USING BENEFICIARY GUARANTEES IN DEFECTIVE GRANTOR TRUSTS

Transcription

1 USING BENEFICIARY GUARANTEES IN DEFECTIVE GRANTOR TRUSTS

2 USING BENEFICIARY GUARANTEES IN DEFECTIVE GRANTOR TRUSTS* BY MILFORD B. HATCHER, JR. AND EDWARD M. MANIGAULT Providing a bona fide guarantee by the IDGT beneficiaries instead of old and cold funding by the grantor can have significant advantages without adding appreciably more risk to what is admittedly an already high-risk technique. For the appropriate client, the possible income, gift, estate, and generation-skipping tax savings usually will be worth the risk. The greatest uncertainty--the consequences if the grantor dies before the note from the trust is paid off--remains, regardless of whether the trust is funded or the beneficiaries guarantee the note. Much has been written about the use of an installment sale to an intentionally defective grantor trust (IDGT). Some commentators have criticized the technique, 1 but many more have praised the potential tax savings of the tool. 2 Even among those who choose to praise its use, there are authors who give differing opinions as to the tax effects of various aspects of the use of the IDGT. For example, if a grantor dies while an installment note is outstanding, is the note income in respect of a decedent (IRD), and what other tax consequences will result? 3 One of the often debated pieces in the structure of the IDGT is how much seed money the grantor trust should have as collateral to prevent the IRS from arguing that the grantor has retained an income interest in the assets sold to the IDGT (which would result in the assets being includable in the grantor s gross estate, and possibly also would trigger a taxable gift). The theories range from no collateral at * This article was originally published in The Journal of Taxation, v. 92 (March 2000), Milford B. Hatcher, Jr. and Edward M. Manigault. MILFORD B. HATCHER, JR., is a partner, and EDWARD M. MANIGAULT is an associate, resident in the Atlanta Office of the law firm of Jones, Day, Reavis & Pogue. The views set forth herein are the personal views of the authors and do not necessarily reflect those of Jones, Day, Reavis & Pogue. 1 Smith, A Sale to an Entity Trust Will Have Better Results Than a Sale to an Intentionally Defective Grantor Trust or a Transfer to a GRAT, 23 T.M. Est. Gifts & Tr. J. 86 (1998); Horowitz, Succession Planning for the Family Business Enterprise: Sales, GRATs and Donative Transfers--the Comparative Advantages, 74 Taxes 428 (1996). 2 Mulligan, Sale to a Defective Grantor Trust: An Alternative to a GRAT, 23 Est. Plan. 3 (January 1996); Mulligan, Sale to an Intentionally Defective Irrevocable Trust for a Balloon Note--An End Run Around Chapter 14?, 32 U. Miami Philip E. Heckerling Inst. on Est. Plan., Ch. 15 (1998) (hereafter Mulligan ); Hesch, Beyond the Basic Freeze: Further Uses of Deferred Payment Sales, 34 U. Miami Philip E. Heckerling Inst. on Est. Plan., Ch. 15 (2000) (chapter and page references correspond to the as-yet unpublished seminar materials); Mezzullo, Freezing Techniques: Installment Sales to Grantor Trusts, 14 Probate & Prop. 17 (2000) (hereafter Mezzullo ). 3 Compare Manning and Hesch, Deferred Payment Sales to Grantor Trusts, GRATs and Net Gifts: Income and Transfer Tax Elements, 24 T.M. Est., Gifts and Tr. J. 3, 27 (1999) (hereafter Manning and Hesch ), and Hesch, supra note 2, page 15-6, to Nicholson, Sale to a Grantor Controlled Trust: Better than a GRAT?, 37 T.M. Mem. 99 (1996) (hereafter Nicholson ) and Horowitz, supra note 1, page 430.

3 all being necessary 4 to the use of 20% or above as seed, 5 with a probable majority of writers settling on a 10% figure as being the minimum amount recommended to avoid estate tax inclusion. 6 Can the IDGT transaction be structured so that the beneficiaries of the trust personally guarantee the installment note as an alternative to a seed gift for the coverage amount? While this is not a totally new idea, 7 the issues have not been fully explored and much confusion remains. Will such a guarantee ever provide sufficient coverage? If so, how much of the purchase price should be guaranteed, and who should guarantee it? Will a guarantee result in a gift by the guarantors? If the guarantee does not provide sufficient coverage, will it cause the assets in the trust to be included in the grantor s estate? Will it risk special valuation of the transaction under Chapter 14, and thus a taxable gift by the grantor? Will the guarantee cause the IDGT to have a mixed inclusion ratio for generation-skipping transfer tax (GST) purposes? As will be seen from the discussion below, when properly structured a bona fide guarantee by the primary beneficiaries of the IDGT who have sufficient net worth to back up the guarantee should provide the same results as a comparable gift of old and cold assets into the IDGT to provide coverage for the installment note issued as part of the IDGT transaction. There should be no material negative transfer or income tax consequences to the grantor or guarantors. If additional safeguards are sought, a commercially reasonable guarantee fee, payable by the IDGT to the guarantors on an annual basis, should eliminate what is sure to be one of the most contentious of the enumerated questions whether the guarantee is a gift by the guarantors. SETTING THE TABLE The income, estate, gift, and generation-skipping tax implications to both the grantor and the guarantor are set out below and are based on the following hypothetical situation. Example: Mother (the grantor) decides to create an irrevocable intentionally defective grantor trust that is structured to last for the duration of the rule against perpetuities. She decides to sell limited partnership interests with an independently appraised value of $20 million to the trust in exchange for an installment note paying only interest for nine years, with a balloon payment at the end of the ninth year. The trust has only negligible assets, and the grantor does not wish to make a taxable gift to the trust for seed collateral (having previously used her applicable credit amount). Instead, the beneficiaries of the trust, the grantor s three moderately wealthy children, agree to provide coverage for the sale by personally guaranteeing in the aggregate 12% (or $2.4 million) of the purchase price payable by the trust. The note is secured by the limited partnership