ESTATE FREEZE TECHNIQUES
AND FREEZE-RELATED ISSUES
By
Ronald D. Aucutt
McGuireWoods LLP
1750 Tysons Boulevard, Suite 1800
McLean, Virginia 22102-4215
Phone: (703) 712-5497
E-mail: raucutt@mcguirewoods.com
(Outline updated through February 28, 2001)
ESTATE FREEZE TECHNIQUES
AND FREEZE-RELATED ISSUES
Ronald D. Aucutt
McGuireWoods LLP
1750 Tysons Boulevard, Suite 1800
McLean, Virginia 22102-4215
Phone: (703) 712-5497
E-mail: raucutt@mcguirewoods.com
Table of Contents
I.
OVERVIEW OF CHAPTER 14 AND RELATED RULES................................................1
II.
CORPORATIONS AND PARTNERSHIPS (SECTION 2701) ..........................................3
A.
Overview ..................................................................................................................3
B.
Preconditions............................................................................................................3
C.
Exceptions ................................................................................................................5
D.
Valuation Rules ........................................................................................................8
E.
The Subtraction Method ........................................................................................12
F.
Minimum Equity Floor ..........................................................................................16
G.
Post-Transfer Treatment of Retained Interests ......................................................16
III.
BUY-SELL AGREEMENTS, OPTIONS, AND SIMILAR
ARRANGEMENTS (SECTION 2703) .............................................................................22
A.
Historical Requirements.........................................................................................22
B.
New Requirements .................................................................................................23
C.
Effective Date—Substantial Modification .............................................................24
IV.
LAPSING RIGHTS AND RESTRICTIONS (SECTION 2704) .......................................26
A.
Preconditions..........................................................................................................26
B.
Operation................................................................................................................26
C.
Coordination with Other Provisions ......................................................................28
D.
Purpose...................................................................................................................29
V.
TRUSTS AND TERM INTERESTS (SECTION 2702) ...................................................29
A.
Overview ................................................................................................................29
B.
Preconditions..........................................................................................................29
C.
Operation................................................................................................................30
D.
Post-Transfer Treatment of Retained Interests ......................................................31
E.
Exceptions ..............................................................................................................32
F.
Term Interests and Joint Purchases ........................................................................33
G.
Personal Residences ...............................................................................................34
H.
Certain Tangible Property ......................................................................................38
VI.
SPECIAL STATUTE OF LIMITATIONS RULE (SECTION 6501(C)(9)) .....................38
VII.
WHAT’S LEFT OF ESTATE FREEZING TECHNIQUES?............................................42
A.
Non-Family Capital Freezes ..................................................................................42
B.
Qualified Payment Capital Freezes ........................................................................43
C.
Non-Qualified Payment Capital Freezes ................................................................46
D.
Gifts of a Single Class of Ownership .....................................................................47
E.
A Section 355 Split-Up or Split-Off ......................................................................49
F.
Use of a Partnership Instead of a Corporation .......................................................54
G.
Use of a Partnership with a Corporation ................................................................58
H.
Use of Installment Sales to Grantor Trusts ............................................................59
I.
Other Debt or Lease Transactions ..........................................................................74
J.
Redemption or Buy-Sell Agreements ....................................................................75
K.
Non-Family Trusts .................................................................................................78
L.
Use of Grantor Retained Annuity Trusts (GRATs) ...............................................79
M.
Comparing Capital Freezes, GRATs, and Installment Sales .................................93
N.
Charitable Lead Trusts (CLATs) .........................................................................100
O.
Use of Personal Residence Trusts (PRTs) and Qualified Personal
Residence Trusts (QPRTs) ...................................................................................102
P.
Other Transactions Involving Personal Residences .............................................108
Q.
Testamentary Freezes ...........................................................................................109
R.
Generation-Skipping Freezes ...............................................................................109
S.
Post Mortem Freezes............................................................................................110
APPENDIX ..........................................................................................................111
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ESTATE FREEZE TECHNIQUES
AND FREEZE-RELATED ISSUES
Ronald D. Aucutt
McGuireWoods LLP
1750 Tysons Boulevard, Suite 1800
McLean, Virginia 22102-4215
Phone: (703) 712-5497
E-mail: raucutt@mcguirewoods.com
(Outline updated through February 28, 2001)
I.
Overview of Chapter 14 and Related Rules
Enacted by section 11602 of the Omnibus Budget Reconciliation Act of 1990, P.L. 101508 (“OBRA”), amended by section 1702(f) of the Small Business Job Protection Act of
1996, P.L. 104-188, and elaborated by regulations proposed on April 4 and September 10,
1991, and published in final form on January 28, 1992 (as corrected April 1, 1992), 56
Fed. Reg. 14321 (April 9, 1991); 56 Fed. Reg. 46245 (Sept. 11, 1991); T.D. 8395, 57
Fed. Reg. 4250 (Feb. 4, 1992), 57 Fed. Reg. 11264 (April 2, 1992), 1992-1 C.B. 316, and
regulations proposed September 11, 1991, and January 28, 1992, and published in final
form on May 5, 1994, 56 Fed. Reg. 46245 (Sept. 11, 1991), 57 Fed. Reg. 4278 (Feb. 4,
1992); T.D. 8536, 59 Fed. Reg. 23152 (May 5, 1994). Amendments regarding personal
residence trusts were proposed on April 16, 1996, and published in final form on
December 23, 1997, T.D. 8743, 62 Fed. Reg. 66987 (Dec. 23, 1997). Amendments to the
regulations regarding grantor retained annuity trusts were proposed published in the
Federal Register on June 22, 1999, and published in final form on September 5, 2000,
T.D. 8899, 65 Fed. Reg. _____ (Sept. 5, 2000). A regulations project (PS-REG-008-93)
was opened January 27, 1993, specifically to “clarify and simplify the regulations under
sections 2701, 2702, 2703, and 2704 of the Code.” Publication of such proposed
regulations was on the Treasury-IRS 1997 Business Plan, released February 28, 1997, but
dropped from the 1998 Business Plan, released March 3, 1998.
1.
Special valuation rules for transfers of interests in closely-held corporations and partnerships. Section 2701.
2.
Special rules for the subsequent tax treatment of retained interests in
closely-held corporations or partnerships valued under section 2701.
Section 2701(d).
-1-
3.
Special valuation rules for transfers of interests in trusts and for transfers
and joint purchases of term interests. Section 2702.
4.
Suspense of the gift tax statute of limitations applicable to such transfers
unless the transfer is adequately disclosed on a gift tax return. Section
6501(c)(9) (extended by the Taxpayer Relief Act of 1997 to all gifts).
5.
Standards for buy-sell agreements, options, and similar arrangements.
Section 2703.
6.
Special valuation rules for certain lapsing rights and restrictions. Section
2704.
7.
Effective date of the statute: October 9, 1990. Section 11602(e) of
OBRA.
8.
a.
Exception from section 2703 for buy-sell and similar agreements
in effect before October 9, 1990, and not substantially modified
on or after that date. Section 11602(e)(1)(A)(ii) of OBRA.
b.
Exception from section 2704 for restrictions or rights created
before October 9, 1990. Section 11602(e)(1)(A)(iii) of OBRA.
See Letter Rulings 9229028, 9644053 & 9802004.
c.
Exception for failure to exercise a right of conversion, failure to
pay dividends, or failure to exercise any other rights specified in
regulations with respect to property transferred before October 9,
1990. Section 11602(e)(1)(B) of OBRA.
d.
But the statute applies when, for example, a $10,000 annual
exclusion gift is made of common stock and preferred stock is
retained.
Effective date of the regulations: Generally, January 28, 1992 (so that
pre-January 28, 1992 instruments will not have to be reformed). For
transfers before that date (or gift tax returns filed before that date, in the
case of the disclosure rules), reliance “on any reasonable interpretation of
the statutory provisions” (including either the proposed or final
regulations) is permitted. Reg. §§ 25.2701-8, 25.2702-7, 25.2703-2,
25.2704-3 & 301.6501(c)-1(e)(3). For an example of the application of
this rule, but without details, see Letter Ruling 9245005.
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II.
Corporations and Partnerships (Section 2701)
A.
Overview
The statute assumes that, one way or another, the value of a transferred interest in
a corporation or partnership is determined for gift tax purposes by a “subtraction”
or “residual” method, under which the value of certain “senior” interests in the
corporation or partnership is, in effect, subtracted from the total value of the
entity. The higher the value of those senior interests, the lower the gift-tax value
of the transferred interest, and vice versa. In determining those amounts to be
subtracted, section 2701 prescribes special valuation rules for determining the
value of certain senior interests.
B.
Preconditions
1.
Stock in a corporation or an interest in a partnership transferred to or for
the benefit of a member of the transferor’s family. Section 2701(a)(1).
The transferor’s “family” includes the transferor’s spouse, descendants,
descendants of spouse, and the spouses of any of the foregoing. Section
2701(e)(1).
2.
A distribution, liquidation, put, call, or conversion right—called an
“applicable retained interest”—in the entity retained, directly or
indirectly, by the transferor, by the transferor’s spouse, by any ancestor of
the transferor or the transferor’s spouse, or by the spouse of any such
ancestor—called “applicable family members.” Sections 2701(a)(1)(B),
(b)(1), (e)(2), and (e)(3)(A).
a.
A distribution right is not an applicable retained interest,
however, unless, immediately before the transfer, the transferor,
applicable family members, and all descendants of the
transferor’s parents and the transferor’s spouse’s parents in the
aggregate hold “control” of the entity. Section 2701(b); Reg.
§ 25.2701-2(b)(5)(i).
b.
“Control” means the holding of at least half of the vote or value
of the stock of a corporation, the holding of at least half of the
capital or profits interests in a partnership, or the holding of any
general partner interest (regardless of value) in a limited partnership. Section 2701(b)(2). Thus, “control” need not be “control”;
it could be exactly 50 percent of the vote, or 50 percent of the
value without vote, or a 50-percent limited partnership interest.
Voting rights held by a fiduciary are treated as held by the beneficial owners, such as the beneficiaries of a trust, including permissible recipients of income. Reg. § 25.2701-2(b)(5)(ii)(B). See
Letter Ruling 9639054.
-3-
3.
4.
Indirect holdings. Section 2701(e)(3)(A); Reg. § 25.2701-6(a)(1).
a.
Proportional (ignoring minority discounts) attribution of equity
holdings from a corporation or partnership to shareholders and
partners. Reg. § 25.2701-6(a)(2) and (3). (It appears that this
attribution rule applies even to the rule of section
2701(b)(2)(B)(ii) that ascribes “control” of a limited partnership
to any general partner. Thus, if a person owned 1 percent of the
stock of a corporation which is the general partner of a limited
partnership, it appears that that person—and thus that person’s
family—would be treated as holding “control” of the limited
partnership for purposes of valuing rights to distributions from
the limited partnership.)
b.
Attribution of equity holdings from an estate or trust to any beneficiary whose interest in the estate or trust could be satisfied out
of that property or the income or proceeds thereof. Reg.
§ 25.2701-6(a)(4).
c.
Ordering rules to prevent multiple attribution. Reg. § 25.27016(a)(5).
d.
For an unexpected application of the trust attribution rules, see
Letter Ruling 9321046, discussed at pages 7- 8 infra.
Indirect transfers. A capital contribution, redemption, recapitalization, or
other change in the capital structure of a corporation or partnership is
treated as a transfer by anyone who receives in the transaction a right that
would trigger the statute (or, as provided in regulations, holds such a
right immediately after the transaction). Section 2701(e)(5).
a.
This will cause the statute to apply to the creation of a new entity,
if different classes of ownership interests are received in different
proportions. See Technical Advice Memorandum 199933002.
b.
This will also cause the statute to apply to an infusion of capital
by a member of an older generation (see Letter Ruling 9808010),
even by someone who has theretofore had no connection with the
entity, in exchange for preferred interest.
c.
Similarly, the statute will apply to an infusion of capital by a
member of a younger generation in exchange for common stock
or a residual partnership interest.
d.
The regulations apply this rule whenever the transferor or an
applicable family member receives an applicable retained interest,
redeems a junior equity interest, or redeems a senior equity
-4-
interest in a transaction in which the fair market value of an applicable retained interest is increased. Reg. § 25.2701-1(b)(2)(i)(B).
e.
C.
The regulations also apply this rule to an indirect contribution to
capital, to a termination of an indirect holding in a corporation or
partnership held through a trust of which the indirect holder is
treated as the owner for income tax purposes, and to the termination of an indirect holding to the extent the value of the
indirectly-held interest would have been included in the gross
estate of the indirect holder if the indirect holder had died
immediately before the transaction. Reg. § 25.2701-1(b)(2)(i)(C).
Exceptions
1.
If there is no applicable retained interest.
a.
A distribution right is not an applicable retained interest if it is
embodied in a class of stock or partnership interest that is the
same as or subordinate to the class of the transferred interest.
Reg. § 25.2701-2(b)(3)(i); see sections 2701(c)(1)(B)(i) and
(a)(4)(B)(i). This is the provision that justifies the so-called
“reverse partnership freeze,” whereby the older generation gives
the younger generation a preferred interest with so high a payout
rate that the payments (or liabilities for payments) freeze or even
deplete the value of the retained residual interest.
b.
A right to receive guaranteed payments described in section
707(c) is not a retained distribution right, if the guaranteed payments are of a fixed amount, not contingent on profits. Section
2701(c)(1)(B)(iii). But see Letter Ruling 9808010.
c.
i.
Because guaranteed payments must be paid (and are taxable to the recipient) whether or not the partnership has
profits, they presumably are viewed as presenting less
potential for abuse.
ii.
The regulations require such guaranteed payments to be
fixed as to time as well as amount. Reg. § 25.27012(b)(4)(iii).
A liquidation, put, call, or conversion right is not an applicable
retained interest if it must be exercised at a specified time (or is
treated as so exercised under the “lower of” rule discussed below)
and at a specified amount or if its exercise or nonexercise would
not affect the value of the transferred stock or partnership interest.
Section 2701(c)(B).
-5-
d.
A conversion right is not an applicable retained interest if it is a
nonlapsing right to convert into a fixed share of the equity of the
entity. Section 2701(c)(2)(C). The right must be adjusted to prevent dilution, not only by capital transactions such as the issuance
or redemption of stock, but also by nonpayment of distributions.
The latter requires compounding of unpaid distributions. Reg.
§ 25.2701-2(b)(4)(iv).
e.
The Service has ruled that a stock option is not an equity interest
and therefore a transfer of the option is not subject to section
2701. Letter Ruling 199952012.
2.
If market quotations for the transferred interest or the retained interest are
readily available as of the date of the transfer on an established securities
market. Sections 2701(a)(1) and (a)(2)(A). See Letter Ruling 9725032
(transfer of stock options not covered by section 2701).
3.
If the retained interest is “of the same class” as the transferred interest.
Section 2701(a)(2)(B). See Letter Ruling 9229028.
4.
If the retained interest is “proportionally the same” as the transferred
interest. Section 2701(a)(2)(C).
a.
For this purpose, nonlapsing differences in voting power, and
nonlapsing differences with respect to management and liability
in the case of a partnership, are disregarded.
Section
2701(a)(2)(C); Letter Rulings 9414012 and 9414013 (transfer of
nonvoting stock while retaining voting stock not subject to
section 2701). But see Letter Ruling 9802004, in which the
Service refused to rule that section 2701 did not apply where all
economic interests seemed proportional.
i.
Thus, the difference between a general partnership interest
and a limited partnership interest is disregarded if the
interests in the partnership are economically the same—
i.e., the partnership is a “straight up” or “pro rata” partnership.
ii.
The statute disregards differences in voting power (not
merely differences in voting rights). Therefore, at least
theoretically (a) the existence of controlling and minority
positions will not affect the availability of this exception,
and (b) the application of this exception will not affect the
availability of minority discounts.
-6-
iii.
5.
The transferor and applicable family members must not
have the right to alter the liability of the transferee.
Section 2701(a)(2), flush language, first sentence. Therefore, care must be taken in retaining the power to convert
limited partnership interests to general partnership
interests, and vice versa. The scope of this rule—for
example, as applied to a partnership in which there are no
non-family partners and the limited partnership interests
are held by trusts with older-generation trustees—is
unclear. See Letter Ruling 9427023.
b.
Lapses caused only by federal or state law are also disregarded,
except as provided in regulations to prevent abuse. Section
2701(a)(2), flush language, second sentence.
c.
The regulations make it clear that a pro rata partnership is not
made subject to section 2701 merely by non-lapsing provisions in
the partnership agreement included to comply with the
partnership allocation rules of section 704(b). Reg. § 25.27011(c)(3).
d.
Reg. § 25.2701-1(c)(4) exempts any transfer to the extent it is a
“proportionate” transfer by the same individual, such as a transfer
of a proportional amount of common and preferred stock.
i.
See Letter Ruling 9226063, as modified by Letter Ruling
9248026 (exemption applies to the proportional reduction
by transferors—husband and wife—in their total holdings
of two classes of stock of a corporation, where no other
family member holds stock of that corporation).
ii.
The holdings that are tested for proportionality are the
total holdings of the transferor and applicable family
members. A transfer that is proportionate as to the
transferor alone might not be proportionate as to the
transferor and all applicable family members.
iii.
If transfers are made at different times (even if in close
succession) or by different people (even if related), the
exception appears to apply on a transfer-by-transfer basis.
If, in a recapitalization, each applicable family member and each member
of the transferor’s family hold substantially the same interests before the
transaction as after the transaction.
-7-
D.
a.
Thus, if all the owners of the common stock of a corporation are
individuals and they each receive new preferred stock in proportion to their holdings of common stock, section 2701 does not
apply. Letter Ruling 9321046.
b.
But if some of the stockholders are trusts, the ordering provisions
of the trust attribution rules might attribute the preferred stock
(the applicable retained interest) to an older generation and the
common stock (the subordinate equity interest) to a younger
generation, thereby causing section 2701 to apply to this otherwise vanilla recapitalization. Id. (Letter Ruling 9321046 is an
alarming mix of attribution rules and actuarial references.
Neither its unifying principle nor its potential scope is clear.)
c.
Cf. Letter Ruling 9309018 (reverse stock split to reduce the
Delaware franchise tax held not subject to section 2701, even
though some of the shareholders were trusts).
d.
See also Letter Ruling 199947034 (exchange of common and
preferred shares of stock in a corporation for membership units
with similar characteristics in an LLC that “checks the box” to be
treated as an association taxable as a corporation not subject to
section 2701).
6.
If a shift of rights results from a qualified disclaimer.
§ 25.2701-1(b)(3)(ii).
Reg.
7.
If a shift of rights results from the release, exercise, or lapse of a nongeneral power of appointment, except to the extent the release, exercise,
or lapse is otherwise a taxable gift. Reg. § 25.2701-1(b)(3)(iii).
Valuation Rules
In determining the value of a transferred interest for gift tax purposes (i.e., for
determining whether there is a gift and, if so, the amount of the gift), special
valuation rules are prescribed for determining the value of rights retained by the
transferor, by the transferor’s spouse, by any ancestor of the transferor or the
transferor’s spouse, and by the spouse of any such ancestor.
1.
Valuation of a retained distribution right—that is, a right to distributions
with respect to stock of a corporation or a partner’s interest in a partnership. Section 2701(c)(1).
a.
Valued at zero unless the distributions are “qualified payments.”
i.
“Qualified payments” are defined as cumulative dividends
(or comparable partnership distributions) payable periodi-8-
cally at a fixed rate or with reference to a specified market
interest rate. Sections 2701(a)(3)(A), (c)(3)(A), and
(c)(3)(B).
ii.
b.
c.
Indexed payments must be indexed to a market interest
rate. For example, a preferred stock dividend tied to the
yield of certain comparable publicly-traded preferred
stocks is not a qualified payment. Letter Ruling 9324018.
Not subject to the valuation rules of section 2701 if the distributions are “qualified payments.” Section 2701(a)(3)(C).
i.
Presumably the value of such a distribution right is the
present value of such payments received each year in perpetuity (if the appraiser finds adequate coverage and
considers this approach otherwise appropriate). See H.R.
Rep. No. 101-964, 101st Cong., 2d Sess. 1134 (1990)
(“Conference Report”).
ii.
The discount rate to be used will also be the subject of the
appraiser’s judgment. There is no “safe harbor” discount
rate and no reason to rely on any particular “federal rate,”
such as the “table rate” under section 7520.
Valued without regard to section 2701 if it is a right to receive a
specified amount on the death of the holder of the right—
included in the term “mandatory payment right.” Reg. § 25.27012(b)(4)(i).
Example 1: The owner of all the common and preferred stock of a
corporation gives all of the common stock to descendants. An
appraisal determines the total value of the corporation to be
$1,000,000, the value of the preferred stock to be $200,000, and
the value of the common stock therefore to be $800,000. If the
preferred stock dividends are cumulative dividends that meet the
definition of “qualified payments,” the gift tax value of the transferred common stock is $800,000. If the preferred stock dividends
are not “qualified payments” (and any other valuable features of
the preferred stock are ignored), then the gift tax value of the transferred common stock is $1,000,000. If the gift were of only part of
the common stock, it is valued on the basis of a total value of
$800,000 or $1,000,000, as the case may be, with any appropriate
minority discount or similar adjustment taken into account.
-9-
2.
Qualified payment elections.
a.
b.
In the case of a “qualified payment” right:
i.
The transferor may waive “qualified payment”
treatment—”electing out.” Section 2701(c)(3)(C)(i). The
regulations permit partial elections “with respect to a
consistent [presumably fractional] portion of each
payment right.” Reg. § 25.2701-2(c)(1).
ii.
The distribution rights of every holder other than the
transferor will be treated as “qualified payment” rights
only to the extent those holders affirmatively elect.
Section 2701(c)(3)(C)(i); Reg. § 25.2701-2(c)(4).
In the case of a distribution right other than a “qualified payment”
right:
i.
Any holder, including the transferor, may elect “qualified
payment” treatment, assuming payments in such amounts
and at such times as are specified in the election—
”electing in.” Section 2701(c)(3)(C)(ii).
ii.
The terms specified in the election must be consistent
with—i.e., permitted by—the original terms of the
interest. Id.; Reg. § 25.2701-2(c)(2)(ii).
iii.
The value assigned to the retained interest by reason of
the election may not exceed the value of the retained
interest determined without regard to section 2701. Reg.
§ 25.2701-2(c)(2).
c.
The content of
§ 25.2701-2(c)(5).
these
elections
is
set
forth
in
Reg.
d.
These elections are made by statements attached to the applicable
gift tax return.
i.
Under the regulations, no election was due earlier than
April 6, 1992. Id.
ii.
In addition, section 1702(f)(5)(C) of the Small Business
Job Protection Act of 1996 (P.L. 104-188) provides that
the special election-in by an applicable family member
required by Section 2701(c)(3)(C)(i) and Reg. § 25.27012(c)(4) even when the applicable family member’s distribution right is a right to qualified payments will be timely
- 10 -
if made by the due date (including extensions) of the 1996
gift tax return.
e.
3.
4.
All such elections, once made, are revocable only with the
consent of the Service.
Section 2701(c)(3)(C)(iii); Reg.
§ 25.2701-2(c)(3).
Valuation of a retained liquidation, put, call, or conversion right, called
“extraordinary payment rights” in Reg. §§ 25.2701-1(a)(2)(i) & -2(b)(2).
a.
Valued at zero. Section 2701(a)(3)(A); Letter Ruling 9848006.
b.
No elections in or out.
Valuation of a qualified payment right and a retained liquidation, put,
call, or conversion right combined in the same interest.
a.
Valued as if such liquidation, put, call, or conversion right were
exercised in a manner resulting in the lowest value for all such
rights (the “lower of” rule). Section 2701(a)(3)(B); Reg.
§ 25.2701-2(a)(3). The regulations direct that the valuation
assumptions be consistent, and that due regard be given to “the
entity’s net worth, prospective earning power, and other relevant
factors”—i.e., “coverage.” Reg. § 25.2701-2(a)(3).
Example 2: Retained preferred stock carries a cumulative annual
dividend of $100 per share and may be redeemed at any time after
two years for $1,000 per share. The value of each share of that
preferred stock is considered to be the lesser of (i) the present value
of a $100 annual dividend paid in perpetuity or (ii) the present
value of two annual $100 dividends plus the present value of the
redemption for $1,000 after two years. Conference Report at 1134.
Example 3: Retained preferred stock carries a cumulative annual
dividend of $100 per share and is owned by a stockholder with
sufficient voting power to compel the liquidation of the corporation. If the corporation were liquidated currently, the value of the
assets of the corporation would support a liquidating distribution to
each holder of such preferred stock of only $900 per share. The
value of each share of that preferred stock is apparently considered
to be the lesser of (i) the present value of a $100 annual dividend
paid in perpetuity or (ii) $900. Letter Ruling 9235018, modifying
Letter Ruling 9204016.
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b.
5.
May be treated as a separate interest:
i.
By regulations. Section 2701(e)(7).
ii.
By revenue ruling, notice, or other document of general
application. Reg. § 25.2701-7.
iii.
By letter ruling upon request. Reg. § 25.2701-7.
Liquidation participation rights: The right to share in liquidation
proceeds, but not enhanced by the right to compel liquidation—i.e., without regard to control. Reg. § 25.2701-2(b)(4)(ii).
a.
Not treated as an applicable retained interest. Reg. § 25.27012(b)(4).
b.
Possible applications (although the regulations are unclear):
i.
Corporations: Permit dividends to be valued as if paid in
perpetuity, even though liquidation would cut them off.
See Letter Ruling 9324018. But see Example 3, supra.
ii.
Partnerships:
iii.
E.
(a)
Permit a partnership interest to have a type of “par
value,” as in the case of a corporation.
(b)
Assign value to preference distributions, which are
more analogous to a return of capital than to preferred stock dividends?
Both corporations and partnerships: Enhance the security
of the preferred payments, thereby allowing the use of a
lower discount rate to compute the present value of the
qualified payments.
The Subtraction Method
The legislative history of the section 2701 rules states that “[t]he rules rely on
present law principles that value residual interests by subtracting the value of preferred interests from the value of the entire corporation or partnership, with an
adjustment to reflect the actual fragmented ownership.” Conference Report at
1132. The regulations spell out the methodology to be used to give effect to this
congressional expectation. Reg. § 25.2701-3(b).
- 12 -
1.
Step 1—Valuation of family-held interests: “Determine the fair market
value of all family-held equity interests in the entity immediately after
the transfer.” Reg. § 25.2701-3(b)(1)(i).
a.
