How To Use an Intentionally Defective Irrevocable Trust To Freeze an Estate Michael D. Mulligan All section references are to the Internal Revenue Code ( IRC ) unless otherwise indicated. ETIP, to estate tax inclusion period.; GRAT to grantor retained annuity trust; GRUT, to grantor retained unitrust; IDIT to intentionally defective irrevocable trust; IRD, to income in respect of decedent; IRS, to Internal Revenue Service; and SCIN, to a self-cancelling installment note. A. Introduction 1. This outline discusses the sale of assets to an IDIT in exchange for the trust s promissory note as an estate planning technique. In addition, the outline compares this technique to a GRAT. For a recent outline on this subject that includes citations to numerous other outlines, see Elliott Manning and Jerome M. Hesch, Deferred Payment Sales to Grantor Trusts, GRATs and Net Gifts: Income and Transfer Tax Elements, 24 Tax Mgmt. Est., Gifts and Tr. J. 3 (Jan.-Feb. 1999). See also Jerome M. Hesch, Beyond the Basic Freeze: Further Uses of Deferred Payment Sales, 34th Ann. U. Miami Philip E. Heckerling Inst. on Est. Plan, ch. 14 (2000). Michael D. Mulligan is a partner in the St. Louis office of Lewis, Rice & Fingersh, L.C. A frequent author and lecturer on estate planning topics, he is a fellow of the American College of Trust and Estate Counsel and a member of the editorial board of Estate Planning Magazine. A complete set of the course materials from which this outline was drawn may be purchased from ALI-ABA. Call 1-800-CLE-NEWS and ask for Customer Service. Have the number of the course materials SG027 handy. 5
6 ALI-ABA Estate Planning Course Materials Journal April 2002 2. The legislative history to the Revenue Reconciliation Act of 1990, Pub. L. No. 101-508, 104 Stat. 1388-400 indicates that a purpose of the estate freeze provisions of section 2701 was to eliminate the potential for transferring wealth through the nonexercise of discretionary rights, e.g., puts, calls, and conversion rights. Discretionary rights are valued at zero under the statute. Sen. Rpt. P.L. 101-408 at page 59. 3. The legislative history also indicates that a purpose of section 2702 was to eliminate the undervaluation of gifts of interests in trust and term interests. The undervaluation resulted from the fact that frequently taxpayers could control the return on retained interests, often producing a lower return than assumed by IRS actuarial tables. This undervaluation problem is avoided under section 2702 by valuing retained interests at zero, unless they take an easily valued form an annuity or unitrust interest. Sen. Rpt. P.L. 101-508 at pages 59-60. 4. If successful, the sales to a defective trust technique can produce an estate freeze while avoiding the strictures of section 2701. Further, although the sales transaction resembles a GRAT, it is not subject to the limitations of section 2702. 5. Although the IRS has issued a number of private letter rulings attacking the use of family limited partnerships in estate planning, it is settling estate and gift tax cases at substantial discounts. If the current law is, in fact, favorable on the use of family limited partnerships to produce valuation discounts, the sales to defective trusts technique can be used to take advantage of that current favorable law without incurring gift tax liability. B. IDIT Promissory Note Sale Compared to a GRAT 1. A GRAT is an irrevocable trust from which the grantor retains the right to receive annuity payments for a specified period of time. At the end of the specified period, assets in the trust pass to other beneficiaries. The annuity payments are designed to constitute a qualified interest described in section 2702(b), reducing the value of the gift made upon establishing the GRAT. 2. A GRAT is used to reduce the gift tax value of property transferred to the transferor s family. The value of the retained annuity interest is determined under section 7520. 2702(a)(2)(B). The GRAT produces estate and gift tax savings if property placed in the GRAT produces a total net return (net income and appreciation) in excess of the assumed discount rate under section 7520.
Irrevocable Trust 7 3. Rather than establishing a GRAT, the grantor might sell assets to an irrevocable trust established by the grantor. a. The trust might be structured to be excluded from the grantor s estate for Federal estate tax purposes, but considered owned by the grantor for income tax purposes. b. Ownership for income tax purposes is achieved by intentionally violating one or more of the grantor trust rules of sections 671 et seq., so both the income and principal portions of the trust are taxed directly to the grantor. c. Such a trust has been referred to as an IDIT. Mulligan, Defective Grantor Trusts Offer Many Tax Advantages, 19 Est. Plan. 131 (May/June 1992). 4. The sale might be in exchange for the IDIT s promissory note which provides for periodic (at least annual) payments of interest for a specified period of time (e.g., 25 years), with a single balloon payment of principal upon the expiration of the specified period. The note could be secured by the assets sold to the trust. Further, the note might authorize the prepayment of principal without penalty. Such a sales transaction is referred to in this outline as an IDIT promissory note sale. 5. The IRS takes the position that the existence of a trust that is a wholly grantor trust is disregarded for income tax purposes, and that transactions between the grantor and the IDIT have no income tax consequences. Rev. Rul. 85-13, 1985-1 C.B. 184. Thus, no gain or loss is recognized on the sale to the IDIT. In addition, the grantor is not taxed separately on interest payments on the note. The grantor continues to be taxed individually on all income generated by assets held by the IDIT, just as though the IDIT did not exist and ignoring interest on the promissory note. 6. Similar to the GRAT, the IDIT promissory note sale produces estate and gift tax savings if the IDIT has a total net return in excess of the interest rate on the note. a. A wholly grantor trust makes it easier to produce a total net return in excess of interest on the note, since the grantor is individually liable for taxes on the IDIT s income. b. The IDIT s income is not reduced by the payment of taxes.
