intentionally defective grantor trusts -...
TRANSCRIPT
Intentionally Defective Grantor Trusts Funding and Structuring Sales to Transfer Assets, Retain Control and Reduce Estate Taxes
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TUESDAY, FEBRUARY 21, 2012
Presenting a live 90-minute webinar with interactive Q&A
Steven R. Owens, Atty, The Law Office of Steven R. Owens, Greenwood Village, Colo.
Joel R. Keeth, Managing Partner, Keeth-Scott Law Group, Denver
Karen L. Brady, Atty, Karen Brady & Associates, Arvada, Colo.
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A Word About “Defective”
• The creature we will be discussing is often called an “Intentionally Defective Grantor Trust”
• Name came about because a “defect” in the trust causes its income to be taxed to the grantor (apparently an outcome many think should be avoided)
• The actual IRS term used to refer to such a trust is “grantor trust.”
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A Word About “Defective”
• There is nothing “defective” about a trust that is written in such a way to intentionally cause the income tax to be attributed to the grantor.
• Clients don’t understand, and don’t want to pay good money for a “defective” anything.
• To be precise, and to converse with clients without scaring them, call them “grantor trusts,” which is the correct name.
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Primary Uses Of Grantor Trusts
• To hold assets, and the growth in value of the assets, outside of the grantor’s taxable estate
• To provide leveraging of gift tax exemptions (both lifetime and annual) – 2012 lifetime gift tax exemption = $5.12 million – 2013 and beyond = unknown – Annual gift tax exemption = $13,000 per
beneficiary, per donor, indexed for inflation
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Primary Uses of Grantor Trusts • To provide leveraging of generation-
skipping transfer tax exemptions – 2012 lifetime GSTT exemption = $5.12 million – 2013 and beyond = unknown
• I.e. if the trust is created with a GSTT inclusion ratio of 0, and all subsequent gifts have the same, it will always have that ratio, even with significant growth in value of the assets held in the trust.
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Primary Uses Of Grantor Trusts
• To leverage both the gift tax exemption and the GSTT exemptions by having the grantor pay income tax on income earned by assets held in the trust – Allows the assets to grow inside the trust as if
they were tax-free (because the grantor pays the income taxes)
– This is the primary focus of this workshop – IRS says this is not an additional gift: Rev. Rul.
2004-64 (note closely—it is a revenue ruling)
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Primary Uses of Grantor Trusts
• To provide asset protection – From grantor’s creditors – From beneficiary’s creditors – On all of the trust’s assets:
• The assets gifted to the trust • The assets sold to the trust • All growth in value of the assets
– Fraudulence conveyance statutes apply
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Primary Uses of Grantor Trusts • To create an Irrevocable Life Insurance
Trust that can purchase an existing policy without incurring the “three-year rule” estate clawback, or the income tax that could result from a transfer for value of the insurance policy – It is not a transfer for value since you are
“selling it to yourself” for all tax purposes – It is not subject to clawback because it is not a
gift, it is a sale for fair value
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Grantor Trust Basics
• To achieve any benefit, the trust must be an irrevocable trust – Revocable trusts are also grantor trusts, but
that is not the topic of today’s conversation • There is a small group of powers that a
grantor can retain that will cause the trust income to be attributed to the grantor, but that will not result in the trust corpus being included in the grantor’s taxable estate
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Grantor Trust Basics • Powers that a grantor can retain:
– Set forth in Code Secs. 673 through 677 • Power to substitute assets of equal value (§675(4))
– IRS confirmed that this will not cause estate inclusion (PLR 200603040 (Oct. 24, 2005))
– My favorite and probably the safest • Power to borrow without adequate security or
interest (§675(2)) • Power to use trust income to pay insurance
premiums (§677(a)(3) & PLR 812047) – Unreliable if no insurance
• Nonadverse trustee’s power to sprinkle income to beneficiaries (§674 & PLR 8103074). Caution: grantor control will cause estate inclusion.