“Family-held” means directly or indirectly held by the transferor,
by applicable family members, and by any descendants of the
transferor’s parents or the transferor’s spouse’s parents. Reg.
§ 25.2701-3(a)(2)(i). See Letter Ruling 9324018 (stock held by
transferor’s aunt and uncle is “family-held,” even though it is not
held by an applicable family member or by a member of the
transferor’s family).
b.
The regulations say nothing about the appraisal methodology to
be used, or whether the entity is to be valued as a going concern
or at its liquidation value, or what discount rate(s) should be used.
c.
2.
i.
The implication is that pre-chapter 14 rules continue to
apply for such purposes. See Reg. § 25.2701-2(a)(3),
which states: “See §§ 20.2031-2(f) and 20.2031-3 for
rules relating to the valuation of business interests
generally.”
ii.
The preamble to the proposed regulations cited the classic
IRS pronouncements on the valuation of closely-held
businesses, Rev. Rul. 59-60, 1959-1 C.B. 237, and Rev.
Rul. 83-120, 1983-2 C.B. 170.
iii.
The Service has warned: “It should be noted that in
determining the value of a preferred stock based on the
present value of the dividend stream to perpetuity, the use
of a discount factor based on the rate prescribed by
section 7520 (120 percent of the federal midterm rate) is
rarely valid when the corporation is closely-held.” Letter
Ruling 9324018.
“Fragmentation discounts” are not allowed at this step, other than
discounts that are appropriate for the aggregate “family-held”
interest (but, with non-marketable interests, those discounts might
be substantial).
Step 2—”Subtract the value of senior equity interests.” Reg. § 25.27013(b)(2).
a.
Subtract the value of family-held senior equity interests other
than applicable retained interests held by the transferor and
applicable family members and the fair market value of any
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family-held equity interests held by persons other than the
transferor, members of the transferor’s family, and applicable
family members of the transferor. Reg. § 25.2701-3(b)(2)(i)(A).
i.
ii.
b.
Examples:
(a)
Valuable elements of senior equity interests that
are not applicable retained interests, such as
guaranteed payments, voting rights, and preemptive subscription rights.
(b)
Distribution, liquidation, put, call, or conversion
rights held by descendants, siblings, or
descendants of siblings—of the transferor or the
transferor’s spouse.
(c)
Interests of any class held by siblings and descendants of siblings of the transferor and the transferor’s spouse.
The first two types of interests are valued on a pro rata
basis as if all family-held senior equity interests of the
same class were held by one person. Id.
Subtract the value of applicable retained interests held by the
transferor and applicable family members, to the extent the proportion of that retained interest held by the transferor and applicable family members (plus any interest received as consideration
for the transfer) exceeds the proportion of junior equity interest
which is “family-held”—valued similarly to the family-held
senior equity interests described in the preceding paragraph. Reg.
§ 25.2701-3(b)(5).
i.
In other words, if the transferor and applicable family
members own 50 percent of the common stock and 60
percent of one class of preferred stock of a corporation,
one-sixth of that preferred stock is valued without regard
to section 2701 at the same per-share value as the preferred stock of that class “family-held” by shareholders
other than the transferor and applicable family members.
Reg. § 25.2701-3(d), Example 2.
ii.
If the transferor and applicable family members own more
than one class of a subordinate interest, such as common
stock or junior preferred stock, the highest percentage
owned is used in this calculation.
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iii.
c.
3.
4.
5.
The benefit of this special rule is presumably, although
not clearly, allocated to the transferor and all applicable
family members proportionately, regardless of any
elections that are made.
Subtract the value of other applicable retained interests held by
the transferor and applicable family members, valued under
section 2701. Reg. § 25.2701-3(b)(2)(ii).
Step 3—Allocate the remaining value among the transferred interests and
other subordinate equity interests held by the transferor, applicable
family members, and members of the transferor’s family. Reg.
§ 25.2701-3(b)(3).
a.
Begin with the most senior class of subordinate equity interest.
b.
Make this allocation among classes “in the manner that would
most fairly approximate their value if all rights valued under
section 2701 at zero did not exist (or would be exercised in a
manner consistent with [the “lower of” rule], if applicable.”
Step 4—Various final adjustments. Reg. § 25.2701-3(b)(4).
a.
Minority “or similar” discounts, limited to the amount of such
discounts that would have been available in the absence of
section 2701. Reg. § 25.2701-3(b)(4)(ii). In other words, there is
no discount on the additional value attributed by section 2701.
Minority discounts are preserved (theoretically, cf. Reg.
§ 25.2701-3(d), Example 4, Step 4), but not created.
b.
Any retained interest given value under section 2702.
§ 25.2701-3(b)(4)(iii).
c.
Consideration received. Reg. § 25.2701-3(b)(4)(iv).
Reg.
Illustrations. The examples in Reg. § 25.2701-3(d) are important and
should be carefully studied. See also Technical Advice Memorandum
9447004. The interrelationship of the subtraction method, the exceptions
from section 2701, and the “lower of” rule are illustrated in Letter
Rulings 9204016 and 9235018. For further application of the “lower of”
rule, see Letter Rulings 9324018 and 9417024. An apparently significant
but not very illuminating recent ruling, discussing the application of
chapter 14 to the formation of a family limited partnership, including the
application of the subtraction method, is Letter Ruling 9808010.
- 15 -
F.
Minimum Equity Floor
In applying these rules, the common stock of a corporation or “junior equity
interest” in a partnership must be given a value equal to at least 10 percent of the
total value of all the equity interests in the entity plus the total indebtedness of the
entity to the transferor and applicable family members. Section 2701(a)(4).
1.
A “junior equity interest” in a partnership must be junior to all other
interests in the partnership as to both income and capital. Section
2701(a)(4)(B)(i). Reg. § 25.2701-3(c)(2). In some partnerships, there
may be no such interest.
2.
Short-term indebtedness (such as compensation for current services),
indebtedness arising from a guarantee, qualified deferred compensation
obligations, and rent payments under a lease determined in good faith to
reflect fair rental value are all excluded from this calculation. Reg.
§ 25.2701-3(c)(3).
Example 4: If, in Example 1, the appraisal valued the total corporation at $1,000,000 and the preferred stock at $950,000, the
common stock could not be valued at only $50,000. It would have
to be treated as having a value of at least 10 percent of the total
value of the corporation, or $100,000.
G.
Post-Transfer Treatment of Retained Interests
If an interest in a corporation or partnership retained by the transferor or an applicable family member is valued under section 2701, that interest is given special
treatment in subsequent transfers, on upon the expiration of the interest of the
transferor or applicable family member in a trust that holds the interest. Sections
2701(d)(1), (d)(2)(C), and (e)(6); Reg. § 25.2701-4(b)(1).
1.
Adjustments to prevent tax-avoidance. If a retained interest is given
value under section 2701 because it is (or is elected to be) a right to
“qualified payments,” and that interest is subsequently transferred during
life or at death, if any such payments are in arrears or have ever been
more than four years in arrears (for any reason), the taxable estate or
taxable gifts will be increased to reflect the value of the distributions in
arrears (and the time-value of distributions that were more than four
years late) on the assumption that all such distributions were timely made
and invested at the discount rate (presumably compounded) originally
used to value the retained interest. Section 2701(d)(2)(A).
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Example 5: Common stock is transferred and preferred stock is retained
carrying a $100 cumulative dividend payable on the first day of each
year—or a $100 noncumulative dividend which the holder of the preferred
stock elects to treat as a “qualified payment” for purposes of valuing the
transferred common stock. The valuation discount rate used is 10 percent.
The $100 dividend is not paid, and the holder dies ten years later. The
holder’s taxable estate is increased to reflect a total value for the unpaid
dividends of $1,753, which is the value of ten annual $100 payments
compounded at 10 percent. Thus, if the unpaid dividends are included in
the holder’s gross estate at a noncompounded value of $1,000, the special
increase to the taxable estate by reason of this rule is $753. Reg.
§ 25.2701-4(c)(1)(ii)(C). (Similarly, if the dividend itself accrued 10
percent compound interest—or were paid in kind, with the same effect—
there presumably would be no addition to the taxable estate.) Note that at
a 55-percent estate tax rate, the estate tax on this right to receive $1,000
would in effect be $964!
Example 6: After the transaction described in Example 5, the first ten
$100 dividends are paid after ten years, and the holder of the preferred
stock dies after another ten years, or twenty years after the dividend was
originally due. The four-year grace period applies to treat the seventh,
eighth, ninth, and tenth dividends as having been paid on time. The first
six $100 payments are compounded at 10 percent from their original due
dates to the date of the holder’s death—that is, for 20, 19, 18, 17, 16, and
15 years, respectively. The total value of those six payments, compounded
to the end of the twentieth year at 10 percent, is $3,223. The $600 paid
with respect to those dividends at the end of the tenth year is also
compounded forward for another ten years, to produce a value of $1,556.
The difference is $1,667. Thus, the holder’s taxable estate is increased by
$1,667.
a.
The regulations clarify that this compounding penalty is not
triggered by an inter vivos transfer that does not remove the value
of the transferred property from the transferor’s gross estate
(without regard to section 2035). Reg. § 25.2701-4(b)(2).
b.
The due date of qualified payments from which the compounding
penalty is calculated is the last day of the calendar year, unless a
different date is specified. Reg. § 25.2701-4(c)(2).
c.
Dickman-like gifts: Under the regulations, the amount of this
compounding penalty is reduced by “[t]he amount by which the
individual’s aggregate taxable gifts were increased by reason of
the failure of the individual to enforce the right to receive
qualified payments”—i.e., gifts imputed under principles of
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Dickman v. Commissioner, 465 U.S. 330 (1984).
§ 25.2701-4(c)(1)(ii)(C)(3).
d.
Reg.
Presumed consequences of operating directly on the taxable
estate (or on taxable gifts), rather than on the value of the retained
interest included in the gross estate.
i.
To the extent the increase is attributable to the compounding, it will not be absorbed by the charitable deduction if the retained interest is bequeathed (or given) to
charity. The common shareholders, not the charity, have
received the benefit of the deferred payment.
Example 7: The stock in Example 5, with ten $100 dividends in arrears, is bequeathed to charity. The value of the
stock plus the ten $100 dividends are included in the decedent’s gross estate and qualify for a charitable deduction.
The taxable estate is still increased by $753.
ii.
e.
There is no effect on basis under section 1014 or the
qualification of the estate for special treatment under
sections 303, 2032A, and 6166.
Limitation: The increase in the taxable estate or in taxable gifts is
limited to the proportional increase in value (from the date of the
original transfer to the date of the subsequent transfer) in the
interests in the entity junior to the applicable retained interest.
Section 2701(d)(2)(B).
i.
The proportion is determined with reference to the
individual’s retained interest, compared to the total
amount of that class of interest outstanding. Reg.
§ 25.2701-4(c)(6)(iii).
(a)
For example, if an individual holds 60 percent of
the outstanding single class of a preferred interest,
the limitation is 60 percent of the intervening
increase in the value of the junior interest.
(b)
The regulations provide that if an individual holds
60 percent of one class of preferred interest and 40
of another class of preferred interest, the limitation
is still 60 percent.
- 18 -
f.
ii.
The increase in value of the junior interest is determined
without regard to any liability with respect to the unpaid
qualified payments. Reg. § 25.2701-4(c)(6)(i)(A)(1).
iii.
The junior interest is valued for this purpose without
regard to the 10-percent minimum equity floor. Reg.
§ 25.2701-4(c)(6)(ii).
iv.
In addition to the increase in value of the junior interest,
however, the regulations add in the amount used by the
entity to redeem any of the junior interest during the
period following the transfer.
Reg. § 25.27014(c)(6)(i)(A)(2).
v.
Apparently the increase in value of all the outstanding
junior interest is taken into account, regardless of how
much of that junior interest is owned by family members
or how much was involved in the original transfer. Therefore, if a preferred interest has been treated once as a right
to qualified payments in valuing any transfer of a junior
interest, there seems to be little reason not to so treat it
again in valuing any subsequent transfer of a junior
interest, at least so long as the same generations are
involved.
vi.
Because of this limitation, if distributions are or have
been more than four years in arrears, and if the value of
the business is demonstrably but (it is thought)
temporarily depressed, that may be a good time to trigger
the compounding rule by a transfer of some or all of the
preferred interest.
Mitigating the overvaluation of these deferred payments that
results from compounding them before income tax.
i.
Section 691(c) might not apply to an adjustment made
directly to the “taxable estate,” nor to a dividend that is
not declared before the decedent’s death.
ii.
Compare Boyle v. United States, 355 F.2d 233, 235-37
(3d Cir. 1965), reh’g en banc denied per curiam, 355 F.2d
237 (3d Cir. 1966), in which the court en banc, with only
one dissent, apparently agreed that the equitable
recoupment principle of Bull v. United States, 295 U.S.
247 (1935), should apply.
- 19 -
iii.
g.
Making qualified payments.
i.
h.
There is no gift tax equivalent of section 691(c) in any
event.
The payment must be made before the taxable event—i.e.,
before death or inter vivos transfer—to qualify for the
four-year grace period. Reg. § 25.2701-4(c)(5).
(a)
In other words, payments in arrears will be compounded and included in the calculation, even if
they are less than four years in arrears.
(b)
Therefore, pre-gift or, if possible, deathbed
planning should include consideration of bringing
such payments up-to-date.
ii.
Payments will be treated, however, as applying first to the
earliest unpaid qualified payments. Reg. § 25.27014(c)(4). (It is not clear how this applies in the case of
payments that were in arrears before the transfer that
triggered the application of section 2701.) Therefore,
pre-gift or deathbed planning must consider the feasibility
of bringing all qualified payments up-to-date.
iii.
Payment may be made by a note with a term of no more
than four years and with compound interest at a rate no
less than the original valuation discount rate, accruing
from the original due date of the qualified payment. Reg.
§ 25.2701-4(c)(5). This ostensibly gives a corporation or
partnership up to eight years to pay a qualified payment in
cash, but compound interest must be paid for the entire
deferral period if cash payment is deferred more than four
years.
iv.
Distributions paid in kind (PIK preferred) are not treated
as payment. Reg. § 25.2701-4(c)(5). Nevertheless,
assuming adequate coverage, the regulations achieve
much the same effect by reducing the compounding
penalty by reference to the then value of any equity
interest received in kind in lieu of a qualified payment.
Reg. § 25.2701-4(c)(1)(ii)(C)(2).
Elective application of these rules: Although the ordinary
occasion for application of these rules is the death of the holder of
the retained interest or a gift or sale of the retained interest by that
- 20 -
holder, the holder may elect to apply these rules at any time a
distribution is paid more than four years late, to stop the compounding. Section 2701(d)(3)(A)(iii).
i.
The compounding is brought current with respect to all
previous payments, which are thereafter treated as having
been timely made. Reg. § 25.2701-4(d)(1).
Example 8: As in Example 6, ten $100 dividends are paid
at the end of the tenth year. The recipient could elect to
treat that event as a taxable gift of $643—the first six $100
dividends compounded at 10 percent ($1,243) less the
actual payments ($600) (ignoring the last four dividends,
which are treated as having been paid on time).
ii.
i.
The limitation with reference to the increase in the value
of the junior interest is not available.
Reg.
§ 25.2701-4(d)(2). That precludes the technique of
making catch-up payments in bad years when the overall
value of the entity might be depressed. (The technique,
described above, of transferring the preferred interest in
bad times remains available.)
Transfers to family members.
i.
Spouse: If a transfer of a retained interest that would
otherwise be subject to these rules is a transfer at death to
the holder’s spouse for which an estate tax marital deduction is allowed or an inter vivos transfer to the holder’s
spouse for which the spouse pays consideration or for
which a gift tax marital deduction is allowed, these rules
are not applied at that time, but are applied upon the death
of the spouse or transfer by the spouse. Section
2701(d)(3)(B).
(a)
The regulations treat the surviving spouse’s
purchase from the holder’s estate with funds
received from a marital deduction bequest as a
marital deduction transfer for this purpose. Reg.
§ 25.2701-4(b)(3)(ii)(C).
(b)
Discretionary allocations to a marital bequest after
the due date of the estate tax return and purchases
by the spouse after the due date of the estate tax
return are recognized only if a statement identifying the allocation or purchase is filed with the
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return and the allocation or purchase is confirmed
by another statement filed at least one year before
the expiration of the estate tax statute of limitations. Reg. § 25.2701-4(b)(3)(ii)(B)(2) & (C).
ii.
2.
III.
Others: If an inter vivos transfer of a retained interest is
made to another applicable family member other than the
holder’s spouse, these rules are applied at that time and
again (with respect to payments due after that transfer)
upon the death of that transferee or transfer by that transferee. Section 2701(d)(4)(B); Reg. § 25.2701-4(b)(3)(i).
Adjustments to prevent double taxation.
a.
Section 2701(e)(6) provides that, under regulations, “if there is
any subsequent transfer, or inclusion in the gross estate, of any
applicable retained interest which was valued under the rules of
subsection (a), appropriate adjustments shall be made for purposes of chapter 11, 12, or 13 to reflect the increase in the amount
of any prior taxable gift made by the transferor or decedent by
reason of such valuation.”
b.
Regulations provide that this adjustment takes the form of a
reduction of the subsequent gift or estate tax base by either the
amount by which the transferor’s taxable gifts were originally
increased by the operation of section 2701 or the amount by
which the subsequent taxable transfer is increased as a result of
not applying the valuation rules of section 2701, whichever is
lesser. Reg. § 25.2701-5, T.D. 8536, 59 Fed. Reg. 23152 (May 5,
1994).
Buy-Sell Agreements, Options, and Similar Arrangements (Section 2703)
A.
Historical Requirements
See the discussion in Technical Advice Memorandum 9133001.
1.
Obligation on the part of the estate to sell at death, either under a binding
purchase agreement or under a purchase option held by the entity or by
the other owners.
2.
Reasonable price fixed by the agreement or by a reasonable formula
provided in the agreement.
3.
Prohibition of disposition during life, without first offering to sell to
other parties pursuant to the agreement.
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4.
B.
The tests of Reg. § 20.2031-2(h).
a.
Bona fide business arrangement.
b.
Not a device to transfer such property to the natural objects of the
transferor’s bounty for less than adequate and full consideration.
New Requirements
Buy-sell agreements, options, and similar arrangements, including the right to
“use” property (see Reg. § 25.2703-1(d), Example 1 (applying the rules to a
lease)), are disregarded in determining transfer tax value (including the part-gift
treatment of lifetime sales) unless they meet certain tests.
1.
Codification of the tests in Reg. § 20.2031-2(h).
a.
While the statute uses the undefined term “family” for this
purpose, Reg. § 25.2703-1(b)(1)(ii) in effect interprets “family”
to be the “natural objects of the bounty of the transferor,” which
is the test in Reg. § 20.2031-2(h). The Small Business Job
Protection Act of 1996 contained nothing on this subject,
although an earlier version would have added “natural objects of
the bounty” to the statute itself. Section 102(f)(1) of H.R. 1555,
102d Cong., 1st Sess. (1991).
b.
Thus, nieces and nephews, who are not members of the family for
other purposes of chapter 14, may be members of the family for
purposes of section 2703. See Letter Ruling 9222043.
c.
The Service has taken the position in pending litigation that a
long-time business partner, who is otherwise unrelated, can be a
“natural object of the bounty.” Estate of Louis A. Turner v.
Commissioner, Tax Court Dkt. No. 6869-89 (now settled).
2.
Clarification that both tests must be met, not just one. Section 2703(b).
This adopts the reasoning of St. Louis County Bank v. United States, 674
F.2d 1207 (8th Cir. 1982) (accord, Estate of Lauder v. Commissioner, 60
TCM 977 (1990) (Lauder I)), and prevents the conclusion that a business
purpose necessarily excludes the possibility that an arrangement is a taxavoidance device. See also Estate of Lauder v. Commissioner, 64 TCM
1643 (1992) (Lauder II); 68 TCM 985 (1994) (Lauder III). Cf. Estate of
Hall v. Commissioner, 92 T.C. 312 (1989).
3.
Addition of a third requirement that the terms must be “comparable to
similar arrangements entered into by persons in an arm[’s] length
transaction.” Section 2703(b)(3). Reg. § 25.2703-1(b)(4)(i) and (ii)
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appears to permit either a “general business practice” test based on actual
data or a “could have been” test based on subjective judgment.
C.
4.
Third-party safe harbor. An agreement is considered to meet each of
these three requirements if more than half of the value of the property
subject to the agreement is owned by persons who are not applicable
family members of the transferor, descendants of the parents of the
transferor or of the transferor’s spouse, or natural objects of the transferor’s bounty. Reg. § 25.2703-1(b)(3).
5.
Exception for qualified conservation easements. Reg. § 25.2703-1(a)(4).
6.
Separate test of multiple rights or restrictions. Multiple rights or restrictions are tested separately. Reg. § 25.2703-1(b)(5). Thus, if one such
right or restriction fails the section 2703 tests and is disregarded, any
concurrent right or restriction might still be permitted to affect the transfer tax value of the property subject to that right or restriction.
7.
See Estate of Church v. United States, 2000-1 USTC ¶ 60,369, 85 AFTR
2d 2000-804 (W.D. Tex. 2000), and Estate of Strangi v. Commissioner,
115 T.C. No. 35 (2000) (rejecting the Government’s broad application of
section 2703 to the underlying property in a limited partnership to deny
valuation discounts that are otherwise justified by the partnership
structure).
Effective Date—Substantial Modification
1.
Section 2703 applies to buy-sell and similar arrangements entered into on
or after October 9, 1990, or substantially modified on or after that date.
Section 11602(e)(1)(A)(ii) of OBRA.
2.
A substantial modification is generally one that results in more than a de
minimis change to the quality, value, or timing of the parties’ rights or
restrictions. Reg. § 25.2703-1(c)(1). It does not include—
a.
A modification required by the underlying pre-October 9, 1990
agreement—even to add a family member as a party to the agreement, if that is mandatory under the agreement.
Reg.
§ 25.2703-1(c)(2)(i). But it is not enough that a family member
who becomes a new shareholder or partner must also become a
party to the agreement; adding the family member as a new
shareholder or partner must itself be mandatory.
b.
The addition of a party to an agreement in the same or higher
generation as other parties. Reg. § 25.2703-1(c)(1); Letter
Rulings 9226063 (as modified by Letter Ruling 9248026),
9735043 & 200010015. Cf. Letter Ruling 9620017 (transfer of
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shares to lower-generation family members accompanied by the
release of those shares from the shareholder agreements would
constitute a substantial modification).
c.
The addition as a party to the agreement of a partnership that is
owned entirely by original parties to the agreement. Letter Ruling
199924015.
d.
The addition of a charitable remainder unitrust as a party to a
shareholders’ agreement. Letter Ruling 9652009.
e.
Modification of terms other than the terms of the right or restriction. Reg. § 25.2703-1(c)(2)(ii).
f.
Exemption of additional potential transferees from the restriction
on transfer. Letter Ruling 9719014.
g.
A modification that results in an option price closer to fair market
value. Reg. § 25.2703-1(c)(2)(iv); Letter Rulings 9417007,
9652010, 9735043 & 200015012. This can even include the
selective removal of a discount from full value in the case of
certain owners, such as a surviving spouse, marital trust, or exempt
organization or trust. See Letter Ruling 9719014.
h.
Substitution of an unrelated creditor. Letter Ruling 9226063, as
modified by Letter Ruling 9248026.
i.
A stock split with a corresponding adjustment of voting rights.
Letter Ruling 9241014. See also Letter Ruling 9141043
(corrected by Letter Ruling 9221042).
j.
Recapitalization in which new stock remains subject to buy-sell
agreement. Letter Ruling 9711017.
k.
Split-up of a corporation into multiple corporations, accompanied
by the shareholders’ adoption of the original corporation’s buysell agreement for the resulting corporations. Letter Ruling
9843010.
l.
A pro rata distribution of partnership property (works of art) to
the partners. Letter Ruling 9725018.
m.
Contributions by partners of their partnership interests to LLCs.
Letter Rulings 9811026 & 9811027.
n.
An agreement that adds to, but is consistent with and does not
alter, the terms of a pre-October 9, 1990 agreement (although the
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new terms will themselves be tested under section 2703). Letter
Rulings 9218074 & 9226051.
IV.
o.
Transfers of shares to non-family employees and repurchase of
those shares upon termination of their employment. Letter
Ruling 9620017.
p.
Creation of a stock option plan for non-family employees and
award of stock appreciation rights to non-family employees.
Letter Ruling 200010015.
3.
Generally, all changes made by a single amendment will be considered
together in applying the substantial modification test. See, e.g., Letter
Ruling 9432017.
4.
The failure to update an agreement as required by the agreement can be a
substantial modification. Reg. § 25.2703-1(c)(1). In other words,
grandfathered status can be lost by doing nothing. But see Letter Ruling
9152031, in which the Service ruled that the current updating of the
value of a partnership was not a substantial modification, even though
the partners had neglected such required updating in the past (partnership
agreement required updating at least every five years—last updating had
occurred eight years before).
5.
Such a substantial modification even of a post-October 8, 1990 agreement could be significant, because it could establish a new “entered-into”
date for testing the business purpose, reasonableness, and arm’s-length
comparability of the agreement.
Lapsing Rights and Restrictions (Section 2704)
A.
B.
Preconditions
1.
Control of the entity by the family.
2.
“Family” includes the individual’s spouse, any ancestor or descendant of
the individual or the individual’s spouse, any brother or sister of the individual (but not of the individual’s spouse), and the spouse of any such
ancestor, descendant, brother, or sister. Section 2704(c)(2).
Operation
- 26 -
1.
2.
A lapse of voting or liquidation rights—such as upon the death of a
general partner—that decreases the value of the holder’s interest is
treated as a taxable transfer, subject to gift or estate tax, in the amount of
that decrease (less any consideration received, in the case of a lapse
during life). Section 2704(a); Reg. § 25.2704-1; Technical Advice
Memorandum 9804001.
a.
A voting right includes the right to vote on any matter and
includes the right of a general partner to participate in the
management of the partnership. Reg. § 25.2704-1(a)(2)(iv).
b.
A put right is treated as a liquidation right, not as a voting right.
Reg. § 25.2704-1(a)(2)(iv).
c.
The rule applies to a lapse of a liquidation right only to the extent
the transferor’s family has the power of liquidation after the
transfer, ignoring any restrictions imposed by the governing
instrument. Reg. § 25.2704-1(c)(2)(i). It does not apply to a
lapse which causes liquidation power to pass outside of the
family.
d.