8 ALI-ABA Estate Planning Course Materials Journal April 2002 c. The grantor s payment of taxes on the IDIT s income should not constitute a gift for gift tax purposes in the absence of any unexercised right of reimbursement from the IDIT. Practical Drafting, pp. 3923-4 (Jan. 1995). d. The GRAT is a useful estate planning technique. An appealing attribute of the GRAT is the certainty of the rules by which it is governed and the results it produces. Detailed Regulations have been issued under section 2702 affording a roadmap which can generally be followed without challenge by the IRS. e. This is not the case in all instances. For example, in spite of Treas. Reg. 25.2702-2(d)(1), Example 7, the IRS is now taking the position that a spouse s revocable interest in a GRAT following a grantor s initial interest is not to be accorded any value to reduce the gift upon the establishment of the GRAT. See Richard B. Covey, Recent Developments Concerning Estate, Gift and Income Taxation 1996, 31 Inst. on Est. Plan. Ch. 1, at 120.2A (1997). The IRS s position was upheld by the Tax Court in Cook v. Commissioner, 115 T.C. 15 (2000), aff d, 269 F.3d 854 (7th Cir. 2001). f. For the most part, however, the IRS s positions on the requirements of a GRAT are clearly set forth in the Treasury Regulations. The GRAT affords a great deal of certainty. 7. There is no roadmap for the IDIT promissory note sale. The IDIT promissory note sale is a new technique that has been fashioned from a number of different previously unconnected legal principles. Based upon cases and other authorities, it appears possible to structure an IDIT promissory note sale to produce the results discussed in this outline. However, these results are not a certainty. If you or your client are uncomfortable with that uncertainty, the IDIT may not be an option that you would want to consider. C. Superior Results Produced by IDIT Promissory Note Sale 1. If the IDIT promissory note sale is successful, it can produce results that are superior to the GRAT in a number of respects. 2. Assumed Discount Rate. Section 7520 prescribes the interest rate to be used in valuing annuities, term interests, and remainder interests. The interest rate under section 7520 is 120 percent of the Federal midterm rate in effect under section 1274 on the date of the gift. 7520(a)(2).
Irrevocable Trust 9 a. With a sale to an IDIT, the promissory note bears interest at the applicable section 1274 rate. See Frazee v. Commissioner, 98 T.C. 554 (1992); Priv. Ltr. Rul. 95-35-026 (May 31, 1995). i. In Frazee, the Tax Court adopted the position urged by the Internal Revenue IRS and held that the value of a promissory note given in exchange for the sale of property was to be determined under section 7872. ii. Section 7872, in turn, incorporates the interest rate under section 1274. 7872(f). b. In the case of a promissory note with a term of more than two but less than 10 years, the note need only bear interest at the Federal midterm rate. i. Mathematically, this rate is always less than 120 percent of the Federal midterm rate, which is the rate required by section 7520. ii. A lower interest rate produces a smaller return to the seller, and reduces the portion of the total net return on assets sold to the IDIT which is paid to the seller and included in the seller s estate. iii. Even with a promissory note in excess of nine years, the Federal longterm rate under section 1274 is generally less than the 120 percent rate of section 7520. 3. Inclusion in the Grantor s Estate. The grantor s death during the term of a GRAT causes some or potentially all of the assets in the GRAT to be included in the grantor s estate under sections 2033, 2036, or 2039. See Carlyn S. McCaffrey, GRATs and QPRTs, Split Interest Transfers: An Estate Planner s Panacea?, 20 ACTEC Notes, 47, 55-56 (1994). a. To the extent that inclusion causes appreciation in the value of the assets held by the GRAT to be subject to estate tax, the benefits of establishing the GRAT are lost. In structuring a GRAT, the planner may select a shorter period for annuity payments to the grantor than would be used if possible inclusion were not a consideration. A shorter period for annuity payments increases the value of the gift when the GRAT is established. b. If the IDIT promissory note sale is structured properly, the transaction should be not be treated as a transfer with a retained life estate subject to section 2036(a)(1). If the seller dies while the note remains outstanding, the