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Grantor Trust Basics • The grantor power should be chosen
carefully and have an “off switch” in the event that the grantor wants to stop being responsible for the trust’s income tax. – I.e. – the grantor can revoke the selected power
• All of the other irrevocable trust issues should be considered and addressed: – Choice of trustee (not the grantor or spouse) – Choice of venue – Dynasty or not, etc.
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Grantor Trust Basics
• The spouse can be a beneficiary (i.e. a spousal access trust).
• The grantor cannot be a beneficiary, but each spouse can create a trust, with the other spouse as a beneficiary.
• In general, a grantor trust can own anything an individual can own: – Not qualified retirement plans – Can hold Subchapter S stock
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Grantor Trust Basics • Basic overview:
– Consider purpose and general goals – Draft trust accordingly as a grantor trust – Gift assets to the trust
• We suggest using all or part of the grantor’s lifetime exemption, filing a 709, and affirmatively allocating the GSTT exemption to the trust so that the inclusion ratio is 0.
• Annual exemptions are permissible, but I personally avoid the automatic allocation rules and I require the trustees to file 709s
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Grantor Trust Basics
• Basic overview: – Basis will carry over into the grantor trust – Basic decision:
• Will this be primarily a gifting trust (i.e. the trust assets will be gifted into the trust)?
• Or will this be primarily a trust used to purchase assets from the grantor?
– If a gifting trust, grantors may want to “lock in” all or some portion of the $5.12 gifting and GSTT exemption opportunity of 2012
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Grantor Trust Basics • Basic overview:
– If an asset purchase trust, then the grantor will still gift a significant amount of assets to the trust to begin with:
• Filing the 709 and affirmatively allocating a portion of the available GSTT exemption will set the inclusion ratio of the trust as 0
• The gift (which should be at least 10% of the anticipated value of the assets to be purchased) will quash the IRS argument under § § 2036(a), 2701 and 2702 that the assets should be included in the grantors estate by creating a “bona fide” sale
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Grantor Trust Basics
• Basic overview: – If an asset-purchase trust, then the grantor
will sell the selected assets to the trust, taking back a promissory note bearing interest at least equal to the Applicable Federal Rate:
• February 2012 3-9 year term: 1.24% (Qtr.) • February 2012 +9 year term: 3.22% (Qtr.)
– Grantor trust = no taxable income to grantor upon sale to trust, no deduction for trust for interest paid (Rev. Rul. 85-13)
§
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Grantor Trust Basics
• Basic overview: – Grantor trust = no capital gains tax paid by
grantor upon sale of appreciated assets to the trust (Rev. Rul. 85-13)
– Grantor trust = trust takes assets with carryover basis
– Bottom line: Gift + purchased assets + growth in value are outside the grantor’s taxable estate, are fully GSTT exempt (important for dynasty trusts) and are fully asset protected
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Grantor Trust Basics
• Basic overview: – Bottom line:
• Payments on promissory note (principal and interest) are available to grantor for lifestyle needs, further gifting, etc.
• Promissory note is included in grantor’s estate, but should be diminishing in value as note is paid off.
• Self Cancelling Installment Note (SCIN) can be used (that is cancelled upon death of note payee), but it must be structured very carefully
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Grantor Trust Example • Mom and Dad own 100% of LLC that
owns a profitable shoe factory – Each create a grantor trust – Each gifts a 20% company interest to their
trust as a seed gift, get the interest appraised and file a Form 709 gift tax return allocating GSTT exemption to the gift, so the trust has an inclusion ratio of 0
– Each sells their remaining 30% interest to their respective trust for a carryback note
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Grantor Trust Example
– Mom and Dad choose a 9-year note, so the interest rate is low (1.24%) and the profits from the factory make the note payments of P&I, which are substantial.
– Mom and Dad pay the factory’s income taxes on their return
– Mom and Dad live on the cash flow from the note payments, save & make additional gifts
– In nine years the two trusts own the factory
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Grantor Trust Example • Mom and Dad made the trust a sprinkling
dynasty trust for their descendants so no payments from the trust to the descendants are ever subject to gift, estate or GSTT tax – The assets in the trust are not subject to claims of
creditors of Mom, Dad or any descendant – In Colorado the trust can continue for 1,000 years
(check your rule against perpetuities) • There is nothing “defective” about this
outcome!