The mere transfer of an interest to someone else within the family
is not a lapse, if the voting or liquidation rights are transferred
with the interest. A transfer of one interest that destroys the
ability to liquidate a retained interest is treated as a lapse of a
liquidation right if the retained interest is subordinate to the
transferred interest. Reg. § 25.2704-1(c)(1) & (f), Example 7.
For this purpose, “subordinate” has the same meaning as it does
in Reg. § 25.2701-3(a)(2)(iii), that is, “an equity interest in the
entity as to which an applicable retained interest is a senior equity
interest.” See Reg. § 25.2704-1(a)(2)(vi).
e.
There is no exception for publicly-traded interests or for lapses by
operation of law. There is, however, an exception for lapses
caused by subsequent changes in state law. Reg. § 25.27041(c)(2)(iii).
Lapsing restrictions on liquidation are disregarded for transfer tax valuation purposes. Section 2704(b).
a.
There is an exception for restrictions imposed by federal or state
law. Section 2704(b)(3)(B).
i.
The test is whether the restriction, viewed in isolation, is
more severe than state law. Reg. § 25.2704-2(b). For
examples of how harsh this “viewed in isolation”
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approach can be, see Reg. § 25.2704-2(d), Examples 2 &
3.
C.
ii.
But state law should be examined closely to determine
exactly what rights are conferred upon withdrawal. For
example, a general partner who withdraws from a limited
partnership may be entitled to the “fair market value,” or
simply “fair value,” of his or her partnership interest, but
not necessarily the liquidation value. See, e.g., Revised
Uniform Limited Partnership Act § 604 (1976). A limited
partner may not have the right to withdraw at all, if the
partnership agreement fixes a future date for liquidation.
Id. § 603.
iii.
See Kerr v. Commissioner, 113 T.C. No. 30 (1999), and
Knight v. Commissioner, 115 T.C. No. 36 (2000) (broad
view of “applicable restrictions” rejected in light of state
law).
iv.
“Special allocations” in a partnership agreement, such as
the right of some partners to recover their capital before
distributions are made with respect to other partnership
interests, can create separate classes, which subject the
partnership to section 2701 (and presumably can also
trigger section 2704(a)). Technical Advice Memorandum
199933002.
b.
The rule applies to restrictions which either will lapse (such as a
limitation on the right to vote for a term of years) or can be
removed by the family (ignoring any restrictive rules in the
governing instrument). Reg. § 25.2704-2(b).
c.
The rule does not apply to “any commercially reasonable restriction which arises as part of any financing by the corporation or
partnership with a person who is not related to the transferor or
transferee, or a member of the family of either.” Section
2704(b)(3)(A). The regulations specify section 267(b) as the test
for “related” parties (excluding a bank from the term “fiduciary of
a trust”) and expand the reference to “financing” to include the
provision of equity capital. Reg. § 25.2704-2(b).
d.
There is no exception for publicly-traded interests.
Coordination with Other Provisions
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D.
V.
1.
If a liquidation or put right has been previously valued under section
2701(a), section 2704(a) does not apply to the lapse of that right “to the
extent necessary to prevent double taxation (taking into account any
adjustment available under § 25.2701-5).” Reg. § 25.2704-1(c)(2)(ii).
This exception applies only if the lapsing right is owned at the time of
the lapse by the same person in whose hands it was valued under section
2701(a). Reg. § 25.2704-1(f), Example 8.
2.
If section 2703 applies, section 2704(b) does not apply. Reg. § 25.27042(b).
a.
Therefore, while a “penalty for early withdrawal” will
presumably be disregarded under section 2704(b), it should be
given effect if it is contained in a buy-sell agreement and satisfies
the bona fide business purpose, not-a-device, and arm’s-length
comparability tests of section 2703.
b.
In contrast, the “commercially reasonable” exception of section
2704(b)(3)(A) applies only to agreements with unrelated lenders
or investors.
Purpose
1.
“These rules are intended to prevent results similar to that of Estate of
Harrison v. Commissioner,” 52 TCM 1306 (1987). Conference Report
at 1137. See also 56 Fed. Reg. 46247. Cf. Estate of Watts v. Commissioner, 51 TCM 60 (1985), aff’d, 823 F.2d 483 (11th Cir. 1987). The
apparent objective is to require more use of liquidation value, rather than
going-concern value, for transfer tax purposes.
2.
“These rules do not affect minority discounts or other discounts available
under [former] law.” Conference Report at 1137. This is confirmed in
Reg. § 25.2704-1(f), Example 4.
Trusts and Term Interests (Section 2702)
A.
Overview
Using the general rule that the amount of a taxable gift arising from a transfer in
trust is the total value of the transferred property less the value of the transferor’s
retained interest (Reg. § 25.2512-5(a)(1)(i)), section 2702(a)(2) provides special
rules for valuing that retained interest.
B.
Preconditions
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C.
1.
Transfer in trust to or for the benefit of the transferor’s spouse, a
descendant of the transferor or the transferor’s spouse, the spouse of any
such descendant, an ancestor of the transferor or the transferor’s spouse,
the spouse of any such ancestor, a brother or sister of the transferor, or
the spouse of any such brother or sister. Section 2702(a)(1) and (e).
Such a transfer could take the form of an assignment of an interest in an
existing trust (Reg. § 25.2702-2(a)(2)) or apparently even the lapse of a
“five-and-five” withdrawal power (Letter Ruling 9804047).
2.
Retention of any interest in the trust by the transferor or an applicable
family member—the transferor’s spouse, ancestors of the transferor or
the transferor’s spouse, or the spouses of any such ancestors. Section
2702(a)(1) and (e).
a.
The inclusion of anyone other than the transferor will only rarely
be significant, because normally it is only the interest retained by
the transferor that affects the value of the taxable gift. (See
Example 10 below.)
b.
No minimum percentage interest in the trust is required.
c.
A retained power sufficient to render any part of the gift incomplete is treated as a retained interest. Reg. § 25.2702-2(a)(4).
Operation
1.
Normal valuation rules (under section 7520) (section 2702(a)(2)(B)) will
be used to value a “qualified interest.”
a.
A “qualified interest” is the right to receive—
i.
a fixed amount payable at least annually—i.e., an annuity
interest (section 2702(b)(1));
ii.
an amount payable at least annually equal to a fixed percentage of the fair market value of the trust property,
determined annually—i.e., a unitrust interest (section
2702(b)(2));
iii.
an annuity amount or unitrust amount each year, whichever is greater (and the greater value is used to compute
the gift) (Reg. § 25.2702-3(d)(1)); or
iv.
a noncontingent remainder following one of the above
(section 2702(b)(3)).
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2.
b.
The annuity amount or unitrust percentage may increase by no
more than 20 percent each year, and may go down in any amount.
Reg. § 25.2702-3(b)(1)(ii)(A) & (B), (c)(1)(ii) & (e), Examples 2
& 3.
c.
The regulations contain technical rules recalling the rules applicable to charitable split-interest trusts under the Tax Reform Act of
1969. Reg. § 25.2702-3.
d.
Commutation of the term interest is prohibited. Reg. § 25.27023(d)(4). Cf. Rev. Rul. 88-27, 1988-1 C.B. 331.
e.
The value of the retained interest may not be increased by giving
the grantor a contingent reversion or (apparently) by continuing
the retained interest for a term certain (payable to the grantor’s
estate) beyond the grantor’s death. Reg. § 25.2702-3(e), Examples 1 & 5.
The value of any retained interest other than a qualified interest will be
treated as being zero. Section 2702(a)(2)(A).
Example 9: A grantor places property with a value of $1,000 in a trust,
retaining the right to a simple income interest for 10 years. The remainder
beneficiaries are children of the grantor. The actuarial value of the income
interest (under section 7520) is $650. The value of the retained interest is
treated as zero, and the grantor is treated as having made a gift of $1,000
to the children.
Example 10: Similarly, if a child made a gift of his or her interest in the
trust during the trust term, that child would apparently be treated as having
made a gift of the entire value of the trust property.
D.
3.
There are no elections—in or out. The election, in effect, must be made
when the trust instrument is drafted.
4.
The gift tax marital deduction is not affected.
Post-Transfer Treatment of Retained Interests
1.
The subsequent failure to timely make prescribed annuity or unitrust
payments will presumably have tax consequences, with no four-year
grace period. Thus, all other things being equal, the availability of a
four-year grace period might make a corporation or partnership more
useful than a trust.
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2.
The subsequent transfer of an interest previously valued at zero will
entitle the transferor to a reduction in aggregate taxable gifts—in
adjusted taxable gifts in the case of a transfer at death. Reg. § 25.2702-6.
a.
The amount of the reduction is the lesser of the original increase
in taxable gifts resulting from the application of section 2702 and
the increase in taxable gifts (or in the gross estate) resulting from
the subsequent transfer. Reg. § 25.2702-6(b)(1).
b.
The increase in taxable gifts resulting from the subsequent
transfer is reduced by any annual exclusion applied to that
transfer. But the annual exclusion is applied to other transfers
first, which maximizes the amount of this adjustment. Reg.
§ 25.2702-6(b)(2).
c.
If the subsequent transfer is “split” by a husband and wife, each
spouse is entitled to half the reduction to which he or she would
otherwise be entitled, but either spouse may assign this entitlement to the other at any time. Reg. § 25.2702-6(a)(3).
Example 11: Following the grantor’s creation of the trust
described in Example 9, the grantor relinquishes the balance of the
term interest when the term interest has a value of $550. The
grantor is allowed a reduction in taxable gifts at that time of $550.
If, however, the value of the balance of the term interest at that
time is $900 (because the value of the trust property has increased),
taxable gifts are reduced by $650 (the amount of the original
increase in taxable gifts by reason of section 2702 at the time of the
original transfer). In each case, it is assumed that the grantor made
other gifts to the same donees sufficient to absorb the annual exclusion, which is applied against those other gifts first. Otherwise, to
the extent of the annual exclusion, this reduction is lost; it may not
be applied against other gifts.
E.
Exceptions
1.
A transfer in trust that is not a completed gift, such as the creation of a
revocable trust. Section 2702(a)(3)(A)(i).
2.
A transfer to a charitable split-interest trust or pooled income fund. Reg.
§ 25.2702-1(c)(3), (4) & (5); Letter Ruling 199936038. Under an
amendment of the regulations proposed on April 18, 1997, and finalized
on December 9, 1998, however, a transfer to a charitable remainder
unitrust on or after May 19, 1997, is excepted only if the payout to the
noncharitable beneficiary or beneficiaries is a straight unitrust amount
(not limited to net income as permitted by section 664(d)(3)) or if the
- 32 -
only noncharitable beneficiaries are the donor, the donor’s spouse, or
both the donor and the donor’s spouse if the spouse is a citizen of the
United States. Reg. § 25.2702-1(c)(3). The purpose of this rule is to
prevent the circumvention of section 2702 by investing the assets of a
“NIMCRUT” (that is, a trust governed by section 664(d)(3)(A) & (B)) in
non-income-producing investments during the term of the interests of the
donor and the donor’s spouse, thereby redirecting distributions that
would otherwise be payable to the donor or donor’s spouse to successive
beneficiaries in younger generations.
F.
3.
The assignment of a remainder if the only retained interest is as a permissible recipient of income in the sole discretion of an independent trustee.
Reg. § 25.2702-1(c)(6).
4.
A transfer to a spouse under a property settlement described in section
2516. Reg. § 25.2702-1(c)(7). But any transfer to a descendant or anyone else, other than the spouse, is not excepted. See Letter Ruling
9235032.
Term Interests and Joint Purchases
1.
For purposes of these rules, a transfer of an interest in property with
respect to which there is a term interest—for life or for a term of years—
is treated as a transfer of a trust interest. Section 2702(c)(1). A lease is
excepted if it provides for rent payments that are determined in good
faith to reflect fair rental value. Reg. § 25.2702-4(b).
2.
For purposes of section 2702, a joint purchase by family members is
treated as a purchase by the person acquiring the term interest followed
by that person’s transfer of the remainder. Section 2702(c)(2).
(Presumably, under section 2702(c)(1), that deemed transfer of a remainder is in turn deemed to be the transfer of an interest in trust, and thus
subject to the annuity trust/unitrust rules. See Letter Ruling 9412036.)
Example 12: A parent and child jointly purchase a piece of property from
an unrelated seller for $1,000. The parent purchases a simple life interest
in the property, and the child purchases the remainder. The parent pays
the actuarial value of the life interest—assumed to be $600—and the child
pays $400. The parent is treated as having made a $600 gift to the child
(the $1,000 value of the property, less the child’s consideration of $400).
The result might be different if the parent’s interest were structured
as an annuity or unitrust interest, although in the case of joint purchases
this is unclear. (See Letter Ruling 9412036.)
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G.
Personal Residences
A trust holding a personal residence of the holder of the term interest in the trust is
exempted from the section 2702 valuation rules. Section 2702(a)(3)(A)(ii).
1.
“Personal residence”: This term has been quite liberally applied. See
Letter Rulings 9639064 (43-acre tract with multiple structures, where
subdivision was prohibited by zoning ordinances), 9645010 (16.6 acres
with multiple structures), 9701046 (five adjoining parcels, the total size
of which was comparable to residential properties in the neighborhood),
9705017 (three adjoining parcels, the total size of which was comparable
to residential properties in the neighborhood), 9714025 (residence, guest
house, caretaker’s residence, carriage house, pool building, and storage
barn), 9717017 (8-acre tract), 9718007 (vacation property consisting of a
main residence, separate guest facilities, a caretaker’s house, and other
appurtenant structures), 9735011 (two parcels, but together still smaller
than the typical lot size in the neighborhood), 9735035 (forest land
improved by a residence, guest house, boathouse, two garages, two
sheds, and a pond), 9741004 (large house with two rental suites
integrated) 9750048 (zoning laws relevant for this purpose even though
the subject property was grandfathered under the zoning laws), 9816003
(property that included a guest house rented to an unrelated tenant),
9817004 (property improved by a large single family dwelling, a
detached garage, a hot tub and changing building, a pool and pool
pumphouse, a gazebo, a camping house, and a storage and equipment
building), 9818014 (property improved by a main house, a guest cottage,
a swimming pool with a cabana and pump shed, a garage with a threeroom apartment above, a barn, and a frame barn, with the total acreage
comparable in size to other residential properties in the area), 9827037
(property including a main residence, guest house, two detached garages,
a boathouse, two sheds and a pond, despite the fact that the property had
been certified by the local government as forestland, which resulted in a
lower property tax rate but which required the first cutting of forest
products by the year 2000), 9829026 (a tract of at least six acres and
possibly at least ten acres, including a 100-year-old residential dwelling
and a barn used for storage), 199908032 (residence with pier, boat dock,
and small guest house, used for half of each year as a vacation home),
199916030 (large single-family dwelling, swimming pool, caretaker’s
residence, garage, small barn or stable, and fenced pasture), 199918042
(single-family residence and two-car garage on wooded/recreational
acreage similar in amount to other parcels in the community), 200004037
(2.5-acre plot, including a house and barn, severed for purposes of the
transaction from an 11.8-acre plot leased for farming use), 200010013 (a
“ranch” used as a vacation home, consisting of a tract of “a” acres on
which the grantor had built a house, garage, and caretaker’s quarters, and
an adjacent tract of “b” acres) & 200039031 (principal residence, two out
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buildings, and a swimming pool on a parcel encumbered by a permanent
conservation easement) and Technical Advice Memoranda 9722009
(personal residence, guest cottage, swimming pool, pool house,
garage/caretaker’s apartment, and horse barn) & 9841015 (single family
home, sheep barn, horse barn, and shed).
2.
Two-residence limit: Limited to either the principal residence of the
term holder or one other residence of the term holder within the meaning
of section 280A(d)(1) (disregarding section 280A(d)(2)) or an undivided
fractional interest in either. Reg. § 25.2702-5(b)(2). The two-residence
limit is applied to residences, not to trusts, and therefore more than two
trusts may hold fractional interests in not more than two personal
residences. No single trust, however, may hold an interest in more than
one residence. Reg. § 25.2702-5(b)(1). A residence includes the stock
and lease of a tenant-stockholder in a cooperative housing corporation, if
the property would otherwise qualify as a residence. Letter Rulings
9433016, 9249014 & 9151046. Cf. Letter Ruling 9544018 and former
section 1034(f). The Service has ruled that this applies even if the
grantor-occupant continues to hold legal title to the stock, as a nominee,
on behalf of the trust. Letter Ruling 9249014.
3.
Personal residence trusts. Reg. § 25.2702-5(b).
4.
a.
The trust ordinarily may not hold cash, and may not hold furnishings. Reg. § 25.2702-5(b)(1).
b.
The term holder may pay trust expenses directly. Id. (But such
payments can be taxable gifts.)
c.
The trust may hold the proceeds of casualty insurance or condemnation (and by implication may therefore hold an insurance
policy), but must reinvest those proceeds within two years. Reg.
§ 25.2702-5(b)(1) & (3).
Qualified personal residence trusts. Reg. § 25.2702-5(c).
a.
This trust may hold cash reasonably required for mortgage payments, expenses, and the cost of improvements within the next
six months, or for purchase of a residence within the next three
months if there is a contract for the purchase of such a house
when the cash is added. Reg. § 25.2702-5(c)(5)(ii)(A)(1).
Excess cash must be distributed to the term holder at least quarterly, and all cash held by the trust at the termination of the term
holder’s interest must be distributed to the term holder within 30
days. Reg. § 25.2702-5(c)(5)(ii)(A)(2).
- 35 -
b.
The regulations expressly authorize the trustee to hold a policy of
insurance on the residence, but proceeds of insurance or condemnation must be held in a separate account, and repair or replacement of the residence must be completed within two years. Reg.
§ 25.2702-5(c)(5)(ii)(D) & (7)(iii). (Care should be taken where
household furnishings are insured by the same policy.)
c.
The trustee may be authorized to sell the residence, but, if so,
must (i) reinvest in a new residence for the term holder within
two years, (ii) terminate the trust and distribute all the trust
property to the term holder, (iii) convert the trust to a qualified
annuity trust, or (iv) have the right to elect either termination or
conversion. Reg. § 25.2702-5(c)(7) & (8). If the reinvestment in
a new residence does not use the entire sale proceeds (or the
proceeds of insurance or condemnation), the excess may be
converted to a GRAT. Reg. § 25.2702-5(c)(8)(ii)(C)(3).
i.
Out of concerns that the grantor’s transfer to the trust
might be treated as an incomplete transfer (because the
grantor can revoke it by moving out of the house), termination of the trust and distribution of all the trust property
to the term holder should be an option only if it is elective
with an independent trustee.
ii.
If a QPRT converts to a GRAT, the annuity is calculated
so as to reproduce the annuity that would have produced
the same gift tax treatment if the trust had been set up as a
GRAT in the first place. Reg. § 25.2702-5(c)(8)(ii)(C).
The annuity will generally be greater than the 7520 rate,
however, because its value under section 7520 will have
to emulate not only the value of the QPRT term interest
but also the value of the contingent reversion that would
have been effective to reduce the amount of the taxable
gift upon creation of the QPRT, even though it would
have no tax effect in a GRAT.
iii.
Conversion to a GRAT may be deferred until 30 days
after disqualification of the trust (i.e., up to 25 months
after sale of the residence), but deferred annuity payments
must bear compound interest at the section 7520 rate.
Reg. § 25.2702-5(c)(8)(ii)(B) & (d), Example 6.
iv.
A qualified personal residence trust that wholly converts
to an annuity trust is no longer counted in applying the
two-residence limit. Cf. Proposed Reg. § 25.2702-5(b),
56 Fed. Reg. 14321, 14338 (April 9, 1991).
- 36 -
d.
Commutation of the term interest is prohibited. Reg. § 25.27025(c)(6). Cf. Rev. Rul. 77-305, 1977-2 C.B. 72.
e.
For trusts created after May 16, 1996, the governing instrument
must prohibit the sale or transfer of the residence to the grantor
(or to the grantor’s spouse or any entity controlled by either of
them) during the QPRT term or at any time thereafter that the
trust is a grantor trust under sections 671-677. Reg. §§ 25.27025(c)(9) & 25.2702-7.
5.
Reversion: Because a personal residence trust or qualified personal residence trust is exempted from section 2702, the gift tax value of the
transferred interest can be further depressed by use of a contingent reversion (or general power of appointment) in the grantor if the grantor dies
during the trust term.
6.
Legal term interests: There is no reason why a legal term interest in a
personal residence should not qualify for the same exception, although
the governing instrument requirements in the regulations apparently
would still have to be met.
7.
Proposed repeal: The Administration’s proposed fiscal 1999, 2000, and
2001 budgets recommended the repeal of the personal residence
exception from section 2702. The Treasury Department’s explanation
gave the following “reasons for change”:
“Because the exemption under section 2702 completely removes
personal residence trusts from section 2702, such trusts receive more
favorable gift tax treatment than that given to the statutorily authorized
GRATs and GRUTs. Specifically, when valuing the gift made to the
remainderman in a personal residence trust, the value of any reversionary
interest in the grantor can be taken into account, and such value reduces
the amount of the taxable gift. In contrast, even if the grantor has a
reversionary interest in a GRAT or a GRUT, section 2702 prohibits the
actuarial value of that interest from being taken into account in valuing
the gift.
“Furthermore, by requiring a grantor's retained interest in a trust
to take the form of an annuity or a unitrust, section 2702 was attempting
to make sure that the grantor would actually receive the interest valued
by the actuarial tables. This requirement was designed to prohibit the
pre-2702 grantor retained income trust (GRITs), in which the actuarial
tables were used to value the grantor's retained income interest even
when the projected income was zero or minimal.
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“Experience has shown that the use value of the residence
retained by the grantor is a poor substitute for an annuity or unitrust
interest. In the personal residence trust, the grantor ordinarily remains
responsible for the insurance, maintenance and property taxes on the
residence. Therefore, the true rental value of the house should be less
than fair market rent. In these circumstances, the actuarial tables
overstate the value of the grantor's retained interest in the house.”
H.
Certain Tangible Property
A trust interest or term interest involving non-wasting tangible property, such as
vacant land, art, or jewelry, will be valued at what the holder of the interest establishes as the amount an unrelated third party would pay for it. Section 2702(c)(4).
VI.
1.
Improvements to land that do not increase the value of the land by more
than 5 percent are disregarded. Reg. § 25.2702-2(c)(2)(ii).
2.
Conversion into non-qualifying property may be treated as a gift of the
entire value of the trust, unless the trust converts to a qualified annuity
trust. Reg. § 25.2702-2(c)(4).
Special Statute of Limitations Rule (Section 6501(c)(9))
1.
Under OBRA, the three-year gift tax statute of limitations was suspended
for gifts resulting from the new valuation rules of sections 2701 and 2702
(or an increase in taxable gifts under section 2701(d)), unless the transfer
was adequately disclosed on a gift tax return. Section 6501(c)(9).
2.
Requirements of adequate disclosure. Reg. § 301.6501(c)-1(e).
a.
A description of the transaction, including a description of both
the transferred and the retained interest.
b.
Identification of all persons involved in the transaction and their
relationship to the transferor.
c.
Identification of all persons related to the transferor who hold an
equity interest in the entity.
d.
A detailed description of the valuation methods used, including
actuarial factors, discount rates, and financial and other data. The
regulations state that this “should generally include” financial
statements of the entity for each of the five preceding years. Reg.
§ 301.6501(c)-1(e)(iii).
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3.
The information required by Reg. § 301.6501(c)-1(e) is a significant
amount of information, and it is unlikely that a gift tax return would
normally contain so much detail. In the case of an operating entity, the
provision of financial statements for the last five years is often regarded
as especially intrusive, and it should not be surprising to learn that many
donors and their advisers point to the fact that the regulation states only
that such financial statements “should” be furnished to justify not
furnishing them, even in a transaction covered by section 2701 or 2702,
especially for relatively small transfers.
4.
Effective January 1, 1997, the Taxpayer Relief Act of 1997 (TRA ’97)
extended this rule, in effect, to all gifts.
a.
b.
TRA ’97 also made the following related changes:
i.
Amendment of section 2504(c) to drop the requirement
that a current gift tax must have been paid to achieve
finality of valuation for gift tax purposes, thus extending
the finality of valuation provided by that statute to gifts
that merely use some or all of the donor’s applicable
exclusion amount.
ii.
A new section 2001(f), overruling, in effect, Estate of
Smith v. Commissioner, 94 T.C. 872 (1990) (reviewed by
the Court), acq., 1990-2 C.B. 1, and precluding
revaluation even for estate tax purposes of all gifts
disclosed on a gift tax return.
iii.
A new section 7477 to empower the Tax Court to issue
declaratory judgments regarding the value of gifts,
including use of the “exclusion amount” (“unified
credit”).
The greatest significance of these “relief” provisions of TRA ’97
is that they will help persons with middle-sized estates, who
cannot afford to make gifts of such magnitude that they are in the
top bracket where the Smith rule does not affect them, and who
cannot necessarily even afford to make gifts that use up their
applicable exclusion amounts and generate some current tax. Cf.
Rev. Rul. 79-398, 1979-2 C.B. 338 (use of the unified credit is
mandatory, and section 2504(c) cannot be invoked by making a
tax payment before the credit is exhausted); Rev. Rul. 84-11,
1984-1 C.B. 201 (use of the unified credit is not a “payment” for
purposes of section 2504(c)). Such a person will now be able to
make a moderate-sized gift and know that three years after filing
a gift tax return reporting that gift the Service will not be able to
- 39 -
revalue the gift for purposes of computing the tax on future gifts
or the tax on that person’s estate. If the gift does not use all of
the donor’s applicable exclusion amount, the exclusion amount
which the donor assumes will be available for future transfers
really will be. If the Service disagrees with that, it must say so
currently—i.e., within three years—and the donor can appeal
such a determination to the Tax Court even if no gift tax
deficiency is actually assessed.
c.
Nevertheless, the expansion of section 6501(c)(9) is a
tremendously significant departure from long-settled policies of
repose in the administration of the tax system. Under the new
rule, the Service will apparently be free at any time to impose gift
tax (with interest and possibly penalties) on the most insignificant
or dubious gift that is inadvertently or for good cause omitted
from a gift tax return.
d.
An example of a “gift” that might innocently be omitted from a
gift tax return is the component of a sale that the Service chooses
with the benefit of hindsight to treat as a gift. This might be an
increasing possibility if, as some predict, the new lower rates of
tax on capital gains encourage more use of sales in estate
planning.
e.