interests, as well as any other assets of the trust, and carries an interest rate equal to the midterm applicable federal rate (AFR) for the month of the sale, compounded semiannually. The guarantee by the beneficiaries is not joint but several, with each child guaranteeing $800,000. Each beneficiary s guarantee is made in exchange for a guarantee fee of 1.5% per annum of the $800,000 amount guaranteed by that child. TAX IMPLICATIONS FOR GUARANTORS The most significant issue for the IDGT beneficiaries making a guarantee would seem to involve the possibility of a taxable gift, although there are substantial estate tax, GST, and income tax questions as well. 4 Manning and Hesch, supra note 3, page 17; Hesch, supra note 2, pages to Manning and Hesch, supra note 3, page 17 ( Analogy to the corporate thin-capitalization cases suggests that perhaps a more conservative 120% [of principal of the deferred payment note] is wise ); Nicholson, supra note 3 ( The risk of a failed IDIT [IDGT] may be reduced, or perhaps eliminated, if the grantor funds the trust with significant assets in addition to those transferred in the sale... ). 6 Mulligan, supra note 2, , ; Wallace, Installment Sales to Irrevocable Grantor Trusts: Better than a GRAT?, 34 So. Fed. Tax Inst. X-10 (1999) (hereafter Wallace ); Abbin, [S]He Loves Me, [S]He Loves Me Not--Responding to Succession Planning Needs Through a Three-Dimensional Analysis of Considerations to be Applied in Selection From the Cafeteria of Techniques, 31 U. Miami Philip E. Heckerling Inst. on Est. Plan., (1997) (hereafter Abbin ). 7 Mulligan, supra note 2, , ; Shore and McClung, Beyond the Basic Superfreeze--An Update and Additional Planning Opportunities, 75 Taxes 41, 44 (1997). 2

4 Guarantors Gift Taxes It is possible that the IRS could argue that any guarantee by the beneficiaries of the trust would be gifts from the beneficiaries to the trust, as the Service has asserted in the past. Of particular concern is Ltr. Rul In this ruling, a father guaranteed debts of corporations in which his children were shareholders. The IRS found that these guarantees were gifts to those children, citing an example under Reg (h)(1) for the proposition that a transfer to a corporation is a gift from the donor to the corporation s shareholders. The Service could argue, at least in the absence of the guarantee fees, that the guarantee by the beneficiaries would effectively be the gratuitous use of the beneficiaries credit for the benefit of the trust. If such an argument by the IRS were successful, it would clearly cause gift tax problems for the beneficiaries, as well as possible estate, generation-skipping, and income tax problems. In all probability, if any of the guarantees is a gift, it would be a future interest gift that would not be offset by the annual exclusion, at least in the absence of withdrawal rights and notice, and thus would be a taxable gift to the full extent of the value of the guarantee (see Section 2503(b)). The timing and amount of the gift, if any, is unclear. Probably the closest commercial analogy is a bank s charge for a letter of credit. Generally, the bank makes an annual or more frequent charge for such a letter. By analogy, there would be an annual gift, probably in the range of 1% 2% of the amount guaranteed, so long as the guarantee is outstanding. It also could be argued, however, that a much larger, one-time taxable gift would occur at the inception of the guarantee, especially if the loan precludes prepayment. 9 The final possibility is that no gift would occur until the beneficiary actually has to make a payment under the guarantee. In this event, the measure of the gift presumably would be the amount of the payment. 10 It is by no means a given that a guarantee by a beneficiary is a gift. Instead, the clear weight of authority seems to support the absence of any gift by the beneficiaries to the trust, at least where the guarantee is a bona fide obligation of the beneficiary making the guarantee and where the beneficiary has sufficient net worth to make good on the guarantee in the event of a default by the trust. Life insurance trusts. A line of cases dealing with the payment of insurance premiums by beneficiaries of insurance trusts provides, by analogy, a persuasive argument that the guarantee should not be a gift by the beneficiaries if they are the primary beneficiaries under the trust. In Seligmann, 9 TC 191 (1947), acq., the wife was a lifetime beneficiary of an insurance trust set up by her husband, with remainder interests to go to their children. The payments of the life insurance premiums by the wife were found not to be gifts because they were made, in effect, to herself because of her interest as beneficiary of the trust. Similarly, in Pleet, 17 TC 77 (1951), acq., payments of insurance premiums by a son for a trust-owned policy that insured his father s life were not gifts, despite the fact that the son s brother, as well as the son, had a present interest in the trust. In Berger, TCM 1/1/51, 1951 WL 9024, rev d in part 201 F.2d 171, 43 AFTR 144 (CA-2, 1953), the Tax Court held that payments of insurance premiums by one beneficiary of a trust that had multiple beneficiaries were not gifts. Nevertheless, on appeal the Second Circuit held that to the extent that one beneficiary paid premiums for the benefit of the other beneficiaries, such payments were gifts. 11 A gift occurred, in the opinion of the Second Circuit, when a beneficiary made a premium payment in excess of the amount required to secure protection of that beneficiary s interest in trust. Reaffirming its prior acquiescences, and relying on Seligmann and Berger, the IRS itself concurred, in Ltr. Rul , that payments of insurance premiums on a policy held in trust by the beneficiaries of such trust were not gifts. If the beneficiaries of a trust can pay for the premiums on the life insurance policies held in trust for their benefit without being deemed to have made gifts to the trust, they should be able to provide guarantees of an obligation of the trust that benefits them without being deemed to have made gifts to the trust. The only limitation seems to be that the beneficiaries guarantees should not exceed their respective interests in the trust. This apparently does not mean that the 8 IRS withdrew Ltr. Rul in Ltr. Rul without any comment as to the gift tax provisions of the previous ruling. See generally August, IRS Reverses Prior Ruling on the Impact of Guarantees on the Marital Deduction, 80 JTAX 324 (June 1994). 9 See Rev. Rul , CB See Bradford, 34 TC 1059 (1960). 11 The Second Circuit also found fault with the decisions in Seligmann, 9 TC 191 (1947), and Pleet, 17 TC 77 (1951), to the extent that they relied on the absence of donative intent for their holdings that no gifts were made, as donative intent had not been an element of a gift since Wemyss, 324 U.S. 303, 33 AFTR 504 (1945). A principal ground for the Berger holding was that the eventual estate taxes of the beneficiary making the premium payments would be reduced by the amount of those premium payments. In contrast, where a beneficiary makes a guarantee, there is no such reduction in the beneficiary s estate taxes--at least in the absence of a default by an insolvent debtor. 3