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Grantor Trust Example • Yadda, Yadda, Yadda:
– Can you apply valuation discounts to the interests sold to the trust? Yes – be conservative!
– Can the trust be a special needs trust? Yes! – Can the trust own operating businesses? Yes! – Can Mom or Dad turn off grantor trust status? Yes! – Who pay the income taxes when Mom and Dad Die
or if they “turn off” the grantor trust status? It becomes a complex trust, those then rules apply.
– Can the trust be a spendthrift trust? Yes! – Can the trust own life insurance? Yes! – Can Mom and Dad be trustee? Is your professional
liability insurance paid up?
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Steven R. Owens, J.D. Attorney and Counsellor at Law
6041 South Syracuse Way, Suite 103 Greenwood Village, Colorado 80111
(720) 529-9800
© 2012 The Law Office of Steven R. Owens, PC
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In General
• Separate Tax Entity - Separate Tax I.D. • Form 1041 • Compressed Income Tax Bracket 2012
–35% @ $11,650 –For Individuals 35% @ $388,350
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Income Taxation of Trusts
Continued
• Trusts receive a deduction:
– For distributions to beneficiaries §§ 651& 661
– Includable in income of beneficiaries §§ 652& 662
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Income Taxation of Trusts
What is a Grantor Trust? • Exception to the general rule
• A trust that is ignored for income tax purposes IRC §§671-678
• A trust that retains the grantor’s tax ID (i.e., SSN) for income tax purposes
• No gain or loss on sales transactions to/from Grantor (Rev. Ruling 85-13, 1985-1 C.B. 184 and Priv. Ltr. Rulings 200001015, 962605,9535026, 9525032 9519029, 9508000)
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Definitions
• What is a Grantor? – “Any person -- to the extent that such person either
creates a trust, or directly or indirectly makes a gratuitous transfer . . . of property to a trust . . . However a person who creates a trust but makes no gratuitous transfers to the trust is not treated as an owner of any portion of the trust under IRC §§ 671 through 677 or 679 (Treas Reg. 1.671-2(e)1)
– NOTE - unless §678 applies only a trust that has received a gratuitous transfer qualifies as a grantor trust
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Definitions
What is an IDGT?
• An irrevocable trust that is structured such that transfers to it are complete for estate and gift tax purposes but incomplete for income tax purposes.
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What is an IDGT
Why is it “defective”? • The trust is intentionally "tainted" with
attributes which bring it under the grantor trust rules (IRC §§ 671-678) for income tax purposes. At the same time making sure that the taint will not render transfers to the trust incomplete for estate and gift tax purposes.
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What is an IDGT
§ 671 – Trust Income, etc. Attributable to Grantors
• The person treated as the owner of any
portion of a trust, shall include in computing the taxable income and credits of such person those items of income, deductions, and credits against tax of the trust
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§ 672(a) Adverse Party
• “Adverse party” is any person who has a substantial beneficial interest in the trust which would be adversely affected by the exercise or non-exercise of the power which such person possesses respecting the trust.
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§ 672(a) Adverse Party
• Beneficial interest – A person having a general power of
appointment over trust property is deemed to have a beneficial interest in the trust.
– A trustee is not an adverse party merely because of his or her role as trustee.
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§ 672(a) Adverse Party
• Substantial – Treas. Reg. §1.672(a)-1(a) states that a
person’s interest is “substantial” if its “value in relation to the total value of the property subject to the power is not insignificant.”
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§ 672(a) Adverse Party
• Adversely affected – His or her substantial beneficial interest in a
trust must be adversely affected by the exercise or non-exercise of a power that he or she possess with respect to the trust.
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§ 672(b) Non-adverse Party
• Non-adverse party – Means any person who is not an adverse
party.