Regulations were published in proposed form in December 1998
and in final form in November 1999. Reg. § 301.6501(c)-1(f).
i.
In contrast to the controversial proposed regulations, the
final regulations provide what might be viewed as “safe
harbors”—lists of elements of disclosure which, if
provided, will cause a transfer to be “considered
adequately disclosed.” Reg. § 301.6501(c)-1(f)(2). Some
of these elements of disclosure may be provided by
submitting an appraisal that meets certain criteria. Reg. §
301.6501(c)-1(f)(3).
ii.
The regulations helpfully confirm that it is possible to
report transactions on gift tax returns that would not
otherwise be reported, such as gifts completely sheltered
by the annual exclusion or transactions believed not to
give rise to gifts at all. Reg. § 301.6501(c)-1(f)(4).
iii.
In a very welcome development, the final regulations
change prior law and provide that for purposes of the
calculation of gift tax in the future, and of estate tax,
adequate disclosure of a transfer will preclude the future
- 40 -
reopening of all issues related to that transfer, including
legal issues, not just issues of valuation. Reg. §§
20.2001-1(b) & 25.2504-2(b).
iv.
f.
g.
For discussion of the regulations in greater detail, see
Aucutt, “Practice Alert: Gift Tax Disclosure And Repose
Rules Clarified By Regulations,” RIA ESTATE PLANNER’S
ALERT, Feb. 2000, at 1.
Disclosure required to start the gift tax statute of limitations must
be made “on a gift tax return . . . or in a statement attached to the
return.” Reg. § 301.6501(c)-1(f)(1); cf. section 6501(c)(9). This
presents the dilemma of how to remedy a shortcoming in the
disclosure that accompanied the original return, when the law
does not specifically provide for amended gift tax returns.
Fulfilling a commitment in the Treasury-IRS 2000 Priority
Guidance Plan to provide “guidance under section 2501 relating
to late adequate disclosure,” Rev. Proc. 2000-34, 2000-34 I.R.B.
186, solves this dilemma.
i.
Beginning August 22, 2000, the disclosure requirements
may be met by filing an amended gift tax return with the
following caption at the top of the first page: “Amended
Form 709 for gift(s) made in [insert calendar year] - In
accordance with Rev. Proc. 2000-34, 2000-34 I.R.B.
186.” Rev. Proc. 2000-34, § 4.
ii.
The amended return, which must be filed in the same
Service Center as the original return, must identify the
transfer in question (which presumably can be by a
reference to the appropriate item in the original return),
but otherwise need only provide what the original return
lacked.
iii.
The Service will accept any other submissions filed before
August 22, 2000, if they contain sufficient information to
comprise adequate disclosure under the regulations. No
resubmissions to conform to the format and procedural
requirements of Rev. Proc. 2000-34 are required. Rev.
Proc. 2000-34, § 5.
It is to be expected that clients and their advisers will devise
creative ways to “disclose” transactions, perhaps by
overdisclosing both donative and non-donative transfers each
year.
- 41 -
VII.
h.
Disclosure strategy should also take into account the requirement
at the top of Schedule A of the December 1996 version of the gift
tax return (Form 709) to check a box if the value of any item
reported on the return “reflect[s] any valuation discount.” When
this requirement first appeared, the strategy of choice appeared to
be to avoid checking this box if possible. With the expansion of
section 6501(c)(9), the strategy of choice may actually be to
check the box, so as to reduce the doubt that the disclosure is
adequate.
i.
The six-year statute of limitations of section 6501(e)(2),
applicable where omitted gifts exceed 25% of reported gifts, will
have little or no further significance for gift tax purposes. The
test for determining whether the six-year statute of limitations is
avoided is whether an item has been disclosed “in the return, or in
a statement attached to the return, in a manner adequate to apprise
the Secretary of the nature and amount of such item.” The test for
determining whether the unlimited statute of limitations is
avoided is whether an item has been disclosed “in the return, or in
a statement attached to the return, in a manner adequate to apprise
the Secretary of the nature of such item.” Theoretically, a
disclosure could be adequate to apprise the Service of the
“nature” of a possible gift and still not be adequate to disclose the
“nature and amount” of the gift, so that the unlimited statute of
section 6501(c)(9) is avoided but the six-year statute of section
6501(e)(2) is not. As a practical matter, however, it is likely that
“nature” for this purpose includes “amount,” and the two tests
would be administered in the same way.
j.
Under the six-year statute of limitations, the Government has the
burden of proving both that the disclosure was inadequate and
that a gift was made. Peters v. Commissioner, 51 T.C. 226, 230
(1968); Estate of Dillingham v. Commissioner, 903 F.2d 760, 762
(10th Cir. 1990), aff’g, 88 T.C. 1569 (1987). Presumably this
will also be the rule under the expanded section 6501(c)(9).
What’s Left of Estate Freezing Techniques?
A.
Non-Family Capital Freezes
1.
For example, with a transfer (by gift or sale) of common stock or a
residual partnership interest to nieces and nephews or other persons not
members of the family, while retaining preferred stock or a preferred
partnership interest.
- 42 -
2.
B.
Section 2701 does not apply.
Qualified Payment Capital Freezes
1.
Technique: The older generation transfers common stock or a residual
partnership interest to the younger generation and retains preferred stock
or a preferred partnership interest with cumulative dividends or distributions that meet the requirements of qualified payments (or noncumulative
dividends or distributions that are elected to be treated as qualified
payments).
2.
Advantages.
a.
The value of the corporation or partnership can be frozen with a
cost of a current gift tax on a value which could be as small as 10
percent of the current value of the business (because of the
10-percent minimum equity floor of section 2701(a)(4)).
b.
Additional gift-tax saving and a minimum distribution burden can
be achieved if the value of the corporation or partnership is
currently depressed or market interest rates are currently low.
c.
The gift tax cost might be reduced somewhat if preferred stock is
given a valuable feature not reached by section 2701, such as
voting rights and/or preemptive subscription rights.
d.
The retention of voting rights can permit the transfer of value
without sacrificing control.
e.
The adjustment of gift tax value in connection with an estate tax
audit is now precluded by new section 2001(f), and in any event
the consequences of any such an adjustment is limited to loss of
the unified credit and lower tax rate brackets. Estate of Smith v.
Commissioner, 94 T.C. 872 (1990) (reviewed by the Court), acq.
1990-2 C.B. 1.
f.
Any gift tax paid is itself excluded from the transfer tax base
under the “tax-exclusive” calculation of the gift tax, if the donor
survives three years. Section 2035(c).
g.
Dividends or partnership distributions can be deferred up to four
years (eight years if notes are used and compound interest is provided for) if the corporation or partnership has difficulty paying
them, and there is no penalty for not paying dividends or partnership distributions at all if the corporation or partnership does not
increase in value.
- 43 -
3.
4.
Drawbacks.
a.
The transaction has to be disclosed in meticulous detail to meet
the requirements of section 6501(c)(9) and Reg. § 301.6501(c)1(e) & (f).
b.
The gift tax value could be challenged on audit.
c.
There could be substantial transaction costs, including
particularly the cost of the services of an appraiser, to make the
necessary valuations, to recommend an appropriate preferred
dividend or distribution rate, and to provide the valuations of all
the classes of stock or partnership interests required to apply the
“subtraction method.”
d.
Elections may have to be obtained from older generation shareholders or partners other than the transferor, such as the transferor’s spouse or parents.
e.
The dividends or partnership distributions have to be paid if the
corporation or partnership does well, under penalty of the compounding rule of section 2701(d).
i.
This drains the corporation or partnership of capital and
adds to the estate of the shareholder or partner.
ii.
Only rarely will it be better to keep the capital in the corporation or partnership and incur the compounding for
estate tax purposes (but this is a theoretical possibility).
The corporation or partnership could then pay the estate
tax liability by redeeming preferred stock or a preferred
partnership interest.
Structuring the preferred stock or preferred partnership interest.
a.
Noncumulative, with an election-in. Section 2701(c)(3)(C)(ii)
and Reg. § 25.2701-2(c)(2).
i.
Supposed advantages.
(a)
Avoids a debt on the entity’s financial statements,
if the dividends or distributions are not actually
paid.
(b)
Avoids subjecting the accumulated dividends or
partnership distributions to estate tax (other than
by reason of section 2701(d)).
- 44 -
(c)
ii.
b.
Allows flexibility in the subsequent payment of
dividends on common stock.
Potential problems.
(a)
Without cumulative dividends or distributions, it
might be difficult to sustain the non-section-2701
fair market value of the preferred stock or preferred partnership interest, which is a ceiling on
the value produced by the election-in. Reg.
§ 25.2701-2(c)(2).
(b)
If dividends are not cumulative, there may be no
legal way to make catch-up payments to avoid the
compounding rule of section 2701(d) if dividends
are not paid in accordance with the terms of the
election-in. (This may be less of a problem in a
partnership.)
(c)
The failure to receive a dividend or partnership
distribution might be treated as a gift to the other
shareholders or partners, under the principles of
Dickman v. Commissioner, 465 U.S. 330 (1984).
Letter Ruling 8723007; Technical Advice Memorandum 9301001. Cf. Lewis G. Hutchens NonMarital Trust v. Commissioner, 66 TCM 1599,
1618-20 (1993); Snyder v. Commissioner, 93 T.C.
529, 547 (1989).
See Reg. § 25.27014(c)(1)(ii)(C)(3) (reducing the amount of the
section 2701(d) compounding penalty by the
amount of any such Dickman-like gift).
(d)
The compounding treatment of section 2701(d)
can be horrendous. To avoid it, the payments may
have to be made anyway.
Cumulative, with no election-out (although applicable family
members must elect to stay in under Reg. § 25.2701-2(c)(4)).
i.
Avoids the above problems with noncumulative interests.
ii.
Guarantees security for the shareholder or partner, if, for
example, the preferred stock dividends or preferred
partnership distributions are intended to provide
retirement income for a retiring owner who parts with
control of the entity.
- 45 -
C.
Non-Qualified Payment Capital Freezes
1.
Technique: The older generation transfers common stock or a residual
partnership interest to the younger generation and retains noncumulative
preferred stock or a noncumulative preferred partnership interest.
2.
Advantages.
3.
a.
The value of the corporation or partnership can be frozen with a
cost of a current gift tax on the entire value of the corporation or
partnership, which could be relatively small if the value of the
corporation or partnership is currently depressed. This is
especially useful if the total gift is no more than $600,000
($1,200,000 in the case of a married couple).
b.
The gift tax cost might be reduced somewhat if preferred stock is
given a valuable feature not reached by section 2701, such as
voting rights and/or preemptive subscription rights.
c.
The retention of voting rights can permit the transfer of value
without sacrificing control.
d.
The adjustment of gift tax value in connection with an estate tax
audit is now precluded by new section 2001(f), and in any event
the consequences of any such an adjustment is limited to loss of
the unified credit and lower tax rate brackets. Estate of Smith v.
Commissioner, 94 T.C. 872 (1990) (reviewed by the Court), acq.
1990-2 C.B. 1.
e.
Any gift tax paid is itself excluded from the transfer tax base
under the “tax-exclusive” calculation of the gift tax, if the donor
survives three years. Section 2035(c).
f.
Dividends or partnership distributions do not have to be paid, but
are available in the event of the preferred shareholder’s or
partner’s special need. (A put right that lapses at or before death
can provide the same benefit.)
g.
No elections have to be obtained.
Drawbacks.
a.
The tax on the entire value (or virtually the entire value) of the
corporation or partnership might be high.
- 46 -
4.
D.
b.
This transaction also has to be disclosed in meticulous detail to
meet the requirements of section 6501(c)(9) and Reg.
§ 301.6501(c)-1(e) & (f).
c.
The gift tax value could be challenged on audit.
d.
The failure to receive a dividend or partnership distribution might
be treated as a gift to the other shareholders or partners, under the
principles of Dickman v. Commissioner, 465 U.S. 330 (1984).
Cf. Snyder v. Commissioner, 93 T.C. 529 (1989). See Reg.
§ 25.2701-4(c)(1)(ii)(C)(3) (reducing the amount of the section
2701(d) compounding penalty by the amount of any such
Dickman-like gift).
Structuring the preferred stock or preferred partnership interest.
a.
Noncumulative, with no election-in: Avoids a debt on the financial statements of the corporation or partnership, avoids subjecting the accumulated dividends or partnership distributions to
estate tax, and allows flexibility in the subsequent payment of
dividends on common stock.
b.
Cumulative, with an election-out: Seems never to be appropriate,
except perhaps to deal with cumulative preferred stock which is
already outstanding but on which dividends have not consistently
been paid.
Gifts of a Single Class of Ownership
1.
Advantages.
a.
A corporation’s status as an S corporation (which cannot have
preferred stock) can be preserved.
b.
Control can be retained through the transfer of nonvoting
common stock (or a limited partnership interest in a pro rata
partnership).
- 47 -
c.
d.
In contrast to preferred capital freezes, discounts for lack of
control or lack of marketability can be maximized, even if the
initial ownership is not fractionalized.
i.
For example, if 70 percent of the stock of a corporation is
recapitalized into preferred stock, and a minority, etc.
discount of 40 percent is applied to the common stock, the
total discount is equal to only 12 percent (40% x 30%) of
the total value of the corporation.
ii.
In contrast, if the corporation is not recapitalized, the
discount might absorb a full 40 percent of the value of the
corporation.
As to discounts generally,
i.
“[A] minority discount will not be disallowed solely
because a transferred interest, when aggregated with
interests held by family members, would be a part of a
controlling interest.” Rev. Rul. 93-12, 1993-1 C.B. 202
(minority discounts allowed with respect to simultaneous
gifts of five equal portions of all the stock of a corporation
to the donor’s five children). See also Reg. § 25.27013(d), Example 4, Step 4. Cf. Propstra v. United States,
680 F.2d 1248 (9th Cir. 1982); Estate of Bright v. United
States, 658 F.2d 999 (5th Cir. 1981) (en banc); Estate of
Lee v. Commissioner, 69 T.C. 860 (1978). Cf. also
Minahan v. Commissioner, 88 T.C. 492 (1987) (litigation
costs assessed against the Service for continuing to litigate
this issue); Whittemore v. Fitzpatrick, 127 F. Supp. 710
(D. Conn. 1954) (gifts of three 200-share blocks by owner
of all 820 shares of stock of a corporation valued as three
separate blocks, not as a 600-share control block). For
further elaboration of the Service’s reasoning in Rev. Rul.
93-12, see Technical Advice Memorandum 9449001.
ii.
“[A]ll relevant factors are to be considered when valuing
closely held stock. . . . All relevant factors including the
minority nature of each block, any marketability concerns,
and swing vote potential, should be taken into account in
valuing each block.” Technical Advice Memorandum
9436005 (emphasis added) (swing-vote attributes of three
30-percent blocks of stock transferred by the donor are to
be taken into account).
- 48 -
iii.
2.
E.
In other words, the opportunity to combine or ally with
other blocks to form a control block should be taken into
account (TAM 9436005), but such combination or
alliance should not be presumed (Rev. Rul. 93-12).
e.
The adjustment of gift tax value in connection with an estate tax
audit is now precluded by new section 2001(f), and in any event
the consequences of any such an adjustment is limited to loss of
the unified credit and lower tax rate brackets. Estate of Smith v.
Commissioner, 94 T.C. 872 (1990) (reviewed by the Court), acq.
1990-2 C.B. 1.
f.
Dividends do not have to be paid, and no elections are needed.
Drawbacks.
a.
The gift tax value could be challenged on audit.
b.
For this technique to work best, transfers should be made in
increments. Meanwhile, however, the increase in value of the
corporation might outrun the gifts. In addition, the shareholder
might die before the gift program can make a significant
difference.
A Section 355 Split-Up or Split-Off
1.
The principal issue regarding the application of section 355 to a
corporate division that occurs as part of an estate plan relates to the
business purpose requirement.
2.
The following are examples of business purposes, collected by the
Service in part through its review of ruling requests, set forth in Rev.
Proc. 96-30, 1996-1 C.B. 696, Appendix A (and illustrated in letter
rulings sampled from a roughly one-year period):
a.
To facilitate the issuance of stock to a key employee. E.g., Letter
Rulings 9822037 (Feb. 27, 1998), 9826045 (March 31, 1998),
9830016 (April 24, 1998), 9849013 (Sept. 4, 1998), 199911049
(Dec. 16, 1998) (modified by Letter Ruling 199937019 (June 16,
1999)), 199917026 (Jan. 27, 1999), 199924013 (March 16, 1999)
(“in order to satisfy the desire of each shareholder-general
manager” “to have a direct and substantial interest in the business
each manages and not as part of a multi-faceted entity”) &
199947024 (Aug. 31, 1999).
b.
To facilitate a stock offering by either corporation. E.g., Letter
Ruling 9821055 (Feb. 24, 1998), Letter Ruling 9841050 (April
- 49 -
15, 1998), supplemented by Letter Ruling 9841027 (July 13,
1998) & Letter Ruling 199910026 (Dec. 10, 1998) (facilitating a
public offering by, or acquisition of, the spun-off corporation)
and Letter Rulings 9844020 (Aug. 3, 1998), 199909029 (Dec. 2,
1998), 199910025 (Dec. 10, 1998), 199937001 (March 25, 1999)
(apparently modified by 199938021 (June 28, 1999)) &
199951014 (Sept. 22, 1999). In addition, Letter Ruling 9821055
involved a spin-off that allowed the parent to comply with
requirements of the Bank Holding Company Act of 1956 and
allowed the spun-off subsidiary to expand its businesses (in a
publicly-traded corporation) free from federal and state banking
regulation. Cf. Letter Ruling 199909027 (Dec. 2, 1998) (allowing
a distributing corporation to retain a percentage of the stock of a
spun-off corporation, to reduce the distributing corporation’s
costs of raising capital by permitting it to sell the retained stock in
a contemplated public offering of the spun-off corporation’s
stock).
c.
To facilitate borrowing by either corporation. E.g., Letter
Rulings 199911005 (Dec. 1, 1998), 199937008 (June 8, 1999) &
199951033 (Sept. 28, 1999).
d.
To obtain significant cost savings, including reduction of state or
foreign taxes, insurance costs, and borrowing costs. E.g., Letter
Rulings 9823052 (March 11, 1998) (eliminating a nexus for state
taxation), 9833006 (May 13, 1998) (reduced insurance premiums
and reduced auditing costs), 199909038 (Dec. 8, 1998) (saving
state tax) & 199921025 (Feb. 24, 1999) (unspecified cost savings
from the elimination of a holding company).
e.
To achieve “fit and focus.”
i.
Often these involve explicit shareholder disputes. E.g.,
Letter Rulings 9819033 (Feb. 6, 1998) (“numerous
business disputes”), 9819035 (Feb. 9, 1998) (“serious
disputes have arisen”), 9819044 (Feb. 11, 1998) (“serious
disputes have arisen”), 9823040 (March 9, 1998)
(“serious disputes have arisen”), 9823046 (March 10,
1998) (“numerous disputes have arisen . . . which have
resulted in substantial litigation”), 9829050 (April 22,
1998) (“serious disputes have arisen”), 9832035 (May 11,
1998) (“certain disputes have arisen”), 9836013 (June 4,
1998) (“differences of opinion have arisen”), 9843016
(July 21, 1998) (“serious disputes have arisen”), 9844001
(July 22, 1998) (“serious disputes have arisen”), 9847009
(Aug. 18, 1998) (“serious disputes have arisen”),
- 50 -
199906024 (Nov. 17, 1998) (“serious disputes have
arisen”), 199909031 (Dec. 3, 1998) (“marital discord . . .
result[ing] in management deadlock”), 199911031 (Dec.
18, 1998) (“significant disputes have arisen”), 199913026
(Jan. 4, 1999) (“serious disputes have arisen”),
199916014
(Jan.
13,
1999)
(“concerns
of
mismanagement” resulting in a lawsuit), 199920017 (Feb.
12, 1999) (“dissension and jealousy have arisen”),
199924045 (March 24, 1999) (“significant disputes have
arisen”), 199929018 (April 21, 1999) (“serious disputes
have arisen”), 199937011 (June 11, 1999) (“corporate
deadlock”), 199946009 (Aug. 13, 1999) (“H and W were
divorced on date f, and their split up has not been
amicable. Although their management styles and business
philosophies have always differed, their differences
escalated dramatically before the divorce.”), 199947019
(Aug. 30, 1999) (“significant disagreements have
developed”), 199947020 (Aug. 31, 1999) (“substantial
differences in the managerial philosophies of the
Businesses that have arisen among the shareholders”) &
199952032-034 (Sept. 27, 1999) (“serious fundamental
differences of opinion”). In a related ruling, Letter Ruling
9843016 held that the unamortized section 481(a)
adjustments of the distributing corporation could not be
split between the two corporations, but would continue to
be amortized only by the distributing corporation.
ii.
But often the reasons are expressed less dramatically.
E.g., Letter Rulings 9821054 (Feb. 24, 1998) (the
shareholders “believe that the operations of each business
would be more efficient and profitable if each shareholder
were allowed to operated independently of the other”),
9823039 (March 9, 1998) (“for various reasons each of
[two shareholders] shares a desire to operate a portion of
[the business] apart from the influence of the other”),
9826044 (March 31, 1998) (desire to reflect the
concentration of each shareholder’s efforts), 9843033
(July 28, 1998) (“misalignment” of management
expertise), 199906007 (Nov. 2, 1998) (“the interaction
between the businesses has gotten smaller”), 199907007
(Nov. 12, 1998), supplemented by Letter Ruling
199912019 (Dec. 12, 1998) (“each shareholder group
wishes to go its own way”), 199913002 (Dec. 14, 1998)
(“over the years, the shareholders . . . have differed on a
number of business issues”), 199915018 (Jan. 7, 1999)
- 51 -
(“to improve the fit and focus”), 199928022 (April 5,
1999) (separation along geographic lines), 199932041
(May 19, 1999) (each family “wishes to concentrate” on
its respective business), 199937001 (March 25, 1999) (“a
separation (i) will enhance the success and efficiency of
Business F by removing limitations and internal conflicts
resulting from Distributing’s ownership of Business F and
(ii) will enhance the future success and efficiency of the
Other
Businesses
by permitting
Distributing’s
management to focus exclusively on its business plan”),
199939025 (June 24, 1999) (“to allow each of the
shareholders to go their separate ways and enhance the
efficiency and profitability of each of the two businesses”)
& 199940006 (Aug. 13, 1999) (“B is more interested in
managing business a which is conducted by Distributing
while A and C are more interested in managing business b
which is carried on by Controlled”).
iii.
The history of “fit and focus” as a ground for an IRS
ruling is controversial. See White, “Rev. Proc. 96-30
Revisited: What Is IRS Ruling Policy on ‘Fit and Focus’
Cases?” 40 TAX MGMT. MEMO., S-7 (Jan. 18, 1999).
f.
To address significant concerns of customers or suppliers. E.g.,
Letter Rulings 9829047 (April 21, 1998), 199904040 (Oct. 19,
1998), 199908010 (Nov. 19, 1998), 199915031 (Jan. 12, 1999) &
199937014 (June 15, 1999). See also Rev. Rul. 75-337, 1975-2
C.B. 124 (ensuring that survivors could renew an automobile
dealership franchise under the auto manufacturer’s rules granting
franchises only to majority shareholders or to minority
shareholders active in the business is a valid business purpose).
g.
To facilitate an acquisition of the distributing corporation or an
acquisition by either corporation.
i.
E.g., Letter Ruling 9833003 (May 8, 1998) (facilitating a
subsidiary’s acquisition of a corporation, whose shareholders refused to consent to the acquisition only if the
subsidiary was separated from the parent).
ii.
This permitted purpose is now limited by the “anti-Morris
Trust” amendments to section 355 made by the Taxpayer
Relief Act of 1997. See section 355(e), and proposed
regulations (REG-116733-98) published August 19, 1999.
- 52 -
h.
To significantly reduce the risks to one business from another
business. E.g., Letter Rulings 199915018 (Jan. 7, 1999) &
199920024 (Feb. 17, 1999).
See Bloom & Kelloway, “New Guidelines for Spinoff Rulings Bring
Consistency and Predictability but Problems Remain,” 85 J. TAXATION
36 (1996); Mahoney, “New §355 Procedure Addresses Business Purpose
Ruling Areas,” 37 TAX MGMT. MEMO., S-128 (May 27, 1996).
3.
Many estate planning purposes for a spin-off or other divisive transaction
are likely to be personal purposes of the shareholders. Although the case
law provides some support for the view that personal purposes can justify
a tax-free division, the regulations limit valid business purposes to
corporate purposes.
4.
Estate of Parshelsky v. Commissioner, 303 F.2d 14 (2d Cir. 1962), and
Rafferty v. Commissioner, 452 F.2d 767 (1st Cir. 1971), cert. denied, 408
U.S. 922 (1972), illustrate the view of the case law. Both cases involved
similar facts: a distribution by an operating company of stock of a real
estate subsidiary to enable the principal shareholder or his estate to
transfer ownership of the operating and real estate companies to separate
grantees or legatees. In Parshelsky, the Court of Appeals for the Second
Circuit held that “shareholders’ personal non-tax avoidance reasons” for
a spin-off must be considered in addition to the corporate benefit
resulting from the transaction. 303 F.2d at 17. In contrast, in Rafferty,
the Court of Appeals for the First Circuit suggested that personal
purposes, while not irrelevant, should be given less weight than corporate
purposes. The court wrote that personal purposes cannot justify the
application of section 355 to a transaction that has “considerable” device
potential. 452 F.2d at 770-71.
5.
Although the case law is unclear regarding the extent to which a business
purpose may be a shareholder purpose instead of a corporate purpose, the
regulations leave no doubt regarding the position of the Service and the
Treasury Department.
i.
The regulations limit the application of section 355 to
transactions that are motivated, in whole or in substantial
part, by one or more corporate business purposes. Reg.
§ 1.355-2(b)(1). Adding further emphasis to the point, the
regulations go on to state that “[a] shareholder purpose
(for example, the personal planning purposes of a
shareholder) is not a corporate business purpose.” Reg.
§ 1.355-2(b)(2).
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F.
ii.
The regulations acknowledge, however, that in a case
involving closely-held corporations, it may be difficult to
differentiate between shareholder and corporate purposes.
The regulations provide that the business purpose
requirement is met in a case in which the shareholder
purpose is so nearly coextensive with a corporate business
purpose that the two cannot be distinguished. Id. Thus,
the purpose of resolving shareholder differences in values,
business objectives, or risk tolerance in a closely-held
business can be a business purpose.
iii.