5 beneficiaries guarantees should be in proportion to their actuarial interests in the trust. Instead, if a beneficiary entering into a guarantee is one of several current beneficiaries of the trust generally, he or she would have an interest in the entire trust, and no gift should result. In contrast, if the trust provides for separate shares and the beneficiary has an interest in only one of those shares, the beneficiary s guarantee may very well constitute a gift, at least in the absence of the guarantee fee, to the extent that the guarantee benefits separate shares in which the beneficiary has no interest. Guarantee precedents. The cases involving the payment of premiums by beneficiaries of life insurance trusts are not the only tax precedents supporting the absence of any gift by an IDGT beneficiary making a bona fide guarantee. There are income tax precedents, estate tax precedents, and even one possible gift tax precedent. Income tax cases. Over the years, the IRS has often attempted to disallow bad debt deductions for income tax purposes by contending that the guarantees and payments under the guarantees were gifts. In Pierce, 41 BTA 1261 (1940), a father guaranteed his son s debts. The Board of Tax Appeals held that the guarantee, and the subsequent payment under the guarantee, was not a gift for several reasons. First, the son was solvent at the time of the original guarantee. Second, the father expected the son s collateral to increase in value, thus enabling repayment of the guaranteed debt. Third, the father s guarantee was made in part to protect the price of the son s securities held as collateral. The issuers of two of those securities were companies in which the father was an officer and material shareholder. Although such enlightened self-interest was not determinative, it was viewed as evidence countering the Service s gift argument. Pierce is not an isolated case. Other income tax decisions upholding a bad debt deduction and rejecting the Service s gift argument include Ortiz, 42 BTA 173 (1940), where a wife s guarantee of her husband s accounts was not a gift because of her expectation of repayment and her right of reimbursement for any payment; Fox, 14 TC 1160 (1950), rev d on other grounds 190 F.2d 101, 40 AFTR 953 (CA-2, 1951), where again a wife s guarantee of her husband s margin loan was not a gift because it was made with an expectation that any payment under the guarantee would be repaid; and Shiman, 60 F.2d 65, 11 AFTR 700 (CA-2, 1932), where Learned Hand found that the guarantee of a brother-in-law s accounts was not a gift, as the guarantor expected repayment from his brother-in-law who was solvent at the time of the guarantee. A bad debt deduction has been disallowed, however, on a showing that the guarantee was not bona fide. In Cogan, TCM , a mother s guarantee of her son s debt was found to be a gift, as she made the guarantee without his knowledge and the court did not believe that she intended to enforce collection... against her son who was the sole support of his wife and three young children. A subsequent failure by the parties to enforce the terms of a guarantee, including the guarantor s rights of subrogation following a default and a payment under the guarantee, has been held to be decisive in finding that a payment under a guarantee was a gift. For example, in Estate of Davidson, 26 BTA 754 (1932), a father s pledge of securities for his son s benefit was found to be a gift, as the subsequent obligation was not treated as a debt of the son and there was no finding of an agreement for the securities to be returned. Therefore, by analogy under the line of income tax cases dealing with bad debt deductions, the guarantee by the beneficiaries should not be a gift as long as (1) the trust is solvent at the time of the guarantee, (2) there is a reasonable expectation by the beneficiaries that the assets in the trust will grow sufficiently to cover the guaranteed indebtedness, and (3) the guarantee is a bona fide obligation of the guarantor that is not only legally enforceable but also is likely to be enforced if the trust defaults (or at least there is no understanding between the grantor and the beneficiaries that the guarantee will not be enforced in the event of a default by the trust). Estate tax cases. Similarly, a guarantor s obligations have served as a basis for estate tax deductions, notwithstanding the fact that the guarantor was related to the debtor. In Estate of Scofield, TCM , a decedent s estate was allowed a deduction under Section 2053(a)(4) for the lien on his estate due to his guarantee of the bank loans of his son, despite the argument by the IRS that the guarantee was a gift or testamentary disposition by reason of the failure of the decedent to receive full consideration in exchange for making the guarantee. The Tax Court found for the taxpayer and allowed the deduction because the arrangements were commercially reasonable and there was no evidence of a hidden agenda for gifts, even though the decedent did not receive any consideration for the guarantee. 12 In Porter, 92 F.2d 426, 20 AFTR 265 (CA-2, 1937), a guarantee for a son-in-law was not a gift, as the son-in-law initially had collateral in excess of the debt and the guarantee was an ordinary business transaction by which an accommodation guarantor, if required to pay, would acquire 12 Two aspects of Estate of Scofield, TCM , are notable. First, the IRS only raised the gift argument at trial, and therefore had the burden of proof. Second, this holding was questioned in Estate of Theis, 81 TC 741 (1983), at least to the extent that Scofield allowed the deduction under Section 2053(a)(4) for a debt, as it was only potentially payable by the guarantor. 4

