LIFETIME WEALTH TRANSFER STRATEGIES THAT NEED NOT INCUR LIABILITY FOR TRANSFER TAX GRATS, SALES TO GRANTOR TRUSTS, DEFINED VALUE CLAUSES, INTER VIVOS QTIP TRUSTS, AND CHARITABLE LEAD TRUSTS STEVE R. AKERS Bessemer Trust 300 Crescent Court, Suite 800 Dallas, Texas 75201 (214) 981-9407 akers@bessemer.com ALI-ABA Estate Planning for the Family Business Owner July 14, 2005 Copyright 2005 by Bessemer Trust Company, N.A. All rights reserved.
LIFETIME WEALTH TRANSFER STRATEGIES THAT NEED NOT INCUR LIABILITY FOR TRANSFER TAX GRATS, SALES TO GRANTOR TRUSTS, DEFINED VALUE CLAUSES, INTER VIVOS QTIP TRUSTS, AND CHARITABLE LEAD TRUSTS TABLE OF CONTENTS Page No. PART ONE SPECIAL PLANNING CONSIDERATIONS FOR GRATS AND INSTALLMENT SALES TO GRANTOR TRUSTS... 1 I. OVERVIEW OF TRANSFER PLANNING STRATEGIES... 1 A. Basics of Gifting Strategies... 1 1. Annual Exclusion and Medical/Tuition Exclusion Gifts... 1 2. Applicable Exclusion Amount Gifts... 1 3. Excess Gifts... 1 B. Freezing Strategies... 1 II. GRAT DESCRIPTION AND BASIC REQUIREMENTS... 2 A. Significance... 2 B. Example and Description of GRAT Operation... 2 C. Basic Statutory Requirements for GRATs... 3 D. Estate Tax Actuarial Risk... 3 E. No Allocation of GST Exemption Until End of GRAT Term... 3 III. SPECIAL PLANNING CONSIDERATIONS FOR GRATS... 3 A. Significance... 3 B. Factors Affecting Valuation... 3 C. Trustee Selection... 4 D. Use Formula Annuity Savings Clause Recognized by Regulations... 4 E. Use Escalating Payments Approach Keep Appreciating Assets in Trust as Long as Possible... 4 F. Minimize Initial Gift... 4 G. Minimizing Gift Resulting from GRAT Creation... 4 1. Historical Difficulty of Zeroing Out the GRAT Under Example 5 Approach... 5 2. Walton Rejection of Example 5 By Tax Court... 5 3. Revocable Spousal Annuity Not Recognized by IRS and Unneeded in Light of Walton... 5 4. Planning Issues for Married Grantors... 6 H. Payment of Annuity Amount; Structure Trust as Grantor Trust for Income Tax Purposes... 7 1. Cash... 7 2. Fractional Interests of In-Kind Assets... 7 3. Loan from Grantor... 7 4. Loan from Third Party... 8 5. Regulations Prohibiting Issuance of Notes by GRAT to Satisfy Annuity Payments... 8 6. Property Distribution Followed by Substitution of Note... 9 7. Property Distribution Followed by Re-GRAT... 9 8. Structure as Grantor Trust... 9 9. Consider Valuation Discounts... 9 i
I. Structure as Grantor Trust... 9 J. Time Period for Making Annual Payments; Late Payments; Early Payments... 10 K. Use Separate GRAT for Each Asset... 11 L. GRAT Inter Vivos Bypass Trust Continuing for Spouse... 11 M. Use Continuing Grantor Trust... 12 N. Excess Value Over Prescribed Amount May Be Returned to Grantor... 12 O. Front-End Loaded GRAT... 13 P. Two-Year Rolling GRATs... 13 Q. Short Term Vs. Long Term GRATS Taking Volatility Into Consideration... 14 R. Use Revised Spendthrift Clause... 17 S. Funding GRAT with S Stock or Interest in Partnership... 17 1. Particular Advantage... 17 2. Trusts as Qualified Shareholders... 17 3. GRAT as a Qualified Shareholder... 18 T. Effect of Insider Trading Restrictions... 18 U. Using Fiscal Year...18 V. Income Tax Payment by Grantor; Danger of Reimbursement Provisions... 19 W. Tax Reporting... 