This is an area where the Service’s letter rulings must be
watched closely to detect changes in the Service’s views.
The most recent rulings (all favorable) are cited above.
Letter Ruling 9819033 (Feb. 6, 1998), cited above, is a
good straightforward example of the warranties and
representations that generally have to be made to obtain a
favorable ruling.
6.
A divisive transaction could be used to effect a post-mortem “freeze” by
separating ownership of a growth business and a more mature business.
After the transaction, the stock of the two resulting corporations would
be divided by generation. For example, stock of the growth business
could be transferred to the decedent’s children and stock of the more
mature business could be transferred to the decedent’s spouse. It is
unlikely, however, that this purpose, standing alone, would meet the
business purpose requirement, at least as articulated in the regulations.
Note also that, even in Parshelsky, although the spin-off was carried out
to effect a scheme of distribution, leaving separate businesses to separate
legatees, there was no evidence that the scheme of distribution was
motivated by transfer tax savings.
7.
This is not a pro-rata “spin-off.” It requires a complete separation of the
two businesses, with different boards of directors, etc.
8.
If done right, and after an appropriate length of time, the spun-off
subsidiary’s stock might be sold at capital-gain tax rates.
Use of a Partnership Instead of a Corporation
1.
Advantages.
a.
Avoids a double income tax.
b.
Often easier to change.
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2.
3.
c.
May be greater limitations on liquidation or withdrawal,
especially in a limited partnership for a fixed term.
d.
Therefore, likely to warrant greater valuation discounts.
e.
A transfer of a partnership interest while retaining the right to
“vote” as a general partner avoids the “anti-Byrum rule” of
section 2036(b). See United States v. Byrum, 408 U.S. 125
(1972); Rev. Rul. 81-15, 1981-1 C.B. 457; Technical Advice
Memoranda 8611004 & 9131006; Letter Rulings 9415007,
9332006, 9310039 & 9026021; GCMs 38984 & 38375. But see
Technical Advice Memoranda 9043074 & 9751003. On the other
hand, the transfer of voting stock to a partnership controlled by
the transferor as general partner may well be caught by section
2036(b).
f.
Sometimes shielded better from creditors, who can only get a
charging order (which could trigger a mandatory buy-back
provision).
Disadvantages.
a.
Sacrifice of limited liability.
b.
Even a limited partnership needs at least one general partner,
which could be an S corporation (if the classification of the entity
as a partnership for tax purposes is not jeopardized).
Types.
a.
Straight.
i.
With guaranteed payments.
(a)
An advantage of guaranteed payments, rather than
returns that are treated as qualified payments, is
that they are not “applicable retained interests” at
all (section 2701(c)(1)(B)(iii) and Reg. § 25.27012(b)(4)(iii)), and therefore they avoid both the
subtraction method of Reg. § 25.2701-3(b) and the
compounding rule of section 2701(d).
(b)
Note that noncontingent guaranteed payments
could create taxable income to the partner in years
when the partnership cannot use the deduction.
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ii.
iii.
b.
(c)
In general. a guaranteed payment is “portfolio
income” under the passive activity loss rules of
section 469 and presumably “personal holding
company income” under section 543.
(d)
Under the disguised sale rules adopted in 1992, a
guaranteed payment that exceeds 150 percent of
the highest applicable federal rate will be
presumed to be a payment of proceeds of sale,
subjecting the “seller” to taxable gain. Reg.
§ 1.707-4(a)(3)(ii).
(e)
Generally a person must have more than just a
guaranteed payment, or he or she might not be a
partner at all for income tax purposes.
With gross income allocations (preference returns)—e.g.,
a specified percentage share of the profits up to a stated
dollar amount each year, carried forward (i.e., cumulative)
to the extent profits in any year are insufficient.
(a)
If the qualified payments are not made contingent
on profits, they might be guaranteed payments,
with the consequences described above.
(b)
Dependence on profits should not affect “qualified
payment” status, so long as the payments are
cumulative. If there is concern about this, a protective election-in might be used, so long as the
family is quite confident that the distributions in
fact will be made.
(c)
A valid gross income allocation should not
produce either “portfolio income” or “personal
holding company income.”
(d)
The value of preferred partnership interests should
be reinforced with “liquidation participation
rights,” discussed at page 12 supra, but avoiding
the “lower of” rule discussed at page 11.
With both guaranteed payments and preference returns.
Reverse (the “reverse partnership freeze”).
i.
Basic form.
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ii.
iii.
4.
(a)
Transfer of a preference interest to a younger
generation.
(b)
The interest rate or other return rate is set high, to
reflect the speculative nature of such investments.
Rev. Rul. 83-120, 1983-2 C.B. 170.
Effects.
(a)
The high rate of return on the preference interest
depletes the value of the retained interest.
(b)
Section 2701 does not apply to a transfer of a
“senior” interest. Cf. Letter Ruling 9204016,
modified by Letter Ruling 9235018.
(c)
Nominally “residual” nature of the retained
interest prevents the older generation from
becoming impoverished relative to the younger
generation.
Risks.
(a)
The Service might argue that the nominally
“senior” interest is really the residual interest, and
section 2701 applies.
(b)
The Service might not allow the use of such a high
interest rate (such as a “junk bond” rate) without
assigning virtually all the value of the partnership
to the transferred interest anyway.
(c)
If the partnership agreement has not been carefully
drafted to avoid various income tax issues, the
Service might raise allocation issues under section
704(b), created income issues under section
707(c), denial of nonrecognition under section 721
in the case of a totally frozen interest, or deemed
sale issues (discussed supra).
Alternative: A limited liability company (LLC).
a.
Authorized by statute in all states now and apparently becoming
the wave of the future.
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G.
b.
Facilitated by the “check-the-box” entity classification rules of
Reg. §§ 301.7701-2 & 301.7701-3, as amended by T.D. 8697
(Dec. 17, 1996).
c.
The default provisions of the state law that applies (or the state
law that is selected) should be studied carefully, in light of
section 2704(b).
Use of a Partnership with a Corporation
1.
2.
3.
4.
One technique.
a.
A corporation contributes its operating assets to a partnership in
return for a frozen partnership interest.
b.
Members of younger generations contribute cash or other property to the partnership in return for a growth partnership interest.
To avoid the application of the minimum equity floor, the growth
interest should have a value equal to at least 10 percent of the
value of the entire partnership.
Advantages.
a.
The older generation’s interest is frozen without a specific
preferred stock obligation.
b.
No section 306 stock is created, and no corporate liquidation is
required.
Drawbacks.
a.
Although the preferred partnership distributions are made from
pre-tax partnership income, they are subjected to corporate
income tax when made and again to individual income tax when
they are carried out to the shareholders as dividends.
b.
Eligibility for deferral of estate tax payments under section 6166
might be lost.
Variation: Partnership of S corporations.
a.
Permits an S corporation to have a frozen partnership interest—in
effect permitting a preferred freeze in an S corporation without
using preferred stock. See Letter Ruling 8804015.
b.
Probably held to a high business-purpose standard, to avoid
recharacterization as a device to circumvent the one-class-of-
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stock rule. Cf. Rev. Rul. 77-220, 1977-1 C.B. 263 (multiple S
corporation-partners held to be a device to circumvent the limit
on the number of shareholders). Although Rev. Rul. 77-220 was
revoked by Rev. Rul. 94-43, 1994-2 C.B. 198, the extent to which
its principles might still apply to multiple S corporations with
different interests is unclear.
H.
c.
Substantial and distinct activities should be conducted at both the
partnership level and the corporate partner level. See Letter
Ruling 9026025.
d.
An arrangement involving a going concern is probably more
likely to work than one put together to house a brand new
activity. See the discussion of the “business purpose” and “sham
transaction” rules in the GCM underlying Rev. Rul. 77-220,
GCM 36966 (revoked by GCM 39886).
Use of Installment Sales to Grantor Trusts
1.
For this purpose, a grantor trust is a trust as to all of which the grantor is
treated as the owner under section 671 (and the grantor is the seller).
2.
Obvious advantages of using a grantor trust.
3.
a.
No capital gain is realized on the sale. Rev. Rul. 85-13, 1985-1
C.B. 184.
b.
No income is realized when the trust pays interest on the
installment obligation to the grantor.
c.
No gain is realized if property is transferred to the grantor in kind
in payment of any part of the installment obligation.
d.
The trust may be a shareholder of an S corporation, under section
1361(c)(2)(A)(i).
Fundamental authorities.
a.
Rev. Rul. 85-13, 1985-1 C.B. 184.
i.
Bottom line: For income tax purposes, a grantor trust is
disregarded. There can be no transactions between a
grantor and the trust. The trust is simply a pocket of the
grantor.
ii.
Rev. Rul. 85-13 essentially involved a grantor’s 1981
installment purchase (for a note) of closely-held stock
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from a Clifford-type trust. The income beneficiary of the
trust was the grantor’s son for 15 years, which, prior to the
replacement of the ten-year standard by a 5% standard in
section 673, did not render the trust a grantor trust.
Neither was there any other feature of the trust that would
render it a grantor trust.
b.
(a)
Nevertheless, the Service treated the trust as a
grantor trust, because the installment purchase was
the economic equivalent of the grantor’s purchase
of the trust’s property for cash followed by the
grantor’s borrowing the cash from the trust in
exchange for the note, and the grantor’s borrowing
from the trust, until repayment, rendered it a
grantor trust under section 675(3).
(b)
Since the trust was a grantor trust, the grantor was
treated as the owner of the trust and therefore the
owner of the note. Therefore, the transaction
could not be a sale, because the grantor was both
the maker and owner of the note, and a transaction
cannot be a sale if the same person is treated as
owning the purported consideration both before
and after the transaction.
(c)
Since the transaction was not a sale, the grantor
did not obtain a new cost basis in the stock.
iii.
The Service acknowledged that Rothstein v. United States,
735 F.2d 704 (2d Cir. 1984), had reached the opposite
result on essentially identical facts, but the Service
announced that it would not follow Rothstein (without
even an exception for the Second Circuit).
iv.
The Service has consistently cited Rev. Rul. 85-13 for the
proposition that a grantor and a grantor trust cannot have
transactions with income tax significance, most recently
in Letter Ruling 9838017 (June 19, 1998).
Letter Ruling 9535026 (May 31, 1995).
i.
Bottom line: An installment sale to a grantor trust works!
ii.
Letter Ruling 9535026 involved installment sales of stock
to trusts that were grantor trusts under section 677(a)(1)
because the trustees (the grantors’ mother and a bank),
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who had no interest in the trusts, could pay income or
principal to the respective grantors for any reason. Citing
Rev. Rul. 85-13, the Service held that the sales were
therefore nontaxable, and the trusts took the respective
sellers’ basis in the stock.
iii.
The Service went on to give three other rulings.
(a)
There would be no imputed gift if the value of the
stock equaled the face amount of the note in each
case, because the notes bore interest at the rate
prescribed under section 7872. In ruling, in effect,
that the notes would be valued at face if they bore
interest at the section 7872 rate, the Service cited
the Tax Court’s holding to that effect in Frazee v.
Commissioner, 98 T.C. 554 (1992).
(b)
Section 2701 did not apply to the transaction,
because debt is not an “applicable retained
interest.”
(c)
Section 2702 did not apply to the transaction,
because the notes were not “term interests” in the
trusts.
These three rulings were all conditioned on the status of
the notes as debt and not equity, which the Service
viewed as primarily a question of fact as to which, citing
section 4.02(1) of Rev. Proc. 95-3, 1995-1 C.B. 385, the
Service refused to rule. (Section 4.02(1) of Rev. Proc.
99-3, 1999-1 I.R.B. 103, is the same.)
iv.
c.
4.
Although the ruling does not refer to any “equity” in the
trusts, such as other property to secure the debts or
property with which to make a down payment, it is well
known that the Service required the applicants for the
ruling to commit to such an equity of at least 10% of the
purchase price. See generally Mulligan, “Sale to a
Defective Grantor Trust: An Alternative to a GRAT,” 23
EST. PLAN. 3, 8 (1996).
Thus, yesterday’s “defective” grantor trust has become today’s
effective briar patch, into which everyone wants to be thrown!
Structuring the trust.
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a.
b.
There are generally two types of assets that will be sold to a
grantor trust in an installment sale.
i.
Income-producing assets which it is hoped can remain in
the family. The estate planning objective is to protect
those assets from erosion and jeopardy of a forced sale,
caused by a large estate tax obligation. A typical example
is a family-owned business.
ii.
Any other kind of asset which for some reason is expected
to greatly outperform the interest rate on the installment
sale note and which therefore can be used to fund a family
estate plan. Typical examples include real estate in the
path of development and a business that might soon be
acquired by a public company.
In either case, the trust should be structured to give effect to the
grantor’s long-term non-tax dispositive objectives.
i.
If the subject of the installment sale is going to be
something like the family business, then the drafting of
this trust is the occasion for making decisions about the
ultimate disposition of both the control of and the
economic benefit from the business.
ii.
In all cases, this is the occasion for making decisions
about beneficiaries, standards for distributions, incentives
and rewards, control by younger generations, and the like.
iii.
This is also the time to consider and apply to this family
situation the pros and cons of locating the trust in a
jurisdiction with a relaxed rule against perpetuities.
iv.
Obviously, flexibility is important, particularly with
respect to issues such as the succession of trustees and the
situs of the trust.
c.
Plans should probably be made to allocate GST exemption to this
trust. There is generally nothing about an installment sale that
prevents that, as there is, for example, in the estate tax inclusion
period (“ETIP”) of section 2642(f) in the case of a GRAT.
d.
It might be possible to find an existing trust that is a grantor trust.
i.
It is so much the better if such a trust is a GSTgrandfathered trust (generally a pre-September 25, 1985
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irrevocable trust), to which it is unnecessary to allocate
GST exemption.
ii.
e.
5.
It might even be possible to find a GST-exempt trust that
can be made a grantor trust, perhaps by the trustee’s
relinquishment of a safeguard that would otherwise
prevent grantor trust status, such as the requirement for
adequate security within the meaning of section 675(2) for
any loans to the grantor. In practice, this is not easy,
however, because it strains fiduciary duty and it can create
the risk of including the trust property in the grantor’s
gross estate under section 2036 or 2038.
The installment purchase, particularly by a generation-skipping
trust, contemplates that the grantor will fund the trust (and
allocate GST exemption), probably at least in the amount needed
for the down payment.
Ensuring grantor trust treatment.
It is of supreme importance, of course, that the trust be a grantor trust
under subpart E of part I of subchapter J of chapter 1 of the Internal Revenue
Code. Since the conventional indicia of grantor trust status – revocability by the
grantor, payment of income to the grantor, reversion in the grantor, etc. – would
result in inclusion of the value of the trust assets in the grantor’s gross estate and
thereby defeat the purpose of the trust, it is necessary to examine the more
“exotic” provisions of subpart E.
a.
Power to use trust income to pay premiums on insurance on the
life of the grantor or grantor’s spouse. Section 677(a)(3).
i.
A few ancient cases questioned whether the power to pay
premiums is enough, if the power is not exercised. See
generally Rand v. Helvering, 116 F.2d 929 (8th Cir.), cert.
denied, 313 U.S. 594 (1941); Schoellkopf v. McGowan, 43
F. Supp. 568 (W.D.N.Y. 1942); Weil v. Commissioner, 3
T.C. 579 (1944), acq., 1944 C.B. 29; Moore v.
Commissioner, 39 B.T.A. 808 (1939), acq., 1939-2 C.B.
25.
ii.
In modern times, the Service has ruled that it is. Letter
Ruling 8852003 (Aug. 31, 1988). Cf. Letter Ruling
8103074 (Oct. 23, 1980) (entire trust treated as a grantor
trust where only a part of the income was to be used to
pay premiums).
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iii.
b.
The Service now regards the issue as “under extensive
study” and declines to rule. Rev. Proc. 99-3, 1999-1
I.R.B. 103, § 5.22; Letter Ruling 9413045 (Jan. 4, 1994).
Power to reacquire the trust corpus by substituting other property
of an equivalent value. Section 675(4)(C).
i.
The Service now rules that this power will be reviewed on
audit to determine if it is held in a nonfiduciary capacity
and therefore makes the trust a grantor trust. See, e.g.,
Letter Rulings 9525032 (March 22, 1995) & 9504024
(Oct. 28, 1994). Cf. Letter Ruling 9442017 (July 19,
1994) (investment power).
ii.
It seems unlikely that a grantor who is not a trustee or
cotrustee of the trust would be treated as holding this
power in a fiduciary capacity.
iii.
The exclusion of the property from the grantor’s gross
estate seems secure under Estate of Jordahl v. Commissioner, 65 T.C. 92 (1975), acq., 1977-1 C.B. 1 (power
to reacquire trust property and substitute other property of
equal value held not to result in inclusion in the gross
estate). See also Letter Ruling 9413045 (Jan. 4, 1994)
(Jordahl applied to incidents of ownership in a life
insurance policy under section 2042).
iv.
Nevertheless, both the power that qualifies the trust as a
grantor trust and the sale of assets to that trust presumably
must be “real,” and that might be difficult to establish.
v.
The apparent power to reacquire the trust assets by
foreclosing on the security for the loan might be merely
the right of a creditor, not a power of trust administration,
and not exercisable unconditionally in any event.
Moreover, such a power might have less substance if the
trust has ample other assets or when the note has been
paid down significantly.
vi.
A power in another to “reacquire” trust property by
substituting property of an equivalent value has recently
been held to support grantor trust status (again subject
review on audit to determine if the power is held in a
nonfiduciary capacity). Letter Ruling 199908002 (Nov. 5,
1998). Such a power gives no protection if the power
holder dies.
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c.
d.
e.
Other administrative powers. Section 675.
i.
The grantor’s powers to deal with the trust for less than
adequate and full consideration (section 675(1)) and to
borrow without adequate security or interest (section
675(2)) have always raised concerns about includibility of
the trust assets in the gross estate.
ii.
Actual borrowing of trust funds by the grantor (section
675(3)) is hard to reconcile with the installment sale.
Borrowing by the grantor would presumably be nominal
compared to the amount of the trust’s installment sale
note, and might simply be an offset against that note.
iii.
The powers to vote stock (section 675(4)(A)) and control
investments (section 675(4)(B)) are limited to certain
control situations, and in any event they raise issues under
sections 2036 and 2038, especially under section 2036(b).
Certain spousal rights or powers. Sections 672(e) & 677(a).
i.
The ability to qualify a trust as a grantor trust by making
the income payable to the grantor’s spouse (section
677(a)(1) & (2)) is intriguing. The gift tax marital
deduction, however, is not a consideration, because it is
not desirable to subject the trust corpus to estate tax when
the spouse dies.
ii.
Grantor trust status achieved through the grantor’s spouse
evidently survives divorce (section 672(e)(1)(A)), but it
does not survive the spouse’s death. For that reason, and
because it is not available to single people at all, this
technique is unreliable.
Power of an independent trustee to add beneficiaries. Section
674.
i.
The reason for specifying an “independent” trustee is to
avoid an “adverse party,” whose consent would prevent
the power from rendering the trust a grantor trust. Section
674(a). An “adverse party” is a person with a substantial
beneficial interest in the trust that would be adversely
affected by the exercise or nonexercise of the power.
Section 672(a). Nearly any beneficiary’s interest would
be adversely affected by the addition of new beneficiaries.
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ii.
It is essential to fail to “qualify” for any of the exceptions
in section 674(b) and probably section 674(c).
(a)
Section 674(c) does not apply when the grantor or
grantor’s spouse is a trustee or when more than
half of the trustees are “related or subordinate
parties who are subservient to the wishes of the
grantor.”
(b)
It is awkward to rely on the identity of trustees for
grantor trust status, because trustees can die or
become incompetent (while corporate trustees are
generally not related or subordinate or subservient)
or can simply resign. It can also artificially limit
the recruitment of capable trustees.
iii.
The flush language in section 674(c) provides that the
exceptions in that subsection do not apply to the power to
add to the beneficiaries or to a class of beneficiaries
designated to receive income or corpus, other than to
provide for after-born or after-adopted children.
iv.
The beneficiaries that might appropriately be added (in
“violation” of section 674(c)) are spouses (or
companions) of descendants and charitable organizations.
v.
(a)
Such a power can have significance, when, for
example, it is contemplated that the trustee will
shift the beneficial interest away from a
descendant or other beneficiary who engages in
some conduct that the grantor presumably would
want to discourage.
(b)
In drafting any standards for the trustee, though,
care must be taken to avoid simply designating the
class in the instrument and, in effect, taking away
the trustee’s discretion that is relied on under
section 674.
(c)
If the power is limited to periods after the death of
the grantor, then a hypothetical reversion in the
grantor must exceed 5% of the value of the trust.
Sections 674(b)(2) & 673(a).
The power to add charitable beneficiaries was
acknowledged to render a trust a grantor trust in Madorin
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v. Commissioner, 84 T.C. 667 (1985) (holding that the
trustee’s renunciation of that power was a deemed
disposition of trust assets and a realizing event). The
Service has followed Madorin in Letter Rulings 9710006
(Nov. 8, 1996), 9709001 (Nov. 8, 1996), and 9304017
(Oct. 30, 1992).
vi.
6.
Because sections 674(a) and 674(c) explicitly refer to both
income and corpus, they leave no doubt that under those
provisions a grantor would be treated as the owner of the
entire trust.
Structuring the sale.
a.
b.
Assets.
i.
As previously stated, the asset should be expected to
outperform the interest rate on the installment sale note,
so that the buildup of value in the trust (which the sale
allows the grantor/seller to avoid) exceeds the buildup in
value in the grantor/seller’s estate by reason of the
payment or accrual of interest on the note.
ii.
If the asset is itself leveraged, such as closely-held stock
or a limited partnership interest, that is so much the better.
iii.
As in the case of a GRAT, S corporation stock is well
suited to an installment sale to a grantor trust, because the
distributions from the S corporation needed to enable the
shareholders to pay income tax on the corporation’s
income are generally available to make payments on the
note. But a purchase of stock from an S corporation is not
the same as a purchase from the grantor/shareholder. An
S corporation is a pass-through entity for income tax
purposes, but it is not disregarded as a grantor trust is
under Rev. Rul. 85-13.
iv.
If the grantor’s estate may be eligible for special tax
treatment under sections 303, 2032A, 2057, or 6166,
attention should be paid to the effect of the sale on that
eligibility, as with any major transfer.
Documentation.
i.
Since the sale is intended to be a fully effective sale for
property law purposes and for gift, estate, and GST tax
purposes (although not for income tax purposes), it should
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be as fully documented as any sale to an unrelated party
would be. This includes a contract of sale, an assignment,
a promissory note, and, if applicable, a deed of trust,
mortgage, or similar security document (although the
terms that might otherwise appear in a contract of sale are
sometimes simply incorporated into the promissory note).
c.
ii.
Where recording is required or customary, it should be
done.
iii.
Thereafter, the parties’ conduct should be consistent with
a completed sale. The trustee, not the grantor, should
exercise the rights and assume the responsibilities of
ownership, and the grantor should enforce all available
rights as a creditor.
Interest rate.
i.
The interest rate on an installment sale to a grantor trust
should be the rate prescribed by section 7872(f)(2)(A) for
term loans.
(a)
The Tax Court has held that section 7872 is the
applicable provision. Frazee v. Commissioner, 98
T.C. 554 (1992). The court stated: “We find it
anomalous that respondent urges as her primary
position the application of section 7872, which is
more favorable to the taxpayer than the traditional
fair market value approach, but we heartily
welcome the concept.” Id. at 590.
(b)
Section 7872(d)(2) provides that in a gift context
(which includes a transfer to a grantor trust) the
gift tax consequences of a term loan are analyzed
under section 7872(b)(1). Section 7872(b)(1)
treats as a transfer from the lender (the
grantor/seller) to the borrower (the trust) an
amount equal to the excess of the amount loaned
(the value of the property transferred, less any
down payment) over the present value of the
payments to be made under the terms of the loan.
Section 7872(f)(1) defines “present value” with
reference to the “applicable Federal rate.” Section
7872(f)(2)(A) defines the “applicable Federal rate”
for a term loan.
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ii.
The rate prescribed by section 7872(f)(2)(A) is the
applicable Federal rate in effect under section 1274(d) for
the period represented by the term of the loan,
compounded semiannually.
iii.
Under section 1274(d), loans are divided into “short-term”
(not over three years), “mid-term” (over three years but
not over nine years), and “long-term” (over nine years).
Under Rev. Rul. 2001-12, 2001-11 I.R.B. __, those rates,
compounded semiannually, are as follows for March
2001:
(a)
Short-term (not > 3 years): 4.80%.
(b)
Mid-term (> 3 years but not > 9 years): 5.01%.
(c)
Long-term (> 9 years): 5.50%.
The same Revenue Ruling prescribed a March rate under
section 7520, for valuing annuities, life interests, term
interests, remainders, and reversions, of 6.2%.
d.
Payment.
i.
There is no requirement for any particular term for the
note, or for any particular payment schedule. Payment of
principal may balloon at the end. While there is no
requirement to pay interest currently, and therefore
interest may be added to principal and paid at the end, it
may be most commercially reasonable to require the
payment of interest at least annually (but compounded
semiannually), even if all principal balloons at the end.
ii.
Attention must be paid to the fact that the grantor will be
paying income tax on all the income realized by the trust
(since it is, after all, a grantor trust). If the trust has
extraordinary income, such as by reselling the asset, the
grantor may owe a lot of income tax. A “due-on-sale”
clause in the note might help, but will not cover tax on the
appreciation that accrues after the grantor’s sale to the
trust. Generally, grantor trusts are not for those who can’t
afford them.
e.
Reimbursement of the grantor for the payment of income tax.
See the discussion on pages 89-90, related to GRATs.
f.
Use of a self-canceling installment note (“SCIN”)?
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i.
ii.
g.
h.
There is no reason not to use an installment note that is
payable until the expiration of a stated term or the death
of the holder, whichever occurs first – that is, a note that
“self-cancels” at the holder’s death.
(a)
If such a note is used, it is important that there be a
commercially reasonable interest or principal
premium for that feature, bearing a reasonable
relationship to the age and probably the health of
the holder. (Section 7520 probably does not apply
in determining the value of such contingencies.)
(b)
In addition, if such a note is used, it is important
that principal and interest both be paid in level
payments or in some equivalent manner.
The holding of Estate of Frane v. Commissioner, 98 T.C.