6 rights equal in value to the obligations assumed. In Carney v. Benz, 90 F.2d 747, 19 AFTR 915 (CA-1, 1937), a husband s guarantee of a brokerage account of a corporation that was owned by his wife and daughter was not a gift because he did not expect to lose any funds and he had a right of recourse against the corporation. 13 Estate of Borland, 38 BTA 598 (1938), involved a pledge to cover a cousin s margin account. This was found not to be a gift, as the estate of the guarantor acquired substantial rights by subrogation. In Estate of Hofford, 4 TC 542 (1945), the decedent endorsed a note for the benefit of a veterans association. The resulting payment by the estate was allowed as a deduction. Again, however, it must be emphasized that payments under a guarantee that was not bona fide when made have been effectively held to be a gift, or at least not deductible as a claim against the estate for estate tax purposes. In Estate of Jermyn, BTA Memo., 4/2/40, 1940 WL 9978, payments from the estate of a father due to his endorsement of his son s debts were held not deductible. The endorsement was not an ordinary business transaction because the father had no expectation of repayment due to the son being hopelessly insolvent. In addition, Section 2053(c)(1)(A) requires that in order for a claim against the estate or unpaid mortgage to be deductible for estate tax purposes, the agreement on which the claim is founded must be bona fide and for an adequate and full consideration in money or money s worth. Based on the analogy to these estate tax deduction cases, the guarantee by the IDGT beneficiaries should not be considered a gift as long as the guarantee is bona fide and repayment is reasonably expected. This is a standard similar to the one used to determine whether bad debt deductions should be allowed for income tax purposes. So long as the total returns for the trust s assets are reasonably expected to be more than sufficient, by the end of the note term, to repay the loan in full, and so long as there is no evidence that the parties do not expect or intend for the beneficiaries to honor their guarantee in the event of a default by the trust, the guarantee should be bona fide and should not cause taxable gifts to be deemed to have occurred. Gift tax. Finally, there is one gift tax case that may, in some circumstances, support the argument that a guarantee does not result in a taxable gift. In Bradford, 34 TC 1059 (1960), the Tax Court held that, for at least three reasons, a wife s substitution of her promissory notes for those of her husband owed to a bank was not a gift. First, there was no evidence of donative intent, although the Tax Court acknowledged that such a finding was no longer a necessary element for a gift under Wemyss, 324 U.S. 303, 33 AFTR 504 (1945). Second, the Tax Court found that the creditor, the wife, and the husband never contemplated that the guarantee would be enforced, in part due to the circumstances surrounding the arrangement of the substitution of the notes by the husband and the bank, and in part due to the fact that the wife s net worth was only about 30% of the amount of debt she took over on her husband s behalf. Third, the Tax Court held that the guarantee was only a promise to pay in the future if called upon to do so, which it held was not a property interest capable of being transferred. This third holding is probably the most significant aspect of Bradford. It provides authority that if the guarantor makes a gift, that gift may not be deemed to occur until a default occurs and the guarantor has to make a payment under the guarantee. In contrast, Rev. Rul , CB 191, seems to indicate that the gift would occur on the execution of the guarantee. Otherwise, reliance on Bradford probably would be ill-advised. A guarantee that is not bona fide may not trigger a taxable gift by the guarantor for gift tax purposes, but such a sham guarantee would not provide the at-least- 10% credit enhancement or seed money that is generally felt to be necessary to enable the grantor to escape adverse estate and gift tax consequences in an IDGT transaction. Form over substance. Presumably an AFR loan by the grantor to the beneficiaries, followed by a mirror-image loan by the beneficiaries to the trust, would not result in a taxable gift by the grantor or the beneficiaries. For the IRS to argue that a taxable gift results from the beneficiaries guarantee of the loan made directly by the grantor to the trust elevates form over substance. In Putnam, 352 U.S. 82, 50 AFTR 502 (1956), which dealt with the income tax consequences of a guaranteed corporate loan, the Supreme Court stated: There is no real or economic difference between the loss of an investment made in the form of a direct loan to a corporation and one made indirectly in the form of a guaranteed bank loan. The tax consequences should in all reason be the same... The same should hold true in the gift tax area. There should be no difference, at least to the beneficiaries, between the gift tax consequences of back-to-back loans and the gift tax consequences of a guaranteed loan. Full and adequate consideration. As noted above, a transfer is not a taxable gift if it is for full and adequate consideration in money or money s worth. In this regard, the context of the guarantee needs to be considered. The only logical reason for the beneficiaries to enter into a bona fide guarantee is the reasonable expectation that the resulting beneficial interests under the trust will in all likelihood more than offset the risks inherent in the guarantee. Admittedly, tax consequences do not have to be logical. This is one instance, however, in which logic and legal precedents seem to coincide at least in the absence of evidence that the 13 But see Ltr. Rul , discussed in the text accompanying note 8, supra, for an opposite holding by the IRS on similar facts. 5

