpus. 41 The ESBT allows for more distribution flexibility for example, it may have more than one current beneficiary but at a cost. The ESBT s portion of S corporation income must be taxed to the trust at the highest marginal tax rate (39.6% in 2008). 42 The grantor trust suffers neither from the QSST s distribution limitations nor the undesirable tax treatment of the ESBT. Unlike the QSST, the grantor trust enables a grantor to design a trust that benefits more than one person during the trust s term. For example, it may allow the trustee to apportion income and/or principal to any number of current beneficiaries or to terminate the trust and distribute income and/or principal amongst a class of beneficiaries. Unlike the ESBT, the grantor trust s S corporation income will be charged to the grantor, 38 See Treas. Reg (b)(1)(ii). Compare 1274, which does not mandate a particular payment schedule for installment notes. It requires only that the note bear adequate stated interest (i.e., compounded over the note s term at the AFR). 39 See , generally. 40 See 1361(c)(2)(A). Certain other domestic trusts may also own S corporation stock. Subsection (A)(ii) allows former grantor trusts to own S stock for up to two years where the termination of grantor status was caused by the grantor s death. Similarly, subsection (A)(iii) allows an otherwise ineligible trust to hold S stock for up to two years if the stock was transferred to it pursuant to a will. The Code makes exceptions also for voting trusts and trusts operating as 501(c)(3) organizations. 41 See 1361(d)(3). This section mandates that the beneficiary be a person who is a resident or citizen, and that the beneficiary receive all the assets in the trust if the trust terminated during the beneficiary s life (c) outlines the taxation of an ESBT. Importantly, the trust does not receive an income tax deduction for distributions to beneficiaries. See also 1361(e), prohibiting certain types of beneficiaries and the acquisition of an interest in the trust by purchase. 16