341 (1992) (reviewed by the Court), aff’d, 998 F.2d 567
(8th Cir. 1993), that the holder’s death constitutes a
disposition of the SCIN for purposes of section 453B
should not be particularly important in the case of a
grantor trust, where the Service should be expected to
make that argument anyway. (See paragraph 8, infra.)
Use of a private annuity instead of an installment note?
i.
The most common objection to the use of a private
annuity – that it converts capital gain to ordinary income
under section 72 – is not applicable to a transaction
between a grantor and a grantor trust.
ii.
Nevertheless, the payments would probably have to reflect
the higher section 7520 rates, rather than the 7872/1274
rates.
Features advisable for estate tax purposes.
i.
The Supreme Court has held that the irrevocable
assignment of rights in life insurance policies coupled
with retention of annuity contracts did not subject the
insurance policies to estate tax under the predecessor to
section 2036. Fidelity-Philadelphia Trust v. Smith, 356
U.S. 274, 277 (1958). The Court based this holding on
two significant observations:
(a)
The annuity payments were not linked to income
produced by the transferred insurance policies.
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(b)
i.
The obligation was not specifically charged to the
transferred policies.
ii.
Fidelity-Philadelphia Trust has been rather consistently
followed. Stern v. Commissioner, 747 F.2d 555 (9th Cir.
1984); Lazarus v. Commissioner, 513 F.2d 824 (9th Cir.
1975); Samuel v. Commissioner, 306 F.2d 682 (1st Cir.
1962); Cain v. Commissioner, 37 T.C. 185 (1961).
iii.
The reasoning in Fidelity-Philadelphia Trust suggests the
following features to be careful to observe in an
installment sale to a grantor trust:
(a)
The note should be payable from the entire corpus
of the trust, not just the sold property, and the
entire trust principal should be at risk.
(b)
The note yield and payments should not be tied to
the performance of the sold asset.
(c)
The grantor should retain no control over the trust.
(d)
The grantor should enforce all available right as a
creditor.
Down payment.
i.
As previously stated, it is well known that the Service
required the applicants for Letter Ruling 9535026 to
commit to trust equity of at least 10% of the installment
purchase price.
ii.
More recently, the Service has refused to rule on proposed
installment sales to “dry” trusts – i.e., trusts with no other
assets.
iii.
“Equity,” in the form of either a down payment or other
assets to secure the loan, is usually considered a good
idea. Ten percent is usually regarded as safe, although
lower percentages are often considered acceptable.
iv.
On the other hand, the need for equity is very thoughtfully
challenged in Hesch & Manning, “Beyond the Basic
Freeze: Further Uses of Deferred Payment Sales,” 34
UNIV. MIAMI INST. EST. PLANNING ch. 16 (2000).
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7.
8.
v.
The risk here is probably includibility in the gross estate
under section 2036, a gift upon the cessation of section
2036 exposure, continued estate tax exposure for three
years after cessation of section 2036 exposure under
section 2035, and inability to allocation GST exemption
during the ensuing ETIP. Nevertheless, it is often
assumed that this problem goes away as the principal on
the note is paid down.
vi.
If the grantor’s gift to the trust to equip it to pay the down
payment is followed too closely (for example, at the same
time!) by the installment purchase, there might be some
concern that the transaction would be collapsed and
recharacterized as a part-sale and part-gift, although it is
hard to see what overall difference that would make.
Advanced applications.
a.
When a grantor trust that has made an installment purchase
becomes “in the money” – i.e., when the cash flow from the
investment exceeds the debt service and/or permits the debt to be
paid off – the trust can use that cash as the down payment in
buying more of the asset on an installment basis, without
additional funding by the grantor.
b.
If a grantor trust purchases the grantor’s right to the retained
annuity in a GRAT, the appreciation represented by assets that
the GRAT distributes in kind in satisfaction of its annuity
obligation will not accumulate in the grantor’s estate, and the
payback at the 7520 rate will, in effect, be converted to a lower
payback at the 7872 rate.
Tax consequences at the grantor’s death.
a.
If the grantor/seller/note-holder dies before the note is paid off,
the Service may argue that that causes a realization of the
grantor’s gain, to the extent the note is unpaid. That would be
argued to be similar to the realization that occurs when a grantor
cures the defect or renounces the power that causes the trust to be
a grantor trust. Madorin v. Commissioner, supra.; Rev. Rul. 77402, 1977-2 C.B. 222. It would be no more aggressive than the
Service’s argument that the death of the holder of a SCIN causes
a realization. Estate of Frane v. Commissioner, supra. (Both the
Service’s argument and the courts’ holdings are open to serious
question; this writer believes that Frane was wrongly decided.)
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b.
Estate planners have often assumed, without much analysis, that
this would be the result – perhaps on some type of IRD theory.
c.
A recent thoughtful and rigorous article, reflecting considerable
collegial advisory board input, has plowed new ground in
articulating the argument that there should not be such realization
at death. Manning & Hesch, “Deferred Payment Sales to Grantor
Trusts, GRATs, and Net Gifts: Income and Transfer Tax
Elements,” 24 TAX MGMT. EST., GIFTS & TR. J. 3 (1999).
i.
The argument is that for income tax purposes, under Rev.
Rul. 85-13, there is no transfer of the underlying property
to the trust while the trust is a grantor trust. Therefore, for
income tax purposes, the transfer to the trust occurs at the
grantor’s death. But there is no rule that treats a transfer
at death as a realization event for income tax purposes,
even if the transferred property is subject to an
encumbrance, as the property here is subject to the unpaid
installment note. Thus, there is no gain realized on the
property in the trust. Because, for estate tax purposes, the
property is not included in the decedent’s gross estate, it
does not receive a new basis under section 1014.
ii.
Since the note is included in the decedent’s gross estate, it
receives a new basis – presumably a stepped-up basis –
under section 1014, unless it is an item of income in
respect of a decedent (“IRD”) under section 691, which is
excluded from the operation of section 1014 by section
1014(c). Since the fact, amount, and character of IRD are
all determined in the same manner as if “the decedent had
lived and received such amount” (section 691(a)(3); cf.
section 691(a)(1)), and since the decedent would not have
realized any income in that case (Rev. Rul. 85-13), there
is no IRD associated with the note. Thus, the note
receives a stepped-up basis, and the subsequent payments
on the note are not taxed.
iii.
Confirmation of this treatment is seen in sections
691(a)(4) & (5), which set forth rules specifically for
installment obligations “reportable by the decedent on the
installment method under section 453.” In the case of
installment sales to grantor trusts, of course, there was no
sale at all for income tax purposes, and therefore nothing
to report under section 453.
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I.
iv.
This is not an unreasonable result, since the income tax
result is exactly the same as if the note had been paid
before the grantor’s death – no realization – which fulfills
the policy behind section 691.
v.
Moreover, if the unpaid portion of the note were subject
to income tax on the grantor’s death, the result would be
double taxation, because the sold property, being
excluded from the grantor’s estate, does not receive a
stepped-up basis.
vi.
Meanwhile, although the note is included in the decedent’s gross estate, it is possible that it is valued for estate
tax purposes at less than its face amount, under section
7520 or under general valuation principles, because
section 7872 is not an estate tax valuation rule. (That
would be especially true if interest rates rise between the
date of the sale and the date of death.)
Other Debt or Lease Transactions
1.
2.
Examples.
a.
In a corporation, a “recapitalization,” using debt instead of
preferred stock. This could be a redemption accompanied by a
section 302(c)(2) waiver. See section 302(c)(2)(A)(i).
b.
A straight installment sale (e.g., to children).
c.
A “bootstrap” gift to younger generations, while the entity owes
debt to the transferor.
d.
A redemption for property which is leased back to the entity.
e.
Transactions involving bona fide private annuities or selfcanceling installment notes (SCINs).
Analysis.
a.
Any debt issued in the transaction will have to be amortized, or
remains as IRD at death, with resulting capital gain, whereas
preferred stock could have been held until death to receive a
stepped-up basis. But the corporation will receive an income tax
deduction for the payment of interest, which would not have been
available for the payment of dividends.
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J.
b.
Section 453A(c) requires payment to the Service of an interest
charge each year with respect to the income tax deferred in the
case of installment obligations with a face amount over
$5,000,000. This could have a dramatic adverse effect on a large
installment sale.
c.
Debt of the entity retained by the transferor will raise the 10percent minimum equity floor of section 2701(a)(4), and a nonfair-value lease can trigger the rules of section 2703. But if there
is only one class of equity, the 10-percent minimum junior equity
floor will not apply, because section 2701 will not apply, no
matter how large the debt (so long as the debt is not recharacterized as equity). Reg. §§ 25.2701-1(a)(1) & -3(c)(1).
d.
Chapter 14 is not otherwise concerned with debt or leases.
Redemption or Buy-Sell Agreements
1.
Types of buy-sell agreements.
a.
Cross purchase agreement among shareholders or partners.
i.
Avoids concerns about state law limitations on the use of
corporate funds for redemptions.
ii.
Avoids increasing the estate tax value of the decedent’s
stock by its share of the insurance proceeds. But see
Technical Advice Memorandum 9349002 (insurance held
by a trust for purposes of funding a cross-purchase
agreement held includible in gross estate of insured).
iii.
Ensures capital gain, rather than dividend, treatment in the
case of a corporation where there are other family
members whose stockholdings are attributed under section
318 for purposes of section 302(b).
iv.
Gives a stepped-up basis to the purchasing shareholders
(particularly a factor in a C corporation).
v.
May allow payment of premiums at less after-tax cost, if
the corporation is in a higher income tax bracket than the
shareholders and payments to shareholders to permit them
to pay premiums is justified as compensation.
vi.
May permit sophisticated arrangements for holding the
insurance, such as a trusteed arrangement or a family
split-dollar arrangement.
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b.
c.
2.
vii.
Keeps any insurance policy out of the reach of creditors of
the corporation.
viii.
Avoids concerns about the alternative minimum tax and
the accumulated earnings tax in the case of a C corporation.
Redemption agreement between the entity and the individual
shareholders or partners.
i.
Avoids the awkwardness of each shareholder’s ownership
of life insurance policies on the lives of all of the others,
especially when there are more than two or three owners.
ii.
Reduces transfer-for-value problems under section
101(a)(2) when disposing of the deceased shareholder’s
policies on the lives of the survivors.
iii.
Can provide the business, which typically has the greatest
cash needs, with ready cash from the insurance proceeds.
iv.
Simplifies the payment of premiums.
v.
Works more equitably if stockholdings are greatly disproportionate or ages are greatly different.
vi.
Can reduce the after-tax cost of the premiums, in the case
of a C corporation, since the premiums are nondeductible.
vii.
Permits a redemption without dividend treatment under
section 303 in the case of a C corporation.
A combination of the two, giving the entity the option to purchase
first, and the individual owners the option to purchase to the
extent the entity does not purchase. The risk of structuring it the
other way around is the constructive dividend that might result if
the corporation assumes the shareholders’ legal obligation
(although a mere option should be okay.)
Triggering events.
a.
Death.
b.
Disability, retirement, or withdrawal?
c.
Divorce? (To prevent a transfer to a former spouse.)
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d.
3.
Bankruptcy? (To prevent interference by the bankruptcy trustee,
if the purchase is for fair market value.)
Determining the purchase price.
a.
b.
c.
d.
Fixed price, adjusted periodically by agreement.
i.
Puts pressure on younger owners to resist agreement if the
value increases.
ii.
May be most closely scrutinized by the Service, especially
where family members are parties.
iii.
Should be accompanied by a default formula in any event.
Adjusted book value.
i.
Adjustments can account for items not ordinarily reflected
on the balance sheet.
ii.
Better for some businesses (e.g., professional service
businesses) than for others (e.g., real estate holding).
Formula based on earnings and/or other financial data.
i.
Some factors, such as owners’ salaries, should receive
special treatment.
ii.
A professional appraiser should help determine the best
formula.
iii.
The formula should be tested in a trial run each year, to
see if it produces a result that is intuitively fair.
Establishment of a mechanism to be used when needed.
i.
Independent appraisal.
(a)
Even though it won’t fix value in advance, the
agreement still can serve important non-tax
objectives of continuity, incentive, efficiency,
liquidity, and harmony.
(b)
The ability of an appraisal pursuant to a binding
agreement to fix estate tax value may actually have
been given a boost by the enactment of section
2703.
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ii.
4.
K.
Right of first refusal.
Special tax considerations.
a.
Continued operation under a buy-sell agreement established
before October 9, 1990, without causing a “substantial modification.”
b.
Being careful of a substantial modification even of a post-October
8, 1990 agreement, which could establish a new “entered-into”
date for testing the business purpose, reasonableness, and arm’slength comparability of the agreement.
c.
Actually operating consistently with any agreement in effect.
d.
In an S corporation—
i.
Preserving the S election and other elections that require
the consent of all shareholders.
ii.
Preserving distributions to the shareholders sufficient to
enable them to pay the income taxes attributable to the
corporation’s income.
iii.
Avoiding the creation, in effect, of two classes of stock.
See Reg. § 1.1361-1(l)(2)(iii)(A) & (v), Examples 8 & 9
(buy-sell or redemption agreement does not create a
second class of stock unless a principal purpose of the
agreement is to circumvent the one class of stock requirement and the agreement establishes a price that, at the
time the agreement is entered into, is significantly above
or below the fair market value of the stock). See also
Letter Rulings 8907016, 8920016, 8927027, 8930037,
8933021, 9308006, 9308022, 9404020, 9410010,
9413023, and 9445019 (shareholders’ agreements that did
not affect the shareholders’ interests in the profits and
assets of the S corporation and therefore did not create a
prohibited second class of stock). Cf. Letter Ruling
9821006 (a more recent ruling to the same effect).
Non-Family Trusts
For example, a grantor retained income trust (GRIT) for a niece or nephew or
other “non-family” remainder beneficiary.
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L.
Use of Grantor Retained Annuity Trusts (GRATs)
1.
2.
Circumstances in which a GRAT might be helpful, even though it must
be in the form of an annuity trust.
a.
To make a transfer of property expected to appreciate faster than
the requirement to make the annuity payment required by a
GRAT—i.e., generally at a higher rate than the section 7520
discount rate.
b.
To make a transfer of property expected to appreciate at a time
when the transferor is cash-poor and desires to reduce the gift tax
burden by any means available.
c.
To reduce the transferor’s holdings in an entity to a minority, to
qualify subsequently for a minority discount.
d.
To shelter from gift tax the designation of descendants as remainder beneficiaries in a trust created to provide periodic payments
to a former spouse following a divorce. Letter Ruling 9235032.
Limitations of a GRAT.
a.
Obviously survival for the necessary period can never be assured.
If the grantor dies during the GRAT term, all or part of the value
of the GRAT property at that time is included in the grantor’s
gross estate under section 2036(a).
i.
Cf. Rev. Rul. 82-105, 1982-1 C.B. 133 (describing the
portion of a charitable remainder annuity trust that is
included in the gross estate under section 2036(a)). The
Service has taken the position, however, that section
2039, not Rev. Rul. 82-105, is the proper standard for this
purpose, which would mean that the entire value of a
GRAT would always be included in the gross estate.
Letter Ruling 9345035.
ii.
For an illustration of the “unwinding” (at least in part) of
the gift tax treatment in the case of a “split gift,” see Rev.
Rul. 82-198, 1982-2 C.B. 206. Because the relief of
section 2001(e) is limited to amounts included in the
spouse’s gross estate under section 2035 (not section 2036
or 2039), “gift-splitting” probably should not be used for a
GRIT or GRAT.
iii.
It might be possible to cover the estate tax exposure by
term life insurance.
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3.
b.
If the grantor does survive the GRAT term, the annuity will stop,
and the grantor must have sufficient other assets to absorb this
loss of income.
c.
Although the Service has acknowledged that the gift tax value of
the remainder following a GRAT term can be as small as 0.829
percent of the total value transferred into the trust (Letter Ruling
9239015), under the principles of Rev. Rul. 77-454, 1977-1 C.B.
351, it will never be possible to have a “zeroed-out” GRAT—i.e.,
a GRAT that produces a zero value for the remainder. The
Service has even suggested that the principles of Rev. Rul. 77454 might apply because of the trustee’s discretion to retain
investments in highly speculative assets without regard to the
preservation of corpus. Letter Ruling 9248016.
GRATs as grantor trusts.
a.
Benefits of qualifying as a grantor trust.
i.
Generally, the GRAT will be able to avoid obtaining a
taxpayer identification number and filing income tax
returns. Reg. § 1.671-4.
ii.
A grantor trust can hold stock of an S corporation (where
the mandatory payout could be selected to approximately
match the distributions that a profitable S corporation
must make anyway to enable its shareholders to pay the
income tax on its earnings). See section 1361(c)(2)(A)(i).
iii.
If the GRAT distributes appreciated property in kind in
satisfaction of the annuity obligation, there is no taxable
gain. Rev. Rul. 85-13, 1985-1 C.B. 184.
iv.
If the grantor repurchases the GRAT property before the
end of the GRAT term (perhaps just before the end of the
term)—
(a)
Under Rev. Rul. 85-13, supra, no gain would be
recognized on a sale by a grantor trust to the
grantor. See Letter Rulings 9146025 & 9239015.
Cf. Meek v. Commissioner, 98-1 USTC ¶ 50,179
(9th Cir. 1998) (no loss recognized on sale to a
grantor trust).
(b)
The GRAT property will be returned to the
grantor’s estate (where it will receive a new basis
upon the owner’s death under section 1014), while
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the purchase price is removed from the grantor’s
estate.
b.
Techniques, in addition to those discussed above, for qualifying a
GRAT as a grantor trust.
i.
Income for the benefit of the grantor. Section 677. See
Letter Ruling 9444033 (modified by Letter Ruling
9543049). In addition, there is no reason why a GRAT
could not provide for the grantor to receive the annuity
amount or the net income of the trust, whichever is
greater, except that for gift tax purposes only the value of
the annuity standing alone would be taken into account.
Reg. § 25.2702-3(b)(1)(iii) & (c)(1)(iii).
ii.
Reversion (or general power of appointment). Section
673; Letter Ruling 9152034.
iii.
4.
(a)
Again, additional leverage of the gift tax treatment
by the use of a reversion (as with GRITs in the
past) will be impossible.
(b)
A reversion can have the additional advantages of
conveniently qualifying the trust property for a
marital deduction if the grantor dies during the
term or providing the funds for payment of estate
tax if a marital deduction is not available.
(c)
But a reversion will guarantee the inclusion of the
entire value of the trust property in the grantor’s
gross estate if the grantor dies during the term,
sacrificing the possible advantage of only a partial
inclusion under Rev. Rul. 76-273 or Rev. Rul. 82105.
(d)
A possible compromise is to provide a reversion
only with respect to the portion of the trust
includible in the grantor’s gross estate.
Reversion (or general power of appointment), as applied
to accumulated income, including capital gains. Section
674(a). See Letter Rulings 200001013 & 200001015.
Formula GRATs.
a.
Reg. § 25.2702-3(b)(1)(ii)(B) allows the annuity amount to be
“[a] fixed fraction or percentage of the initial fair market value of
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the property transferred to the trust, as finally determined for
federal tax purposes.”
5.
b.
If this approach is used, and the gift tax value of the property
transferred to the trust is changed as the result of a gift tax audit,
the annuity, and therefore the value of the grantor’s retained
interest, will change proportionately, ensuring that the taxable gift
remains the predetermined fraction of the total value of the
transferred property.
c.
Not only does this contain the damage that might be done by a
gift tax, but by that very fact it can serve to discourage an audit—
or “audit-proof” the transaction—in the first place.
d.
Because it is expressly allowed by the regulations, the use of such
a formula cannot run afoul of the rule against “adjustment
clauses” identified with Commissioner v. Procter, 142 F.2d 824
(4th Cir.), cert. denied, 323 U.S. 756 (1944).
Graduated GRATs.
a.
Reg. § 25.2702-3(b)(1)(ii) allows the annuity amount (whether
expressed as a fixed dollar amount or a fraction of the initial fair
market value of the trust property) to be increased by up to 20%
each year.
b.
The following table assumes that a 50-year-old grantor transfers
$100 to a GRAT, and that the applicable rate under section 7520
is 6.8 percent (as it has been for most of 1998). The table shows
the amount of the current taxable gift and (in parentheses) the
total amount of annuity payments that come back to the grantor,
and thus into the grantor’s estate, over the term of the GRAT
(without adjustment for the timing of those payments). The first
set of results assumes a fixed annuity that does not change. The
second set of results assumes a 10-percent increase in the annuity
each year. The third set of results assumes the maximum 20percent increase in the annuity each year.
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GRANTOR, AGE 50
$100 TRANSFERRED TO TRUST; 6.8% 7520 RATE
TAXABLE GIFT (TOTAL ANNUITY PAYMENTS)
c.
6.
Constant
Annuity
10% Higher
Each Year
20% Higher
Each Year
Initial $50 annuity
2-year term
$9.89
($100.00)
$5.54
($105.00)
$1.20
($110.00)
Initial $31 annuity
3-year term
$19.08
($93.00)
$11.13
($102.61)
$2.67
($112.84)
Initial $22 annuity
4-year term
$26.05
($88.00)
$14.94
($102.10)
$2.38
($118.10)
Initial $16 annuity
5-year term
$35.06
($80.00)
$21.80
($97.68)
$5.86
($119.07)
Although the ultimate estate tax cost of back-loading (represented
by the accumulation of the annuity payments in the grantor’s
estate) appears to outweigh the up-front gift tax saving, this will
generally not be the case. A proper comparison of the
performance of a straight GRAT and a graduated GRAT, taking
into account the investment performance of the GRAT as well as
of the grantor’s own portfolio, is illustrated by the spreadsheets in
the Appendix on pages 111-114 at the end of this outline.
Two-life GRATs.
a.
Example: A transfers property to an irrevocable trust, retaining
the right to a qualified annuity for 10 years. Upon expiration of
the 10 years, the qualified annuity is payable to A’s spouse, if
living, for another 10 years. Upon expiration of the spouse’s
interest, the trust terminates and the trust corpus is payable to A’s
children. A retains the right to revoke the spouse’s interest.
b.
Reg. § 25.2702-2(d)(1), Example 7, holds that the amount of the
gift is the fair market value of the property transferred to the trust
reduced by the value of both A’s qualified interest and the value
of the qualified interest payable to A’s spouse subject to A’s
power to revoke.
c.
Some practitioners, invoking this example, have used “two-life
GRATs,” continuing, in effect, for a term of years or, if earlier,
the death of the second to die of the grantor and the grantor’s
spouse.
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d.
This technique has been welcomed as a means to avoid the harsh
and unexpected result of Reg. § 25.2702-3(e), Example 5, which
holds that a retained unitrust payment (or an annuity) for a fixed
term is nevertheless valued under section 2702 as if it lasts only
for the lesser of the stated term or the grantor’s life.
e.
The stakes are high. The following table shows the value of the
property transferred to a GRAT by a 50-year-old grantor that
would be treated as a taxable gift by the grantor if the applicable
rate under section 7520 is 6.8 percent. The first set of results is
measured by a fixed term of years, without regard to the grantor’s
mortality, in disregard of Example 5. The second set of results is
measured by the stated term or the grantor’s life, whichever is
shorter, in compliance with Example 5. The third set of results
also takes mortality into account, but on the basis of the life
expectancies of both spouses, not just one (assuming that both
spouses are 50 years old).
GRANTOR AND SPOUSE, AGE 50
$100 TRANSFERRED TO TRUST; 6.8% 7520 RATE
TAXABLE GIFT
Term Only
Term or
One Life
Term or
Two Lives
$55.1572 annuity
2-year term
$0.00
$0.59
$0.01
$37.9665 annuity
3-year term
$0.00
$0.90
$0.01
$29.3893 annuity
4-year term
$0.00
$1.21
$0.02
$24.2589 annuity
5-year term
$0.00
$1.54
$0.03
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f.
The following table shows the same results for a 60-year-old
couple.
GRANTOR AND SPOUSE, AGE 60
$100 TRANSFERRED TO TRUST; 6.8% 7520 RATE
TAXABLE GIFT
Term Only
Term or
One Life
Term or
Two Lives
$55.1572 annuity
2-year term
$0.00
$1.37
$0.03
$37.9665 annuity
3-year term
$0.00
$2.07
$0.06
$29.3893 annuity
4-year term
$0.00
$2.80
$0.11
$24.2589 annuity
5-year term
$0.00
$3.53
$0.18
g.
Thus, in both scenarios, the one-life mortality limitation produces
a significantly larger gift than would the use of a fixed term only,
while the use of two lives recovers most, but not all, of that
difference.
h.
Letter Rulings 9352017, 9416009, 9449012, and 9449013
appeared to approve of the two-life valuation technique.
i.
Then the Service reversed itself and has ruled that the contingent
interest of the grantor’s spouse is analogous to a reversion in the
grantor and must be given a value of zero. Technical Advice
Memoranda 9707001, 9717008, 9741001 & 9848004. See also
Letter Rulings 199937043 (modifying Letter Ruling 9352017),
199951031 (modifying Letter Ruling 9449012) & 199951032
(modifying Letter Ruling 9449013).
j.
The Tax Court seems to have agreed with the Service’s more
recent view. Cook v. Commissioner, 115 T.C. 15 (July 25, 2000).
k.
Meanwhile, the Tax Court has also held the controversial
Example 5 of Reg. § 25.2702-3(e) to be invalid, thus encouraging
the use of the term-only models in the above tables. Walton v.
Commissioner, 115 T.C. 41 (2000).
- 85 -
7.
8.
Hedging GRATs.
a.
A safer technique than the two-life GRAT is for husband and
wife to each create a GRAT.
b.
The probability that at least one of them will survive the GRAT
term is the same as in the case of the two-life GRAT, except that
with this technique, in that case, the GRATs will work to the
extent of the funding of the survivor’s GRAT.
One-asset GRATs.
a.
Regardless of the other structural features that are selected, a
GRAT is most likely to be effective if it is funded with only one
asset—e.g., stock of one closely held corporation or interests in
one family limited partnership. In that way, the possible
underperformance of one asset will not detract from the superior
performance of other assets.
b.