7 guarantee is not bona fide (especially because the parties do not intend for it to be honored or the beneficiaries do not have sufficient assets to honor the guarantee). Although the authors recognize that donative intent is not the test of a taxable gift, the overriding motivation of the beneficiaries, in the authors experience, ranges from enlightened self-interest with the emphasis on selfinterest to good old-fashioned greed and avarice. The beneficiaries realize the very real risks posed by their guarantees. Nonetheless, a reasonable expectation by the beneficiaries that they are likely to get more than they give up (especially, because of the note s favorable AFR interest) should generally make a fairly compelling argument that the guarantee is entered into for full and adequate consideration in money or money s worth. That was the effective rationale for the courts finding, and the Service s concurring through acquiescences, that the payments of premiums by life insurance trust beneficiaries were not taxable gifts, even though those beneficiaries made actual transfers to the respective trusts. A bona fide promise by the IDGT beneficiaries to make a transfer only in the event of unexpected, but possible, adverse events seems to be even less susceptible to a gift argument. Gifts have not been found in what would appear to be much weaker contexts the cases discussed above in connection with either the bad debt deduction for income tax purposes or claims against the estate under Section 2053 for estate tax purposes. Many, if not most, of those cases involved one family member s guarantee of another family member s loan. The guarantor did not benefit except to the extent that he or she would have rights of subrogation or other rights to be repaid the amounts paid under the guarantee in the event of the debtor s default. If such potential rights of subrogation or similar rights to repayment were deemed to be sufficient to negate a gift finding, enlightened selfinterest should be much more persuasive. 14 Detached and disinterested generosity, the income tax standard for a gift, 15 is clearly not the basis for the beneficiaries willingness to execute guarantees. Guarantors Estate Taxes If the guarantee is not a gift for gift tax purposes, presumably none of the trust assets should be includable in the gross estates of the beneficiaries, assuming that the assets otherwise would not be so includable due to a general power of appointment under the trust. Buttressing the non-inclusion of any portion of the trust in the gross estate of a beneficiary for estate tax purposes is Goodnow, 302 F.2d 516, 9 AFTR2d 1947 (Ct. Cl., 1962), another case involving the payment of premiums on a trustowned policy by a life insurance trust beneficiary. The Service argued that the beneficiary made a transfer with a retained income interest, causing inclusion under Section 2036(a)(1), but the IRS lost again. Instead, the Court of Claims found that the beneficiary did not retain an interest in the funds she transferred, for her life estate in the trust was granted by the express terms of the trust established by her husband, not by her retention of such interest. Furthermore, even if the beneficiary had retained an interest in the property that she transferred, the premium payments were not the same property as the policy proceeds, the property in which she had an interest. Guarantors GST Similarly, without any gift by the beneficiaries, there should not be any generation-skipping transfer by the beneficiaries (see Reg ). If, however, the IRS successfully argues that a gift was made by reason of the beneficiaries guarantees, the beneficiaries would be treated as the transferors for GST purposes. Administration of a non-gst exempt trust, or partially non-gst exempt trust, with multiple transferors would be a true challenge. Guarantors Income Taxes As with transfer taxes, the absence of a gift should result in no adverse income tax results to the beneficiaries. If, however, the Service successfully argues that the guarantees amount to gifts by the beneficiaries for income tax purposes, the beneficiaries might be considered to be the grantors of the trust, at least with respect to the proportionate value of property deemed to be contributed to the trust by them. In that event, the beneficiaries would be taxed on a proportionate part of the taxable income of the trust under Subchapter J. While such potential income tax liability likely would be material to the beneficiaries, the real income tax downside would be the grantor s risk that in-kind transfers to and from the trust could be taxable in part and that interest payable to the grantor by the trust could be taxable in part as interest income. Indeed, the risks associated with the use of the guarantee are generally much more material with respect to the grantor than the beneficiaries, even though since the issuance of Ltr. Rul the focus seems to have been inordinately on the potential taxable gift by the guarantors. 14 See Pierce, 41 BTA 1261 (1940), discussed in the text above. 15 See Section 102 and Duberstein, 363 U.S. 278, 5 AFTR2d 1626 (1960). 6

8 TAX IMPLICATIONS FOR THE GRANTOR As stated previously, the guarantee should not result in any materially different tax risks than when the grantor uses an old and cold gift as seed money for the trust. Nevertheless, those risks are by no means inconsequential, for the downside in a worst case scenario could be a taxable gift by the grantor of the entire value of the property transferred to the trust, inclusion of the full value of the trust property in the grantor s gross estate, or both. Grantor s Gift Taxes There are always two valuation risks with respect to the IDGT strategy, whether seed money or guarantees are used. First, if the consideration that the grantor receives in the exchange is less than the value of the assets sold to the trust, the grantor will be deemed to have made a taxable gift of the excess to the trust. Depending on the amount of the undervaluation and the remaining amounts of the grantor s applicable credit, that taxable gift may trigger an out-ofpocket gift tax liability. Far worse, the gift could result in the assets in the trust being includable in the grantor s gross estate at their date of death (or alternate valuation date) values, including any appreciation after the initial transfer of the assets to the trust. This potential estate tax downside risk of a bargain sale will be discussed in greater detail below. The second valuation risk inherent in the IDGT strategy relates to the value of the note. If the note itself is not valued at its face amount, the grantor would not have received full and adequate consideration in exchange for the fairly valued assets sold to the trust and would be deemed to have made a gift of the difference between the note s actual value and the value of the assets sold. As a starting point, to avoid characterization as a gift loan under Section 7872, the note must have an interest rate at least equal to the appropriate AFR in effect at the time of the sale. If the note bears interest at the appropriate AFR and is determined to be debt and not equity, it should be valued at face value and be full consideration. 