19 1. Income Tax... 19 2. Gift Tax... 20 X. Joint Purchase With Client Purchasing Qualified Annuity Interest... 20 Y. Lifetime GRAT With Trust Purchasing Remainder Interest... 21 Z. Private Annuities, Installment Sales, Self-Canceling Installment Notes... 22 AA. Purchase of Remainder Interest Prior to End of Trust Term... 22 BB. Sale of Remainder Interest to Dynasty Trust... 23 CC. Reciprocal GRATs... 24 DD. Re-Purchase of GRAT Assets by Grantor... 24 EE. Locking In Gains or Cutting Your Losses.... 25 FF. Use of Options or Derivatives With GRATs... 25 GG. Contribute Cash With Discounted Asset to Facilitate Keeping Appreciating Asset in GRAT as Long As Possible... 26 HH. Using Life Expectancy Term for GRAT in Special Situations... 27 IV. SUMMARY OF GIFT, ESTATE AND GST TAX TREATMENT OF GRATS... 27 A. Gift Tax... 27 1. No Annual Exclusion... 27 2. Gift Valuation of GRAT... 27 B. Estate Tax... 27 1. Grantor Dies During Terms of Trust... 27 2. Grantor Survives to End of Trust Term... 28 C. Generation Skipping Transfer Tax... 29 1. GST Exemption Allocation... 29 2. Taxable Termination Rather Than Direct Skip... 29 V. INSTALLMENT SALE TO GRANTOR TRUST... 29 A. Description... 29 1. Step 1. Create and Seed Grantor Trust... 29 2. Step 2. Sale for Installment Note; Appropriate Interest Rate... 30 3. Step 3. Operation During Term of Note... 32 4. Step 4. Pay Note During Seller s Lifetime... 32 B. Basic Estate Tax Effects... 32 1. Note Includible in Estate... 32 2. Assets Sold to Trust Excluded from Estate... 32 3. Grantor s Payment of Income Taxes... 32 C. Basic Gift Tax Effects... 32 1. Initial Seed Gift... 33 2. No Gift from Sale... 33 ii
D. Basic Income Tax Effects... 33 1. Initial Sale... 33 2. Interest Payments Do Not Create Taxable Income... 33 3. Using Crummey Trust Could Endanger Wholly Owned Status... 33 4. Grantor s Liability for Ongoing Income Taxes of Trust... 34 5. Seller Dies Before Note Paid in Full... 34 6. Gift Tax Basis Adjustment... 35 E. Generation-Skipping Transfer Tax Effects... 35 F. Advantages of Sale to Defective Trust Technique... 35 1. No Survival Requirement... 35 2. Low Interest Rate... 35 3. GST Exempt... 35 4. Interest-Only Balloon Note... 35 5. Income Tax Advantages... 35 G. Risks... 36 1. Treatment of Note as Retained Equity Interest, Thus Causing Estate Inclusion of Transferred Asset... 36 2. Risks of Thin Capitalization... 37 3. Potential Gain Recognition if Seller Dies Before Note Paid... 37 4. Valuation Risk... 37 5. Volatility Risk... 37 6. Recognition of SCIN Sale as Bona Fide Transaction... 37 7. Karmizan Settlement... 38 H. Summary of Structure Issues... 39 1. Term of Note... 39 2. Interest Rate... 39 3. Timing of Payments... 39 4. Security... 39 5. Timing of Sale Transaction... 39 6. Defined Value Clause... 39 7. No Crummey Clause... 39 8. Entire Corpus Liable for Note... 40 9. Payments Not Based on Performance of Sold Asset... 40 10. No Retained Control Over Sold Asset... 40 11. Payments Less Than Income From Sold Asset... 40 12. Ability to Make Payments... 40 13. Reporting... 40 I. Detailed Analysis of Trust Provisions That Cause Grantor Trust Status... 40 1. Power of Disposition by Related or Subordinate Parties Not Governed by Reasonably Definite External Standard... 