To illustrate, using the previous example of a three-year GRAT
funded with $100 with a $38 annuity, the following table shows
the results for a “hot asset” that grows in value at a rate of 60
percent per year, the results for a “cool asset” that does not grow
in value at all, and the results if both such assets were combined
in the same GRAT:
Hot Asset
Both Assets
Beginning value
100.00
100.00
200.00
Year 1 growth
+60.00
+0.00
+60.00
Less annuity
- 38.00
- 38.00
- 76.00
Year 1 balance
122.00
62.00
184.00
Year 2 growth
+73.20
+0.00
+73.20
Less annuity
- 38.00
- 38.00
- 76.00
Year 2 balance
157.20
24.00
181.20
Year 3 growth
+94.32
+0.00
+94.32
Less annuity
- 38.00
- 24.00
- 76.00
213.52
0.00
199.52
Ending balance
c.
Cool Asset
Thus, as two separate GRATs, these assets produce an ending
balance for the remainder beneficiaries of $213.52. The grantor
receives the entire “cool asset” back, but even that is not enough
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to pay $14 of the annuity in the third year, and the GRAT simply
disappears.
d.
9.
As a combined GRAT, these assets produce only $199.52 for the
remainder beneficiaries, but the grantor receives the full annuity
payments. Thus, in the case of the combined GRAT, the
remainder beneficiaries receive $14 less and the grantor receives
$14 more—not a good estate planning result.
Making annuity payments with a note or borrowing from the grantor.
a.
Technical Advice Memorandum 9604005 denied qualification
under section 2702 to GRATs which depended on such borrowing, even while admitting that “[t]he express terms of the GRATs
do satisfy the requirements of §2702 and the regulations thereunder.” It must be acknowledged that the facts of TAM 9604005
were especially bad for the taxpayer. For example, no interest
was paid on the notes. As the TAM pointed out, this had no
income tax effect (because the GRATs were grantor trusts), but it
affected the economics of the arrangement, which was relevant
for gift tax purposes.
b.
To the same effect,
Memorandum 9717008.
c.
Finally, amendments to the regulations, proposed on June 22,
1999, and finalized on September 5, 2000, prohibit the use of
notes, “directly or indirectly,” to pay a GRAT’s annuity
obligation. Reg. § 25.2702-3(d)(5).
i.
however,
was
Technical
Advice
Borrowing from others to make the annuity payments is
not addressed in the regulations, and the practice is
expressly acknowledged in the preamble to the
regulations.
(a)
The preamble warns, however, that the step
transaction doctrine will be applied where
appropriate, such as when the trust borrows money
from a bank but the bank agrees to make the loan
only if the grantor deposits with the bank an
amount equal to the amount of the loan. The
preamble explains that this is the reason for the
words “directly or indirectly” to the prohibition on
the use of notes.
- 87 -
(b)
Moreover, when borrowing from third parties is
outstanding when the GRAT ceases to be a grantor
trust, the Service will take the position that the
grantor realizes income in the amount of the
borrowing. See Technical Advice Memorandum
200010010. (This result could apparently have
been avoided if the grantor bought the assets from
the GRAT before the end of the term, or in any
event if the GRAT continued as a grantor trust for
income tax purposes after the end of the GRAT
term.)
ii.
Borrowing from the grantor for other purposes, such as to
enable the trust to make other investments, is not
addressed, and therefore should be viewed as permissible,
subject to the “directly or indirectly” step transaction
caveat.
iii.
Payment of the annuity amount with trust assets in kind is
not prohibited and is expressly acknowledged as a
permissible option in the preamble.
iv.
For symmetry, the regulations also apply to the use of
notes to pay the obligations to the grantor of a grantor
retained unitrust (GRUT). Reg. § 25.2702-3(c)(1)(i).
v.
Effective dates.
vi.
(a)
The final regulations maintain the requirement that
the use of notes or similar arrangements to meet
the trust’s obligations to the grantor be prohibited
in the governing instruments of trusts created on or
after September 20, 1999.
Reg. § 25.27023(d)(5)(i).
(b)
Likewise, the final regulations maintain the
requirement that notes may not be so used after
September 20, 1999, with respect to a preSeptember 20, 1999 trust and the requirement that
any such notes issued on or before September 20,
1999, must have been paid in full by December
31, 1999. Reg. § 25.2702-3(d)(5)(ii).
The final regulations also clarify that a GRAT may make
its annuity payments to the grantor only on the
anniversary date of the GRAT, and that the annuity
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payments need not be prorated to a calendar year in the
case of GRATs that are not created on January 1. Reg. §
25.2702-3(b)(1)(i), (3) & (4). This helpful amendment
accomplishes what a 1994 amendment of the regulations
was apparently intended to accomplish. See T.D. (May 4,
1994).
10.
11.
Paying the “annuity” in kind.
a.
Technical Advice Memorandum 9604005 states that “it is clear
that [the grantor], acting as trustee, would not distribute the . . .
stock to himself and [his wife] in satisfaction of the annuity, since
such a distribution would clearly defeat the purpose of creating
the GRATs.” Oh, really?
b.
Curiously, the TAM immediately goes on to conclude, dispositively, that “from the inception of the GRATs, there was never an
intention that the annuity payment would be made in cash or in
kind according to the terms of the GRATs.”
c.
Payment in kind is thus left in some doubt, although it would pass
the test described above.
Reimbursement of the grantor for the payment of income tax.
a.
Letter Ruling 9444033, dealing with two GRATs, included the
following notorious paragraph (emphasis added):
Further, each proposed Trust agreement requires the trustee
to distribute to the grantor, each year during the trust term, the
amount necessary to reimburse the grantor for the income tax
liability with respect to the income received by the trustee and not
distributed to the grantor. Under this provision, a grantor will not
make an additional gift to a remainderperson in situations in which a
grantor is treated as the owner of a trust under §§ 671 through 679,
and the income of the trust exceeds the amount required to satisfy
the annuity payable to the grantor. Ordinarily, if a grantor is treated
as the owner of a trust under §§ 671 through 679, the grantor must
include in computing his tax liability the items of income (including
the income in excess of an annuity), deduction, and credit that are
attributable to the trust. If there were no reimbursement provision,
an additional gift to a remainderperson would occur when the
grantor paid tax on any income that would otherwise be payable
from the corpus of the trust. Accordingly, since there is a
reimbursement provision, we rule that, if the income of either trust
exceeds the annuity amount, the income tax paid by the grantor on
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trust income not paid to the grantor will not constitute an additional
gift to the remainderpersons of the Trust.
b.
This paragraph was immediately controversial. One year later,
the ruling was reissued with this paragraph deleted. Letter Ruling
9543049.
c.
Nevertheless, questions remain.
d.
12.
i.
Is the italicized dictum about the result in the absence of
reimbursement right?
ii.
Does the dictum apply only to trust accounting income—
i.e., “income received by the trustee”—and not to
passthrough income for income tax purposes such as a
trust’s undistributed share of the income of an S
corporation?
iii.
Is such a doctrine effectively limited to GRATs, where the
right to receive “fixed amounts” arguably means fixed net
amounts? (The Service still insists on reimbursement as a
condition for issuing a ruling with respect to a GRAT, but
has not extended this policy to other types of grantor
trusts.)
See also Letter Ruling 199922062 (provision in trust instrument
requiring the trust to pay a foreign grantor’s income tax on
income derived from the trust held not to be a retained power for
purposes of section 2036(a)).
GRATs and generation-skipping.
a.
Making grandchildren the remainder beneficiaries of a GRAT—
or even making “descendants per stirpes” the remainder
beneficiaries so that grandchildren will succeed to the interests of
their deceased parents—is generally not a good idea, unless the
parents are deceased when the GRAT is created, because section
2642(f) (the “ETIP” rule) prevents allocation of GST exemption
to such a trust until the expiration of the GRAT term, when
presumably the property will have increased greatly in value.
One technique for dealing with that dilemma is to make only the
surviving children the remainder beneficiaries of the GRAT and
to “equalize” the treatment of children of a predeceased child in
the grantor’s will or revocable trust, where the transfer (possibly
funded by term insurance) would be exempt from GST tax under
the predeceased parent rule of section 2651(e).
- 90 -
b.
A variation is to make all the grantor’s children vested remainder
beneficiaries, in the sense that a child need not survive the GRAT
term to be entitled to share in the remainder and therefore may, if
necessary, bequeath that remainder interest to his or her children
or other persons. The children’s remainders, however, would still
be subject to a reversion in the grantor if the grantor dies during
the GRAT term (which is often desirable for managing the estate
tax exposure at that time in any event).
c.
After the creation of the GRAT, the children could sell their
vested remainders to a generation-skipping trust (or trust). This
trust could be funded by the grantor with whatever cash is needed
to equip it to make the purchase, and the grantor could allocate
GST exemption to that trust in the amount of such funding.
Neither the grantor nor any children of the grantor may have an
interest in this trust.
d.
If the sales are made to one generation-skipping trust for the
benefit of all of the grantor’s descendants other than children, the
valuation rules of section 2702 would prohibit reduction of the
purchase price of the remainder interest by the value of the
grantor’s reversion in the GRAT.
e.
If, instead, the sales can be made to separate generation-skipping
trusts (one for the descendants of each of the grantor’s children),
with each child selling his or her remainder interest to one or
more trusts other than the trust for his or her own descendants,
these sales would not be made to “members of the family” under
section 2702, and the price could be reduced by the value of the
grantor’s reversion.
i.
If some of the grantor’s children do not have children and
local law does not permit the creation of a trust for a class
of beneficiaries none of whom is living at the creation of
the trust, then one or more of the grantor’s living
grandchildren could be included as either temporary or
permanent beneficiaries of those trusts, as long as no
descendant of the selling child is a beneficiary of that
trust.
ii.
This variation is aggressive, in part because of the risk of
recharacterization of these sales under the so-called
“reciprocal trust doctrine.” See United States v. Estate of
Grace, 395 U.S. 316 (1969), and its progeny. The risk is
that each trust would be deemed to have underpaid the
selling child by an amount equal to a proportion of the
- 91 -
value of the grantor’s reversionary interest, so that each
child would be deemed to have made a gift to the
purchasing trust (or trusts) in that amount. That gift
would be deemed a contribution to the generationskipping trust or trusts by the child, and would therefore
require the allocation of the child’s own GST tax
exemption to the trust (possibly on a late allocation basis)
in order to maintain the trust’s exempt status for GST tax
purposes—a generally inconvenient and costly result. A
“price adjustment” clause of the sort given effect in King
v. United States, 545 F.2d 700 (10th Cir. 1976), might
help, but in that case the transaction is likely to be open a
very long time.
(a)
Grace may be distinguishable on the ground that it
applies only for the purpose of identifying the
transferor who has retained an interest in the trust
for estate tax purposes. Here the selling children
will have retained no interest in either the GRAT
or the generation-skipping trust.
(b)
Possibly, though, Grace will continue to be a risk
as long as the transaction is “balanced”—i.e., as
long as in the sale transactions each branch of the
family “gets” as much as it “gives.”
f.
A way should be found for the selling children to disclose the
transaction on gift tax returns, so as to begin the running of the
statute of limitations under section 6501(c)(9).
g.
It is possible that income tax basis will be lost in the
implementation of this technique, but that may be an acceptable
cost in any case and might be especially acceptable where the
underlying GRAT asset is an asset that the family expects to
retain, such as an interest in a closely-held business.
h.
In drafting the trust instruments involved, care should be taken
that the trustee of the generation-skipping trust is authorized to
invest in contingent remainders (that is, contingent on the
grantor’s survival for the GRAT term) and that the spendthrift
clause applicable to the GRATs does not prohibit the sale.
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13.
Collapsing an underperforming GRAT.
a.
b.
M.
Sale of the GRAT property to the grantor (unlike commutation)
need not be prohibited. Cf. Reg. § 25.2702-5(b)(1) & (c)(9)
(prohibiting such sales in the case of a PRT or QPRT).
i.
Such a sale has no income tax consequences if the GRAT
is a wholly-owned grantor trust. Rev. Rul. 85-13, supra.
ii.
Under section 1041, a sale to the grantor’s spouse is
likewise non-taxable.
iii.
Unlike notes from the GRAT to make the annuity
payments (discussed supra), there should be no problem if
such a sale is made, at least in part, for notes to the GRAT
from the purchasing grantor (or spouse).
Following such a sale, presumably at a depressed sale price, the
repurchased property may be placed in a new GRAT, with a
lower annuity payment, while the original GRAT simply pays out
its cash (or notes) and collapses.
Comparing Capital Freezes, GRATs, and Installment Sales
Bearing in mind that case-by-case analysis is always needed, the
following discussion compares entity capital freezes, GRATs, and installment
sales to grantor trusts, with reference to 21 issues that are often considered:
1.
2.
Is it necessary to make payments?
a.
“Qualified payments” are required in a capital freeze, a GRAT
must pay the annuity, and the purchase price plus interest must be
paid in an installment sale. In an installment sale, however, the
payments can balloon at the end.
b.
Advantage: Installment sale.
Can the grantor count on payments for cash flow? For example, could
the transferor receive payments for life?
a.
Preferred payments from an entity freeze can be, and ordinarily
are, payable in perpetuity. GRAT payments and installment sale
payments (except possibly in the case of a sale for a private
annuity) are limited to the prescribed term.
b.
Advantage: Capital freeze.
- 93 -
3.
4.
5.
6.
Is it necessary for the transferor to receive payments for life (which
increase the transferor’s estate)?
a.
In a capital freeze, yes, unless the preferred interest is sold or
redeemed, which also increases the transferor’s estate. Not in a
GRAT or installment sale.
b.
Advantage: GRAT and installment sale.
Are payments easy to value?
a.
In a capital freeze, an appraisal – often a costly appraisal – is
generally needed. In a GRAT, the statute and regulations insist
upon the use of section 7520, which is very simple. In an
installment sale, Frazee indicates that section 7872 can be used,
which is also relatively simple, except for questions of ability to
pay (coverage).
b.
Advantage: GRAT. Runner-up: Installment sale.
Can the rate of return be low, to minimize the return that builds up the
transferor’s estate?
a.
In a capital freeze, the rate of return, often determined by the
appraiser, will generally be greater than the 7520 rate. A GRAT,
of course, uses the 7520 rate, which is 120% of the “federal
midterm rate.” The 7872 rate, used for an installment sale, will
typically be less than the 7520 rate, because it avoids the 120%
factor.
b.
Advantage: Installment sale. Runner-up: GRAT.
Can other features be used to prop up the value of what the transferor
retains or receives for gift tax purposes, so as to reduce the need to make
monetary payments?
a.
In a capital freeze, within limits, such features as voting rights
and preemptive rights associated with a preferred interest might
be given value under section 2701. This cannot be done in a
GRAT and probably not in an installment sale.
b.
Advantage: Capital freeze.
- 94 -
7.
8.
9.
10.
Is it possible to “zero out” the transaction, resulting in no taxable gift at
all?
a.
In a capital freeze, this is effectively limited by the 10% equity
floor of section 2701(a)(1). A GRAT can do better, unless it is
constrained under the principles of Reg. § 25.2702-3(e), Example
5 (held invalid by Walton v. Commissioner, 115 T.C. No. 41
(2000)). A sale is, by definition, a value-for-value—i.e., zeroedout—transaction. Nevertheless, the initial funding of the trust to
equip it to pay the desired down payment is usually a gift, which
a GRAT avoids.
b.
Advantage: Installment sale or GRAT.
Is an equity floor needed?
a.
In a capital freeze, 10%, under section 2701(a)(1). In a GRAT,
no. In an installment sale, probably enough to avoid “dry trust”
characterization, perhaps 10%, but this can be supplied from
other assets.
b.
Advantage: GRAT. Runner-up: Installment sale.
Can one attempt to “audit-proof” by formula?
a.
In a capital freeze this is difficult or impossible. In a GRAT, such
a formula is explicitly permitted by Reg. § 25.2702-3(b)(1)(ii)(B).
An installment sale can use either a price adjustment clause of the
sort addressed in In re King, 545 F.2d 700 (10th Cir. 1976), or a
“value definition clause” of the sort addressed in Technical
Advice Memorandum 8611004 (Nov. 15, 1985), but each of these
techniques has its complications and drawbacks.
b.
Advantage: GRAT.
Is it necessary to obtain cooperative actions from other family members?
a.
In a capital freeze, “elections” by other “applicable family
members” are often needed under Reg. § 25.2701-2(c)(4). There
is no such requirement in the case of a GRAT or installment sale.
b.
Advantage: GRAT and installment sale.
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11.
12.
13.
14.
15.
Is there a gift if the payments are not made?
a.
Probably not in the case of a capital freeze, under the principles
of Snyder v. Commissioner, 93 T.C. 529 (1989). Probably so in
the case of a GRAT or installment sale.
b.
Advantage: Capital freeze.
Is there a grace period, without tax consequences, for making the
required payments back to the transferor?
a.
Section 2701(d)(2)(C) provides a four-year grace period for
making “qualified payments” in a capital freeze. There is no such
provision in the case of a GRAT or installment sale.
b.
Advantage: Capital freeze.
Is there a harsh result if payments are not made?
a.
In the case of a capital freeze, the compounding provisions of
section 2701(d) are very harsh. In the case of a GRAT or
installment sale, the penalty is probably the normal gift tax
consequences.
b.
Advantage: GRAT and installment sale.
Must payments be made if the underlying investment does not work out?
a.
Under section 2701(d)(2)(B), there is no penalty for not making
“qualified payments” if the entity does not increase in value. In a
GRAT or installment sale, payments are absolute obligations that
must be made until the trust is exhausted.
b.
If the grantor trust has other assets, it can be a disaster if the
property that was the subject of an installment sale declines in
value, but the promissory note is included in the grantor’s gross
estate at face value.
c.
Advantage: Capital freeze.
Is there a double income tax on the arrangement?
a.
This is generally thought to be a disadvantage of a preferred stock
freeze, but, of course, a preferred capital freeze in a partnership
form avoids a double tax. There is no double tax in a GRAT or
installment sale, and, indeed, the grantor’s payment of income tax
- 96 -
on capital gain or other income retained by the trust can be an
additional advantage.
b.
16.
17.
18.
19.
Advantage: GRAT and installment sale (slightly).
Can future transfers be made to reduce the buildup of payments made
back to the transferor?
a.
In a capital freeze, the preferred interest can subsequently be
transferred. A precisely equivalent transfer is not available in a
GRAT or installment sale.
b.
Advantage: Capital freeze (slightly).
Can the arrangement be unwound when it has served its purpose?
a.
A capital freeze may be amended. A GRAT generally may not be
amended or commuted (although the GRAT asset may be
distributed in kind in satisfaction of the annuity obligation). An
installment sale note may be prepaid or even renegotiated, with
perhaps some risk of jeopardizing the original transaction.
b.
Advantage: Capital freeze. Runner-up: Installment sale.
Is survival required for a prescribed term to ensure that future
appreciation will escape tax?
a.
Not at all in a capital freeze. Perhaps not in the case of an
installment sale either; it could be complicated if the
grantor/holder died before the note was fully paid, but the only
question in such a case would be whether gain were recognized
for income tax purposes, not whether the future appreciation
escaped tax. The grantor of a GRAT must survive the GRAT
term for the GRAT to work.
b.
Advantage: Capital freeze and installment sale.
Can GST exemption be allocated to the arrangement?
a.
In a capital freeze and installment sale, yes, but not in a GRAT,
because of the ETIP rules during the GRAT term.
b.
Advantage: Capital freeze and installment sale.
- 97 -
20.
21.
Do the payment rules apply when the family-owned interest is only a
minority interest?
a.
Generally not in a capital freeze, because distribution rights are
subject to section 2701 only if the family controls the entity,
under section 2701(b)(1)(A). The presence or absence of family
control does not affect a GRAT or an installment sale.
b.
Advantage: Capital freeze.
Is the technique available for stock of an S corporation?
a.
A capital freeze is not. A GRAT and installment sale are.
b.
Advantage: GRAT and installment sale.
The foregoing comparisons are illustrated in the following table, in which bold
entries for the respective factors indicate probable advantages (to the extent that
particular factor is important, and all other things being equal):
- 98 -
1. Payments
required?
Capital
Freeze
GRAT
Installment
Sale
Yes
Yes
Can balloon at end
Can be perpetuity
Limited to GRAT term
Limited to sale term
3. Payments required
for life?
Yes
No
No
4. Payments easy to
value?
No (appraisal needed)
Yes (section 7520)
Somewhat (section
7872)
5. Rate of return
2. Permitted payout
Higher than 7520 rate
7520 rate
Lower (section 7872)
6. Able to use other
valuable features?
Within limits
No
Probably not
7. Able to “zero-out”?
Limited by 10% floor
Maybe
Yes
8. Need equity floor?
Yes (10%)
No
Probably
9. Can “audit-proof”
by formula?
Difficult or impossible
Yes
Difficult
10. Need elections?
Sometimes
No
No
Probably not
(Snyder)
Probably
Probably
Four years
None
None
Yes
No
No
No (section
2701(d)(2)(B))
Yes
Yes
Only in a corporation
No
No
16. Can make future
transfers?
Yes
No
No
17. Able to unwind?
11. Gifts if payments
not made?
12. Grace period?
13. Section 2701(d)
applies?
14. Must pay if losing
money?
15. Double income
tax?
Yes, by amendment
No
Can prepay
18. Survival required
for future growth to
escape tax?
No
Yes
No
19. GST exemption
available?
Yes
No
Yes
20. Rules apply when
family interest is a
minority interest?
Generally not
Yes
Yes
21. Available for an S
corporation?
No
Yes
Yes
The factors must be weighed, however, not merely counted. Generally, the most
important factors are thought to be the ability to zero-out (#7), the lack of need
to survive for a term (#18), and the ability to allocate GST exemption (#19). All
those factors (except possibly #7) favor an installment sale, while a GRAT is
predictable under section 2702 and the regulations thereunder and a capital
freeze is a traditional technique obviously contemplated by section 2701 and the
regulations thereunder. Moreover, depending on the assets used, and the
client’s ability and willingness to pay gift taxes, a taxable gift almost always
outperforms any other freeze technique (provided the donor survives for three
years).
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N.
Charitable Lead Trusts (CLATs)
1.
The central feature of a charitable lead annuity trust (“CLAT”) is that it
is required to pay a fixed dollar amount (the “annuity” amount) to charity
each year for a prescribed term (which I will call the “CLAT term”). At
the end of the CLAT term, the trust will either be distributed outright to
the remainder beneficiaries—for example, the grantor’s children—or
continue in trust for their benefit. This benefit to the remainder
beneficiaries is a gift. For gift tax purposes, however, the charitable
annuity is valued at the 7520 rate, regardless of the actual investment
performance of the property in the CLAT.
2.
Whatever discount rate is used to value the gift when a CLAT is created,
any total return from the CLAT assets in excess of that discount rate
effectively accrues to the remainder beneficiaries free of gift or estate
tax. For example, if $1 million is placed in a CLAT that is required to
pay charity $88,605.41 per year for 20 years and then distribute its
remaining assets to the grantor’s children, and the applicable 7520 rate is
6.2% (as it is in March 2001), the value of the gift to the children would
be calculated on the assumption that the CLAT earns exactly 6.2% in
each year of its existence, with the following results:
Year
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
3.
20-year CLAT at 6.2%
Beginning
Yield
Annuity
1,000,000.00 62,000.00
88,605.41
973,394.59 60,350.46
88,605.41
945,139.64 58,598.66
88,605.41
915,132.89 56,738.24
88,605.41
883,265.72 54,762.47
88,605.41
849,422.79 52,664.21
88,605.41
813,481.59 50,435.86
88,605.41
775,312.04 48,069.35
88,605.41
734,775.97 45,556.11
88,605.41
691,726.67 42,887.05
88,605.41
646,008.32 40,052.52
88,605.41
597,455.42 37,042.24
88,605.41
545,892.25 33,845.32
88,605.41
491,132.16 30,450.19
88,605.41
432,976.94 26,844.57
88,605.41
371,216.10 23,015.40
88,605.41
305,626.09 18,948.82
88,605.41
235,969.50 14,630.11
88,605.41
161,994.20 10,043.64
88,605.41
83,432.43
5,172.81
88,605.41
Ending
973,394.59
945,139.64
915,132.89
883,265.72
849,422.79
813,481.59
775,312.04
734,775.97
691,726.67
646,008.32
597,455.42
545,892.25
491,132.16
432,976.94
371,216.10
305,626.09
235,969.50
161,994.20
83,432.43
(0.17)
On these assumptions, the trust is exhausted after 20 years, and the
children receive nothing. Therefore, the taxable gift is zero. (That, of
course, is how the annuity of $88,605.41 was derived in the first place!)
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But if, in fact, the trust property earns, say, 10% each year, then the
actual result would be as follows:
Year
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
20-year CLAT at 6.2% with 10% Yield
Beginning
Yield
Annuity
Ending
1,000,000.00 100,000.00
88,605.41 1,011,394.59
1,011,394.59 101,139.46
88,605.41 1,023,928.64
1,023,928.64 102,392.86
88,605.41 1,037,716.09
1,037,716.09 103,771.61
88,605.41 1,052,882.29
1,052,882.29 105,288.23
88,605.41 1,069,565.11
1,069,565.11 106,956.51
88,605.41 1,087,916.21
1,087,916.21 108,791.62
88,605.41 1,108,102.42
1,108,102.42 110,810.24
88,605.41 1,130,307.26
1,130,307.26 113,030.73
88,605.41 1,154,732.57
1,154,732.57 115,473.26
88,605.41 1,181,600.42
1,181,600.42 118,160.04
88,605.41 1,211,155.05
1,211,155.05 121,115.51
88,605.41 1,243,665.15
1,243,665.15 124,366.51
88,605.41 1,279,426.25
1,279,426.25 127,942.63
88,605.41 1,318,763.47
1,318,763.47 131,876.35
88,605.41 1,362,034.40
1,362,034.40 136,203.44
88,605.41 1,409,632.43
1,409,632.43 140,963.24
88,605.41 1,461,990.27
1,461,990.27 146,199.03
88,605.41 1,519,583.88
1,519,583.88 151,958.39
88,605.41 1,582,936.86
1,582,936.86 158,293.69
88,605.41 1,652,625.14
4.
In other words, from an initial transfer of $1 million, the grantor’s
children would receive $1.65 million in 20 years, while charity would
also receive enough in the interim to completely eliminate any taxable
gift. Of course, an increase from $1 million to $1.65 million represents
compound annual growth of only about 2.54%, but the point is that both
the growth and the initial $1 million would completely escape gift or
estate tax.
5.