16 The statutorily sanctioned use of the AFRs as the standard for measuring a fair interest rate for gift tax purposes is extremely generous in its own right. The AFRs are based on the credit-worthiness of the U.S. government. Much less credit-worthy purchasers, such as the trust, are effectively allowed to piggyback the federal government s credit rating and pay much lower rates of interest than otherwise would be required to avoid a gift. The ability to use such favorable interest rates is one of the major advantages of the IDGT, if not the primary one. Inclusion of the appropriate AFR in the note is not necessarily a panacea. Although the IRS has issued favorable rulings in regard to IDGTs, it has expressly included caveats if the promissory notes are determined to be equity and not debt. 17 By negative implication, the downside risks of the note s being characterized as equity, and not debt, are as follows: The extremely favorable Section 7872 AFRs would not be available for purposes of determining the value of the note. The trust effectively could be treated for gift tax purposes as a preferred partnership subject to Section 2701, with the note representing a preferred partnership interest. The good news is that interest payments under the note should be qualified payments if they are payable at least annually 18 and that a fixed maturity date should be taken into account for valuation purposes under Section The bad news is that the AFR would be materially below the preferred rate that would be required to avoid a very substantial gift. The worst-case scenario would occur if the note does not call for annual or more frequent payments but instead defers all interest payments. In that event, the grantor probably would be treated as having made a taxable gift equal to a substantial portion, if not all, of the value of the property transferred to the trust. 20 The note could be regarded as a retained interest with respect to the transfer of an interest in trust, causing the retained interest to be valued under the special valuation rules of Section If the note provides for equal annual (or more frequent) installments of principal and interest over a specific term, the payments may be a qualified interest with a present value for gift tax purposes based on 120% of the mid-term AFR at the time of the 16 See Frazee, 98 TC 554 (1992), and Ltr. Rul See, e.g., Ltr. Rul See Sections 2701(a)(3)(A) and (c)(3) and Reg (b)(6). 19 See Section 2701(c)(2)(B)(i). 20 See note 18, supra. See also Section 2701(c)(2)(B)(i), which may permit the present value of the payment at the maturity of the note to be taken into account to reduce the amount of the taxable gift, but only to the extent that a specific amount is payable as of a specific date. 7

9 transfer. 21 There would be some taxable gift. The amount of that gift, although likely to be material, should not be too great, however, for it would be based primarily on the lesser present value resulting from the required use of 120% of the mid-term AFR as opposed to the present value determined by using the more favorable AFR incorporated in the note. In contrast, providing for annual or more frequent payments of interest only over the term of the note, with a balloon payment of principal as of the maturity date, would cause a gift tax fiasco. The entire value of the property transferred to the trust would be a taxable gift. Since the final payment would be more than 20% greater than the immediately preceding payment, none of the debt service would be a qualified interest, 22 and the entire note would be deemed to have a zero value under Section If no old and cold gift of seed money is made to the trust, or if the beneficiaries do not execute a guarantee, it is extremely difficult to escape the conclusion that Section 2702 should control, for how can a note from a totally leveraged trust with no other source of funds be substantively distinguished from a GRAT, and probably a defective GRAT treated for gift tax purposes as having a zero value? If any material old and cold gift of seed money or a guarantee is furnished, Section 2701 would seem to be the more likely downside risk, although the matter is not free from doubt. 24 The issue then becomes the amount of the old and cold gift of seed money or guarantee required to avoid characterization of the note as equity, and not debt. The determination of whether an instrument should be treated as debt or equity is inherently factual. Courts have stressed any number of factors, including the presence of a maturity date, the source and enforcement of payments, and the debtto-equity ratio. 25 In an effort to cut down on the uncertainty caused by confusing and often apparently inconsistent decisions, Congress finally enacted Section 385. That statute, which by its terms is limited to the income tax treatment of corporate debt, authorizes the IRS to issue debt-equity Regulations and directs that the factors to be taken into account should include (1) whether there is an unconditional promise to repay a specific amount on demand or on a specific date, and to pay a fixed rate of interest, (2) whether the indebtedness is subordinated, (3) whether the debt-toequity ratio is inordinately high, (4) whether the indebtedness is convertible into an equity interest, and (5) whether the loans are made by the equity holders, especially if the debt and equity holdings are in the same proportion. Section 385 was effective on 12/31/69, more than 30 years ago, and the IRS still has not issued final Regulations. On several occasions the Service issued Regulations and then withdrew them when confronted by strong congressional opposition. 