40 2. Power of a Non Adverse Person to Distribute to or Accumulate Income for the Grantor or the Grantor s Spouse, 677(a)(1) or (2)... 42 3. Power of Non-Adverse Person to Use Income to Pay Life Insurance Premiums on Life of Grantor or Grantor s Spouse, 677(a)(3)... 43 4. Actual Borrowing of Trust Funds By Grantor or Grantor s Spouse Without Adequate Interest Or Security, 675(3)... 44 5. Power Exercisable in a Nonfiduciary Capacity to Reacquire Assets by Substituting Assets of Equivalent Value, 675(4)(C)... 45 6. Power of Non-Adverse Trustee to Make Loans to the Grantor and/or Grantor s Spouse Without Adequate Security, 675(2)... 46 7. Power of Non-Adverse Party to Add Beneficiaries, 674(b), 674(c), 674(d)... 47 8. Foreign Grantor... 48 9. Summary of Selection of Trustee Issues With Respect to Grantor Trust Rules. 49 J. Grantor Trust Toggle Provisions... 49 1. Desirability of Flexibility... 49 2. General Guidelines to Maximize Flexibility... 49 3. Examples of Toggle Arrangements... 50 K. Grantor Trusts with Split Purchase Transactions... 51 L. Charitable Lead Trusts... 51 iii
1. General Description... 51 2. Alternatives for Describing Charitable Amount... 51 3. Permissible Term of Charitable Interest... 52 4. Grantor CLT... 52 5. Non-Grantor CLT... 52 6. Gift Tax Considerations in Structure of CLT... 52 7. GST Tax Considerations... 52 8. Replacement of Grantor s Charitable Contributions... 53 9. Applicability of Private Foundation Rules... 53 PART TWO FORMULA VALUATION AND DEFINED VALUE CLAUSES... 53 I. PROBLEMATIC VALUATION ISSUES... 53 A. Gift Issues... 53 B. GST Transfers... 53 C. Sales... 53 D. Testamentary Transfers... 53 II. III. DEFINED VALUE CLAUSES ARE COMMON IN TESTMENTARY PLANNING... 54 CASE LAW AND RULINGS REGARDING VALUATION ADJUSTMENT CLAUSES... 54 A. Commissioner v. Procter... 54 B. Favorable Decision-King v. US... 54 C. Recent Case-Estate of McClendon... 54 D. Revenue Ruling 86-41... 55 E. TAM That Recognized a Defined Value Clause... 55 F. IRS Objection to Formula Allocation to GST-Exempt and Non-Exempt Trusts, East v. Commissioner... 55 G. Tax Court Refuses to Recognize Defined Value Clause in Gift Transaction Because Parties Did Not Respect the Clause-Knight v. Commissioner... 56 H. IRS Refuses to Recognize Defined Value Clause in Field Service Memorandum... 56 I. TAM 200245053 IRS Refuses to Recognize Defined Value Clause in Sale Transaction... 56 J. TAM 200337012 IRS Refuses To Recognize Transfer of Fractional Interest Having A Specified Value... 57 K. Tax Court Refuses to Give Effect to Defined Value Clause Under Interpretation Analysis-McCord v. Commissioner... 58 L. Karmazin Settlement (T.C. Docket No. 2127-03, filed Feb. 10, 2003)... 59 IV. ALTERNATIVE APPROACHES TO DEFINED VALUE CLAUSES... 59 A. Distinction Between Defined Value Approach and Tax Savings Clause... 59 B. Use Specifically Sanctioned Defined Value Clauses... 60 1. Traditional Marital Deduction Formula Clauses... 60 2. GRAT... 60 3. Charitable Remainder Annuity Trusts... 60 4. Disclaimers... 60 C. Transfer of Fractional Share Based on Gift Tax Values Plus Some Excess Percentage of Amount... 61 D. Trust Formula Allocation... 61 E. Sale to Children and Spouse/Charity On a Formula Fractional Allocation... 62 F. Formula Should Reference Statutory Provisions Regarding iv