In structuring a CLAT, the first key is to pick a payout (roughly 8.86% in
the foregoing example) that can be comfortably satisfied from the cash
flow from the trust property and still permit the trust assets to grow in
value, and then pick a term that will minimize the gift. The larger the
payout, of course, the shorter the term needs to be. Then the second key
is to pick a total amount to put into the CLAT that will produce an
annual payment to charity roughly equal to (or somewhat less than) the
charitable contributions the grantor expects to make each year anyway.
In that way, the funding of the CLAT will maximize the amount that
goes to the grantor’s children in a leveraged manner without reducing the
grantor’s net cash flow, since the cash flow lost to the grantor because it
is received by the trust is roughly matched by the cash flow the grantor
saves by being able, in effect, to make “his” or “her” annual charitable
contributions from the trust. (Of course, the grantor cannot legally make
- 101 -
his or her contributions from the trust, and, in particular, the trust may
not satisfy any pledges the grantor might personally make. But there is
nothing wrong, for example, in John Doe’s naming the trust something
like the John Doe Charitable Income Trust and making contributions in
that name.)
O.
6.
There is nothing wrong with giving the trustee of the CLAT discretion to
select the charitable recipients of the annuity amount on a year-by-year
basis. In that case, the most conservative approach would be to provide
that the grantor cannot serve as a trustee. A grantor who wants to serve
as trustee must generally be excluded from participating in decisions
regarding the selection of charitable recipients. Similarly, the trust
document might have to prohibit contributions to organizations of which
the grantor serves as an officer, director, or trustee—unless again the
grantor is screened from participating in decisions regarding the ultimate
use of the funds.
7.
Like a GRAT, a CLAT is not an efficient vehicle for providing for
generation-skipping. This disadvantage of a CLAT can be avoided by
instead using a charitable remainder unitrust and paying charity each year
a fixed percentage of the net value of the trust assets that year, rather than
a fixed dollar amount. But using a unitrust would sacrifice the leverage
that a CLAT achieves by permitting excess appreciation to accrue to the
grantor’s descendants free of estate or gift tax. It is also impossible to
achieve a zero gift in the case of a unitrust.
8.
In general, the grantor will receive no income tax deduction as such
when creating and funding the trust, but the trust itself, although taxed on
its net income, will be entitled to charitable deductions for its
contributions, without regard to the size of the grantor’s gross income or
the trust’s gross income.
Use of Personal Residence Trusts (PRTs) and Qualified Personal Residence
Trusts (QPRTs)
1.
All requirements of the regulations, including the detailed governinginstrument requirements, must be followed.
2.
A reversion will almost always be a good idea.
a.
It depresses the gift tax value further.
b.
It creates no estate tax downside, because the entire value of the
trust property will be included in the grantor’s gross estate under
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section 2036(a) if the grantor dies during the trust term anyway.
Rev. Ruls. 76-273 and 82-105, supra, will not apply.
3.
c.
It facilitates use of the marital deduction if the grantor dies during
the trust term.
d.
It ensures grantor trust treatment for the principal portion of the
trust, which is important in securing nonrecognition of gain on
repurchase. Rev. Rul. 85-13, 1985-1 C.B. 184 (discussed below).
Grantor trust treatment historically was also important for
rollover treatment under the former section 1034 (Rev. Rul. 66159, 1966-1 C.B. 162) and the one-time exclusion of gain under
the former section 121 (Rev. Rul. 85-45, 1985-1 C.B. 183).
Letter Ruling 199912026 confirms that it continues to be
important in securing the exclusion of gain under section 121 as
amended by the Taxpayer Relief Act of 1997. (The deductibility
of mortgage interest, if any, requires only that the occupant of the
qualified residence have a “present interest” or “interest in the
residuary” of the trust. Section 163(h)(4)(D). See Letter Ruling
9249014. The rule for the deductibility of taxes is the same. Id.)
Special planning is needed if the grantor is to continue living in the
residence after the trust term ends.
a.
Unless circumstances change dramatically during the term of the
trust (and perhaps even if they have do), continued occupancy at
the sufferance of the remainder beneficiaries will raise an
inference of an implied understanding caught by section 2036(a).
Rev. Rul. 78-409, 1978-2 C.B. 234; Rev. Rul. 70-155, 1970-1
C.B. 189.
b.
A lease should not be a problem if the rent is fair.
i.
The rent may be subject to income tax (but at a rate that is
generally less than the transfer tax rate), but this can be
avoided by making the continuing trust a grantor trust.
ii.
If the rent is subject to income tax (but not in the case of a
grantor trust), the trust should be entitled to depreciation
and other appropriate deductions.
iii.
The residence may have a low basis for purposes of depreciation (if any) and calculating the gain on sale.
iv.
In any event, the payment of rent is an additional transfer
to the remainder beneficiaries, without transfer tax.
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c.
d.
The retention of the right to rent at the time the trust is created
should not cause the residence to be included in the gross estate
under section 2036(a).
i.
Retention of the right to rent without triggering section
2036(a) is consistent with Rev. Rul. 70-155, supra, where
an implied understanding of continued occupancy was
held to fall within section 2036(a) where the nominal
transferees (the decedent’s son and daughter-in-law)
“neither occupied the property nor received reasonable
income therefrom during [the decedent’s] lifetime.”
ii.
This view finds support in Estate of Barlow v.
Commissioner, 55 T.C. 666 (1971). See also Estate of
McNichol v. Commissioner, 265 F.2d 667 (3d Cir. 1959),
cert. denied, 361 U.S. 829 (1960).
iii.
This view has been taken in Letter Rulings 9249014,
9425028, 9433016, 9735011, 9735035, 9829002, and
199931028.
iv.
Cf. Letter Ruling 9626041 (allowing the trust to be
required to retain the residence after the QPRT term, with
the trustee permitted to rent the residence back to the
grantor).
v.
But the retention of the right to rent was held to trigger
section 2036(a) in Technical Advice Memorandum
9146002, which dealt with a very aggressive plan involving a “lease” of a 5-percent interest in a personal
residence. The Service distinguished Barlow on the
ground that the property in Barlow was business property
and the leaseback had a business purpose.
A repurchase of the residence by the grantor before the end of the
trust term has been thought to be the most advantageous
approach. Letter Ruling 9425028 actually allowed the retention
of the right to repurchase (or rent). For trusts created after May
16, 1996, however, the regulations require the governing
instrument of a personal residence trust (PRT) or qualified
personal residence trust (QPRT) to prohibit the reacquisition of
the residence by the grantor or the grantor’s spouse (or an entity
controlled by either of them) during the original trust term (in the
case of a QPRT) or at any time thereafter that the trust continues
to be a grantor trust for income tax purposes. Reg. §§ 25.27025(b)(1) & (c)(9) and 25.2702-7.
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4.
5.
Spouses may be co-grantors of a personal residence trust or a qualified
personal residence trust and co-transferors of a residence, including a
residence held as community property. Reg. § 25.2702-5(b)(2)(iv) &
(c)(2)(iv). Special attention must then be given, however, to the terms
that take effect when the first spouse dies.
a.
The trust instrument must prohibit anyone other than the spouse
from holding the remainder of the term interest with the surviving
spouse. Id.
b.
The trust instrument might provide that the surviving spouse
simply succeed to the benefits of the deceased spouse, but that
provision might not qualify for the marital deduction.
c.
The easiest solution might be for each spouse to simply devise his
or her reverting interest to the surviving spouse outright, or to a
QTIP trust.
d.
On the other hand, this might be a case where it is better to forgo
the reversion, and provide for each spouse to devise only his or
her remaining interest for the balance of the term to the surviving
spouse.
e.
Of course, the joint tenancy could be severed into a tenancy in
common, and each spouse could transfer a one-half undivided
interest to his or her separate QPRT. Letter Rulings 199918049,
200004037 & 200039031.
f.
For a joint tenancy or tenancy created before 1977, care must be
taken to preserve any claim the surviving spouse might have after
the death of one spouse that the entire property receives a
stepped-up basis for income tax purposes under section 1041.
See Gallenstein v. United States, 975 F.2d 286 (6th Cir. 1992);
Basztov v. United States, 98-1 USTC ¶ 60,305 (D. Fla. 1998);
Anderson v. United States, 96-2 USTC ¶ 60,235 (D. Md. 1996);
Patten v. United States, 96-1 USTC ¶ 60,231 (W.D. Va. 1996);
Hahn v. Commissioner, 110 T.C. No. 14 (1998).
The use of a mortgaged residence presents special problems.
a.
A QPRT’s status as a grantor trust should avoid taxable capital
gain on the transfer of a mortgaged residence to the trust, even if
the mortgage exceeds the grantor’s basis. Cf., e.g., Estate of
Levine v. Commissioner, 72 T.C. 780 (1979), aff’d, 634 F.2d 12
(2d Cir. 1980); Johnson v. Commissioner, 59 T.C. 791 (1973),
- 105 -
aff’d, 495 F.2d 1079 (6th Cir.), cert. denied, 419 U.S. 1040
(1974).
b.
The difficulty is with determining what portion of the subsequent
mortgage payments by the grantor is attributable to the remainder
interest and therefore is a taxable gift (of a future interest).
i.
The most desirable result would be to treat the entire
interest component of the payment to the term interest of
the grantor (because it is a time value cost) and apportion
the principal component between the term interest and the
remainder interest on the basis of actuarial factors
appropriate at the time.
ii.
A possibly more likely, but less advantageous, result
would be to attribute the interest component to the term
interest and the entire principal component to the remainder interest. Another possibility is to apportion both the
interest and principal components on the basis of actuarial
factors, which appears to be the result if, for example,
cash were given to the trust (at least at the time the trust is
created) and used by the trust to make mortgage payments
expected within the next six months. Which of these two
methods is more advantageous will depend on the interrelationship between the actuarial factors, the 7520 rate,
and the terms of the mortgage.
iii.
The worst, though seemingly unlikely, result would be to
attribute the entire principal component to the remainder
interest (on the theory that it is an addition to the equity
value of the residence that benefits only the remainder
beneficiary) and to actuarially apportion the interest
component (on the theory that it is like a cash payment to
the trust).
iv.
The actual result may depend on the local principal and
income law, which may not be well developed.
v.
In any event, the if it assumed that the principal component of each mortgage payment creates a greater gift tax
problem than the interest component, then, in general, this
problem will be aggravated with the passage of time, as
both the principal component of a typical mortgage and
the actuarial value of the remainder interest increase. The
problem may be further aggravated if the 7520 rate
- 106 -
decreases, but may be allayed somewhat if the 7520 rate
increases.
vi.
c.
Further difficulties arise when a residence without a mortgage, or
with a relatively small mortgage, is placed in a QPRT and the
grantor later wants to obtain a favorable loan rate on a taxadvantaged basis by mortgaging the residence or adding to the
existing mortgage.
d.
It has been suggested that the problem of an initial transfer of
mortgaged property to a QPRT can be avoided by, in effect,
transferring the residence free of the mortgage, with the grantor
continuing to be personally obligated on the mortgage.
e.
6.
In addition, subsequent mortgage payments will create an
accounting nightmare, particularly if it ever becomes
necessary to compute the required annuity payment upon
the conversion of the QPRT to a GRAT.
i.
But if the mortgage continues to be secured by the
residence, the arrangement (to the extent of the mortgage
encumbrance) may be nothing more than merely a
promise to make a gift in the future.
ii.
If the lender releases the residence as security for the
mortgage, the income tax deduction for the mortgage
interest is jeopardized under section 163(h)(3).
Perhaps a transfer to a QPRT of a fractional interest, representing,
in effect, the unencumbered portion of the residence, can be used.
i.
This technique might be especially useful when a
residence is being acquired or built contemporaneously
with the creation of the QPRT. The grantor can fund the
QPRT with cash, and the grantor and the QPRT can then
acquire the residence as tenants in common in a joint
purchase, with the grantor financing his or her share.
ii.
Questions of security and deductibility of interest might
still remain, but might be minimized.
iii.
See Letter Rulings 9714025, 9816003 & 9818014 (QPRTs
holding fractional interests).
A trust that does not satisfy all of the regulatory requirements may be
reformed—non-judicially if possible or judicially in necessary—to
comply with the requirements. The reformation must be commenced
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within 90 days after the due date (including extensions) for filing the gift
tax return reporting the transfer and must be completed within a
reasonable time after commencement. Reg. § 25.2702-5(a)(2). In Letter
Ruling 199925027, the Service granted an extension of time (so-called
“9100 relief”) for accomplishing this modification.
7.
P.
The generation-skipping transfer (GST) tax should be considered.
a.
When a qualified personal residence trust (QPRT) is created, it is
a common technique to make only the grantor’s then-living
children the remainder beneficiaries at the end of the QPRT term
and make “equalizing” provisions for the descendants of any nonsurviving children under the grantor’s will or revocable trust
instrument, because those “equalizing” provisions will be “direct
skips” exempt from the GST tax under the predeceased-child rule
of section 2612(c)(2), while the taxable distributions or taxable
terminations at the end of the trust term would not be. This
technique does not seem to be used as much with grantor retained
annuity trusts (GRATs), although, so long as there is enough
other property to fund the “equalizing” provisions, there is no
reason why it should not be.
b.
A pair of letter rulings appear to hold that the estates of the
grantor’s children are not skip persons and that termination of a
trust in favor of the grantor’s children or their estates will not
cause a charitable lead trust to be subject to the GST tax. Letter
Rulings 9533017 and 9534004. This suggests that a QPRT or
GRAT that terminates in favor of the grantor’s children or their
estates may not have as serious a GST tax problem as a trust that
simply terminates in favor of the grantor’s descendants per
stirpes. Considerable further study of such a technique is needed,
however, focusing particularly on the valuation of the contingent
remainder in the children’s gross estates.
Other Transactions Involving Personal Residences
1.
2.
A joint purchase.
a.
Not known to be favored by the Service (see Letter Ruling
9412036), unless in trust (see Letter Ruling 9841017).
b.
Uncertain as to its estate tax effects, if for life. See Letter Ruling
9841017 (“no opinion is expressed or implied regarding the
applicability of section 2036”).
A gift or sale of a remainder following a term of years.
- 108 -
3.
Q.
R.
A sale of a remainder following a retained life estate. Estate of
D’Ambrosio v. Commissioner, 101 F.3d 309 (3d Cir. 1996), rev’g 105
T.C. 252 (1995); Wheeler v. United States, 116 F.3d 749 (5th Cir. 1997);
Estate of Magnin v. Commissioner, 184 F.3d 1074 (9th Cir. 1999), rev’g
T.C. Memo 1996-25. But see Gradow v. United States, 897 F.2d 516
(Fed. Cir. 1990), aff’g 11 Ct. Cl. 807 (Cl. Ct. 1987). See generally
United States v. Past, 347 F.2d 7 (9th Cir. 1965); Estate of Gregory v.
Commissioner, 39 T.C. 1012 (1963); United States v. Allen, 293 F.2d
916 (10th Cir. 1961). On remand in Magnin, the Tax Court seemed to
accept the principle of valuing the remainder at its actuarial value, but it
still found that the seller had gotten the valuation wrong. Estate of
Magnin v. Commissioner, T.C. Memo 2001-31.
Testamentary Freezes
1.
Example: Bequest of common stock to descendants and preferred stock
to spouse.
2.
Caveat: Whenever stock is split up in this way, care must be taken that
the marital deduction (or a charitable deduction) is not reduced. See
Technical Advice Memoranda 9050004 & 9403005 (all stock owned by
decedent valued as a control block for purposes of the gross estate, but
marital bequest valued separately for purposes of the marital deduction),
relying on Estate of Chenoweth v. Commissioner, 88 T.C. 1577 (1987)
(estate of a decedent who owned all the stock of a corporation entitled to
prove a control premium for a 51-percent block of stock bequeathed to
spouse), and Ahmanson Foundation v. United States, 674 F.2d 761 (9th
Cir. 1981). Cf. Technical Advice Memorandum 9327005 (amount of
marital deduction controlled by buy-sell agreement, even though the
agreement is disregarded for purposes of determining the value of the
gross estate).
Generation-Skipping Freezes
1.
2.
Gift or bequest of preferred stock to children and common stock to
grandchildren.
a.
Freezes children’s estates.
b.
May minimize the generation-skipping transfer tax on the direct
skip to the grandchildren, if a low value for the common stock
can be supported. (Section 2701 does not apply for purposes of
the GST tax.)
Simple gift of common stock to grandchildren: Section 2701 applies for
gift-tax purposes, but not in computing the GST tax.
- 109 -
S.
Post Mortem Freezes
1.
2.
Possibly a recapitalization freeze (by executor before distribution).
a.
Marital trust (or spouse) ultimately receives preferred stock.
b.
Credit shelter trust (or descendants) receives common stock.
c.
Preferred dividends don’t have to be paid until the decedent’s
death.
d.
The indirect ownership rules of section 2701(e)(3) and Reg.
§ 25.2701-6(a)(4) might treat a post mortem recapitalization as if
done by the beneficiaries of the estate.
i.
At a minimum, the spouse should not be the executor,
should not have a power to allocate the interests, and
should not play an active role in the recapitalization.
ii.
More conservatively, the executor should be given no
discretion under the will, but must be directed to undertake the recapitalization and make the prescribed allocation, and should have enough voting power to compel the
recapitalization without the consent of other shareholders.
e.
The Chenoweth-Ahmanson caveat above applies here as well. It
may be harder to support the value of the preferred stock (to prevent a deemed gift by the surviving spouse) if there is no history
of dividend payments. See also Provident Nat’l Bank v. United
States, 502 F. Supp. 908 (E.D. Pa. 1980).
f.
See also Rev. Proc. 64-19, 1964-1 C.B. (Part 1) 682.
g.
Generally, preferred stock received in a post mortem recapitalization will be “section 306 stock,” although this is generally irrelevant if the preferred stock is merely held by the surviving spouse
until death.
Funding freeze.
a.
The marital trust (or spouse) receives assets not as likely to
appreciate.
b.
The credit shelter trust receives “hot assets” most likely to
appreciate.
c.
See Rev. Proc. 64-19, supra.
- 110 -
3.
Tax payment freeze.
a.
Pay estate tax on death of first spouse to die (perhaps by using the
spouse’s disclaimer or a partial QTIP election followed by
division of the trust).
b.
Possibly preserve favorable valuation rules and results applicable
at the time of the first death.
c.
This could also maximize the benefit from the credit for tax on
prior transfers under section 2013. See Technical Advice
Memorandum 8512004.
- 111 -
APPENDIX
The following spreadsheets model the scenarios of doing nothing, creating a five-year
straight-line GRAT, and creating a five-year graduated GRAT (in which the annuity amount
increases by 20% each year). In each case, it is assumed that the client starts with a “hot asset”
with an initial value of $1 million, expected to appreciate rapidly over the five years of the
model. The client is assumed to be 55 years old, and the 7520 rate is 6.4%.
In each case, the assumptions are stated at the top of the page, and the year-by-year
calculations begin at line j. The “hot asset” is assumed to have a total-return yield of 25%,
consisting of 4% cash income return and 21% appreciation. The income tax rate is assumed to
be 40%, and the estate (and gift) tax rate is assumed to be 55%.
To make the comparison fair and complete, it is necessary to take into account not only
the performance of the “hot asset,” in or out of the GRAT, but also the performance of the
reinvested cash that the grantor receives. That reinvested cash is assumed to also produce a cash
income yield of 4%, but appreciation of only 4%.
The calculations should be generally self-explanatory, and the formulas are set forth in
non-technical form for each calculation, so the calculations can be reproduced for different
assumptions. In the case of the GRATs, it is assumed that the annuity is paid in kind to the
extent the GRAT’s cash income (assumed in these models to be 4%) is insufficient to pay the
annuity, as it always will be. For simplicity, these models do not include “re-GRATing” of
GRAT assets that are distributed in kind.
In the GRATs, the annuity that is selected is the annuity that would precisely “zero-out”
the gift for a straight five-year term certain (so that there is no “exhaustion” component). The
gift itself, however, is calculated on the basis of an annuity for five years or the grantor’s life,
whichever is shorter. In line dd, the amount of the gift is stated in the column for Year 1, and the
tax on that gift (55%) is set forth in the column for Year 5 and enters into the calculation in the
same way as the estate tax.
The “bottom line” in these models is the total distributable amount after five years,
assuming for the sake of fair comparison in all three scenarios that the client dies one day after
the end of the five-year period. By this standard of comparison, it is apparent that the GRATs are
better than doing nothing, and the graduated GRAT is somewhat better than the straight-line
GRAT. Some unscientific “fiddling” with the underlying spreadsheets persuaded this author that
a graduated GRAT will always do better than the straight-line GRAT by this standard, except
where the “hot asset” substantially underperforms the invested cash. In that case, though, even
doing nothing is a reasonable option.
- 112 -
Illustration of Doing Nothing
a. Initial capital
b. Cash income return (%)
c. Appreciation on hot assets (%)
d. Appreciation on invested cash (%)
e. Income tax rate (%)
f. Estate/gift tax rate (%)
1000000
4
21
4
40
55
Year
j. Initial hot assets [a; then previous l ]
k. Appreciation [c x j]
l . Ending hot assets [j + k]
m. Beginning invested cash [0; then previous t]
n. Cash income from hot assets [b x j]
o. Income from invested cash [b x m]
p. Total cash income [n + o]
q. Income tax [e x p]
r. Net cash flow [p - q]
s. Appreciation of invested cash [d x m]
t. Ending invested cash [m + r + s]
1
2
3
4
5
1000000
210000
1210000
1210000
254100
1464100
1464100
307461
1771561
1771561
372028
2143589
2143589
450154
2593742
0
40000
0
40000
-16000
24000
0
24000
24000
48400
960
49360
-19744
29616
960
54576
54576
58564
2183
60747
-24299
36448
2183
93207
93207
70862
3728
74591
-29836
44754
3728
141690
141690
85744
5668
91411
-36564
54847
5668
202204
u. Ending hot assets and invested cash [l + t]
v. Estate tax [f x u]
w. Distributable balance [u - v]
2795947
-1537771
1258176
- 113 -
Illustration of Straight Line GRAT
[55-year-old grantor; 6.4% 7520 rate]
a. Transferred capital
b. Annuity (%)
c. Annuity factor
d. Cash income return (%)
e. Appreciation of hot assets (%)
f. Appreciation of invested cash (%)
g. Income tax rate (%)
h. Estate/gift tax rate (%)
1000000
23.9987
4.06960
4
21
4
40
55
Year
1
j. Annuity [a x b]
k. Cash payment (GRAT income) [d x m]
l . Annuity payment in kind [j - k]
2
3
4
5
239987
-40000
199987
239987
-40401
199586
239987
-40901
199086
239987
-41527
198460
239987
-42309
197678
1000000
210000
-199987
1010013
1010013
212103
-199586
1022529
1022529
214731
-199086
1038175
1038175
218017
-198460
1057731
1057731
222124
-197678
1082177
q. Grantor's beginning invested cash [0; then previous w]
r. Appreciation [f x q]
s. Cash income from invested cash [d x q]
t. Cash payment from GRAT [d x m]
u. Cash income from hot assets [d x x]
v. Income tax [g x (s + t + u)]
w. Grantor's ending invested cash [q + r + s + t + u - v]
0
0
0
40000
0
-16000
24000
24000
960
960
40401
7999
-19744
54576
54576
2183
2183
40901
17663
-24299
93207
93207
3728
3728
41527
29335
-29836
141690
141690
5668
5668
42309
43434
-36564
202204
x . Grantor's beginning hot assets [0; then previous aa]
y. Appreciation [e x x ]
z. Annuity payment in kind [l ]
aa. Grantor's ending hot assets [x + y + z]
0
0
199987
199987
199987
41997
199586
441571
441571
92730
199086
733386
733386
154011
198460
1085858
1085858
228030
197678
1511565
m. Beginning GRAT corpus [a; then previous p]
n. GRAT appreciation [e x m]
o. Annuity payment in kind [l ]
p. Ending GRAT corpus [m + n - o]
bb. Grantor's ending hot assets and invested cash [w + aa]
cc. Estate tax [h x bb]
dd. Gift/Tax on gift [from a, c & h]
ee. Distributable balance [bb - cc - dd]
ff. Ending GRAT corpus [p]
gg. Total distributable [ee + ff]
- 114 -
23349
1713770
-942573
-12842
758354
1082177
1840531
Illustration of Graduated GRAT
[55-year-old grantor; 6.4% 7520 rate]
a. Transferred capital
b. Initial annuity (%)
c. Annuity factor
d. Cash income return (%)
e. Appreciation of hot assets (%)
f. Appreciation of invested cash (%)
g. Income tax rate (%)
h. Estate/gift tax rate (%)
i. Annual annuity escalator (%)
1000000
16.4903
5.8995
4
21
4
40
55
20
Year
1
j. Annuity [a x b; then previous j x (1 + I)]
k. Cash payment (GRAT income) [d x m]
l . Annuity payment in kind [j - k]
2
3
4
5
164903
-40000
124903
197884
-43404
154480
237460
-46340
191121
284952
-48426
236526
341943
-49134
292808
1000000
210000
-124903
1085097
1085097
227870
-154480
1158488
1158488
243282
-191121
1210649
1210649
254236
-236526
1228359
1228359
257955
-292808
1193506
q. Grantor's beginning invested cash [0; then previous w]
r. Appreciation [f x q]
s. Cash income from invested cash [d x q]
t. Cash payment from GRAT [d x m]
u. Cash income from hot assets [d x x]
v. Income tax [g x (s + t + u)]
w. Grantor's ending invested cash [q + r + s + t + u - v]
0
0
0
40000
0
-16000
24000
24000
960
960
43404
4996
-19744
54576
54576
2183
2183
46340
12224
-24299
93207
93207
3728
3728
48426
22436
-29836
141690
141690
5668
5668
49134
36609
-36564
202204
x . Grantor's beginning hot assets [0; then previous aa]
y. Appreciation [e x x ]
z. Annuity payment in kind [l ]
aa. Grantor's ending hot assets [x + y + z]
0
0
124903
124903
124903
26230
154480
305612
305612
64179
191121
560912
560912
117791
236526
915230
915230
192198
292808
1400236
m. Beginning GRAT corpus [a; then previous p]
n. GRAT appreciation [e x m]
o. Annuity payment in kind [l ]
p. Ending GRAT corpus [m + n - o]
bb. Grantor's ending hot assets and invested cash [w + aa]
cc. Estate tax [h x bb]
dd. Gift/Tax on gift [from a, c & h]
ee. Distributable balance [bb - cc - dd]
ff. Ending GRAT corpus [p]
gg. Total distributable [ee + ff]
- 115 -
27155
1602441
-881342
-14935
706163
1193506
1899669