26 Almost 17 years have now passed without effective IRS guidance obviously, trying to determine in a close case whether an instrument is debt or equity is, at best, an unpredictable Delphic exercise. On its face, the note clearly would appear to be debt. It calls for payment of a fixed principal amount, plus interest based on a fixed rate, on specific dates. Generally, the grantor will be given a first priority security interest in all of the trust assets (although the note might allow for superior security interests for debts incurred to third parties that are used to pay the principal on the note), and the guarantee also may be collateralized. The note typically represents the grantor s only interest in the trust. The two potentially troublesome issues are the debt-to-equity ratio and possibly the convertibility of the note. Debt to equity. The primary focus in a debt-equity analysis is almost inevitably the ratio of debt to equity. At some point, capitalization can be so thin that it has more of the attributes of risk capital than legitimate debt. There is no hard and fast rule for how thin is too thin. A debt-toequity ratio of 700:1 27 has not precluded both a trial court and an appellate court from finding that the instrument in question was properly characterized as debt, but this case probably represents the outer limits of permissible debt-toequity ratios and should not be used for planning purposes. 21 See Sections 2702(a)(2)(B) and See Reg (b)(1). 23 See Section 2702(a)(2)(A). 24 These conclusions are based on the Section 7701 entity characterization Regulations. A joint enterprise among associates is more likely to be classified as a partnership, whereas the absence of associates in a joint enterprise for the conduct of a business for profit would indicate that the entity is more likely to be classified as a trust. Reg (a). 25 See Harllee, 536-2nd T.M., Interest Expense Deductions, page A TD 7747, CB 141, TD 7801, CB 60, TD 7822, CB 84, and TD 7920, CB See Baker Commodities, Inc., 48 TC 374 (1967), aff d 415 F.2d 519, 24 AFTR2d (CA-9, 1969), cert. den. 8

10 Several commentators, some citing discussions with the IRS, suggest an initial seed gift of at least 10% of the purchase price. 28 Such a 10% seed gift corresponds to a debt-to-equity ratio of 10:1. The basis for this suggested 10:1 or lower debt-to-equity ratio is apparently the analogy to the 10% minimum value rule of Section 2701(a)(4) to avoid a taxable gift, the value of the nonpreferred junior equity interests must be at least 10% of the sum of the value of all equity interests plus the total indebtedness of the entity to the transferor and other family members. If, however, the 10% seed funding is based on Section 2701(a)(4), the actual seed gift should be 11% of the initial IDGT note principal, that is, 10% of the total assets transferred to the trust counting the seed gift itself. 29 For example, if the grantor transfers $11 to the trust as seed money and later sells an asset worth $100 to the trust for a $100 promissory note from the trust, the seed amount would be worth approximately 10% of the total transfers to the trust (the $11 seed plus the $100 of assets sold). If the seed gift is 11% of the IDGT note principal, that is the equivalent of a 9:1 debt-to-equity ratio. Thus, the debt-to-equity ratio should be 9:1 or lower. 30 Although a 9:1 or lower debt-to-equity ratio has not publicly been sanctioned as a safe harbor by the IRS, this would appear to be a reasonable guideline that has considerable judicial support in addition to being analogous to Section 2701(a)(4). More conservative persons may wish to lower the debt-to-equity ratio, but that would not appear to be necessary if the only significant cause for concern is thin capitalization. As a practical matter, a bona fide 11% or higher guarantee 31 from a person who has the net worth to back it up should be the equivalent of, and may be preferable to, an old and cold infusion of at least 10% seed money. 32 Would the grantor prefer to have a security interest in a trust holding marketable securities where the note initially has an outstanding balance equaling 90% of the trust s total asset value and where a stock market correction or similar decline in value could wipe out this 10% net value, or would the grantor prefer the credit enhancement to be in the form of a guarantee from the beneficiaries who, at the time of the IDGT transfer, have sufficient net worth to make any payments that they may be obligated to make under the guarantee if the trust s assets fall short? There should be no real difference from a tax perspective, as the IRS has effectively recognized in at least one Chapter 14 private letter ruling. 33 Convertibility. The other Section 385 factor that may come into play is convertibility. At first blush, this factor would seem either inapplicable or weighted in favor of debt, as the note is not convertible on its face. How could a promissory note in the IDGT context ever be convertible? Some promissory notes might expressly provide for satisfaction of principal and interest payments by payment in-kind. At the extreme, if the creditor has the right to demand payment in-kind, the instrument looks more like an equity interest, either in the assets of the trust or in the trust itself. If the trust has the right to pay in-kind only at its option, there is less of an equity flavor. At the other end of the spectrum, if the note does not provide for in-kind payments, but the grantor subsequently acquiesces to such in-kind payments in lieu of cash, there should be no problem with the note being considered convertible. Not atypically, the grantor will retain the right to substitute assets with equivalent value for assets held by the trust in order to make the trust a grantor trust for income tax purposes under Section 675(4)(C). The extent to which such a right of substitution may be regarded as a possible backdoor conversion right is unclear. Even if it is, the existence of a conversion right would not be determinative but simply one factor evidencing equity characteristics. If all other factors indicate debt, the note should be classified as debt. 28 Mulligan, supra note 3, at , citing Abbin, supra note 6, at Constant values are being assumed. Actually, the value of the property traceable to the seed gift, determined as of the date of the IDGT transfer, should be at least 11% of the IDGT note principal. Therefore, past-gift fluctuations in value with respect to the seed gift should be taken into account. 30 The exact seed amount to comport with the Section 2701(a)(4) analogy would be approximately 11.1%, calculated as [seed (100 + seed) = 10%]. 31 All references to an 11% guarantee represent a rounding down of the actual 11.1% number, which in turn represents the amount of the guarantee expressed as a percentage of the initial IDGT note principal. See note 30, supra. It may be appropriate to round up to 12%, thus providing a slightly greater margin of error as well as comporting with the Section 2704(a)(4) analogy. 32 Unless the context requires a different construction, all references to 10% seed money or a 10% seed gift will mean that the value of the property traceable to the old and cold gift represents 10% of the value of all assets held by the trust immediately after the IDGT transfer, including both the assets sold to the trust for the IDGT note as well as the assets traceable to the old and cold gift. 33 See Ltr. Rul , which effectively held that a financially well-situated trust beneficiary s guarantee to issue personal notes in the event that the trust was unable to meet the required qualified interest payments satisfied the requirements of Section 2702, thus avoiding a taxable gift by the grantor. 9

11 Other issues. Beyond the statutory factors referred to in Section 385, other issues might affect the debt/equity tests. Most important, if the grantor does not enforce the debt, the IRS is likely to view it as equity. Indeed, if the grantor gives the beneficiaries reason to believe that they would never be called on to honor their guarantee, such guarantee very well may not be regarded as bona fide and may be ignored. Grantor s Estate Taxes The primary estate tax risk is that because of the thin capitalization, the grantor may be regarded as having retained an income interest in the trust within the meaning of Section 2036(a)(1). An adverse finding would be the client s (and the estate planner s, if adequate risk discussions have not taken place) worst nightmare: The entire value of the trust s assets could be includable in the grantor s gross estate. Again, the initial question is how thin is too thin. Fidelity- Philadelphia Trust Co. v. Smith, 356 U.S. 274, 1 AFTR2d 2151 (1958), and Rev. Rul , CB 273, offer the following three tests, all of which must be satisfied in bootstrap sale situations to escape inclusion under Section 2036(a)(1): The size of the payments to the seller should not be based on the actual income of the assets sold to the trust. The assets sold should not be the sole source of the debt repayment. The liability incurred should be a personal obligation of transferee/purchaser. There is substantial favorable authority, especially in the private annuity area, that, based on the facts in the particular case, Section 2036(a)(1) does not apply in bootstrap sale situations. 34 Applying the Fidelity-Philadelphia Trust Co. three-part test to the note and trust, and relying on the other bootstrap sale cases and the Section 2701(a)(4) analogy cited above, the use of an old and cold gift to provide at least 10% seed money should satisfy these tests by providing a source of funding above and beyond the assets sold. This assumes that the note provides for full recourse against the assets of the trust, including the assets traceable to the old and cold gifts as well as those traceable to the sale. 35 A guarantee of at least 11% of the initial IDGT note principal, or possibly the highest projected balance due under the note if interest is deferred, also should suffice. In Estate of Fabric, 83 TC 932 (1984), an individual transferred to a Cayman Islands trust stock with an FMV exactly equal to the present value of a private annuity, as determined under applicable Regulations. Under Cayman Islands law, the trustee bank was liable for making any annuity payments if the trust assets were depleted. Effectively, the trustee bank was a guarantor of the private annuity. This extra source of funding was held to be sufficient to avoid inclusion of the trust assets in the seller s gross estate under Section 2036(a)(1). Similarly, citing Rev. Rul , the IRS concluded in Ltr. Rul that the guarantee of a child who had sufficient personal wealth to satisfy her potential personal liability under her guarantee provided the additional source of funding needed to avoid inclusion under Section 2036(a)(1). Under any circumstances, however, Section 2036(a)(1) expressly excepts a bona fide sale for an adequate and full consideration in money or money s worth. Therefore, under its literal terms that statute should not apply to a bona fide sale for full and adequate consideration. The Service has made it clear that a too-thinly capitalized sale may be regarded as a capital contribution, not as a bona fide sale. That is a major reason for the caveat in Ltr. Rul , the Service s generally favorable IDGT ruling, that states the ruling would be void if the promissory notes were subsequently determined to be equity, as opposed to debt. A bargain sale to the trust would clearly heighten the estate tax risk, for the Section 2036(a)(1) exception for a bona fide sale for full and adequate consideration would not apply. Ltr. Rul involved a sale/gift, with the bargain sale price representing only 30% of the FMV of the property transferred. The transaction was held to be a transfer with a retained income interest includable in the seller s gross estate under Section 2036(a)(1), for reasons that are almost impossible to fathom. To minimize the risk of a similar bargain sale argument, it is advisable to make any gift of seed money as far in advance of the IDGT transfer as is reasonably possible so that the prior gift will be regarded as old and cold and thus separate and distinct from the IDGT transfer. A reasonable lapse of time between a gift of seed money and the IDGT transfer would not eliminate the bargain sale risk, however. If the property sold to the trust in the IDGT transfer is undervalued, a bargain sale would occur, and the potential for Section 2036(a)(1) to apply would increase appreciably. This risk of an unintended bargain sale, 34 See Cain, 37 TC 185 (1961), acq.; Estate of Bergan, 1 TC 543 (1943), acq.; Estate of Becklenberg, 273 F.2d. 297, 5 AFTR2d 1821 (CA-7, 1959); Lazarus, 513 F.2d 824, 35 AFTR2d (CA-9, 1975); LaFargue, 689 F.2d 845, 50 AFTR2d (CA-9, 1982); Stern, 747 F.2d 555, 54 AFTR2d (CA-9, 1984); and Estate of Fabric, 83 TC 932 (1984). See also Rev. Rul , CB 273, which involved 80% seller financing. But see Ray, 762 F.2d 1361, 56 AFTR2d (CA-9, 1985). 35 See Rev. Rul , supra note