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§ 672(c) Related or Subordinate Party • Any non-adverse party who is in any of the
following relationships with the grantor: • the grantor’s spouse, • the grantor’s father or mother, • the grantor’s issue, • the grantor’s brother or sister • an employee of the grantor, • a corporation or any employee of a corporation in which the stock
holdings of the grantor and the trust are significant from the viewpoint of voting control, or
• a subordinate employee of a corporation of which the grantor is an executive
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§ 673 Reversionary interests
• A grantor will be treated as owner of any portion of a trust in which the grantor has a reversionary interest in either the corpus or the income therefrom, if, as of the inception of that portion of the trust, the value of such interest exceeds the value of 5% of that portion.
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§ 674 Power to control beneficial enjoyment
• A grantor shall be taxable as owner of any portion of a trust in respect of which beneficial enjoyment of the corpus or the income therefrom is subject to a power of disposition, exercisable by the grantor or a non-adverse party, or both, without the approval or consent of any adverse party.
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§ 675 Administrative powers
• Four categories of administrative powers that can trigger grantor trust status. – IRC §675(1) Power to deal for less than
adequate and full consideration – IRC §675(2) Power to borrow without
adequate interest and security – IRC §675(3) Actual borrowing of trust fund
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§ 675 Administrative powers
• Continued – IRC §675(4)(C) Power of Substitution. Power
to reacquire the trust property by substituting property of equal value in a non-fiduciary capacity
• IRS will not issue PLRs on whether a trust is a grantor trust under this provision
• Under the statute mere possession of this power - not exercise - triggers grantor trust status
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§ 676 Power to Revoke
• A grantor will be treated as owner of any portion of a trust, where at any time the grantor has the power to revest in the grantor the title to such portion.
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§ 677 Income for benefit of grantor
• A grantor is taxable as the owner of any portion of a trust as to which the grantor has the ability to use the trust income for the benefit of the grantor
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The Grantor Trust Rules • §675(4)(C) Power of Substitution is widely used to
create grantor trust status – Grantor can have substitution power without estate inclusion
under IRC §2038(a) - Rev.Rul. 2008-22 – Estate of Jordahl v. Commissioner 65 T.C. 92 (1975) – Service has agreed with Jordahl in PLRs 9413045, 9247024
• No inclusion under §2036 or §2042 – The power must be exercisable in a nonfiduciary capacity,
without the approval or consent of any person acting in a fiduciary capacity.
– The grantor should certify equivalent values when exercising the power.
– The trustee should have a fiduciary obligation to confirm equivalent values on a substitution.
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Drafting the IDGT Estate Planning Consideration • The plan must be tailored to meet the needs of
the client • Consider the cash flow and projected taxable
income of the asset sold to the IDGT • Consider the cash consumption needs of the
client and the client’s ability to pay income tax on income he/she does not receive
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Drafting the IDGT Estate Planning Consideration • Who can be a trustee
– IDGT Trustee - should not be related or subordinate to grantor
• Build in as much flexibility as possible • Gratuitous transfers - don’t forget to make the
gift
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Intentionally Defective Grantor Trusts
Joel R. Keeth, J.D., LL.M. (tax) 1120 Lincoln Street, Suite 1511
Denver, Colorado 80203 (303) 914-1111
© 2012 Keeth-Scott Law Group, PC
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Basics of the Transaction
• Create Trust • Fund Trust with Seed Money • Trust Purchases Asset(s), usually with a
down payment and “owner carry” financing via promissory note
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Overarching Principle
• Transaction should be commercially reasonable
• Best if this can be documented, i.e. opinion of commercial lender that terms would be acceptable
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Seed Money • Principle: Assets in trust must be sufficient to service the loan • What if it isn’t? • Possible inclusion in estate, see Estate of Malkin v. Commissioner,
T.C. Memo 2009-212
• Or possible treatment as taxable gift • Possible loss of GST exemption • Possible loss of S corp status • Possible treatment of corp as association
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Seed Money • Establish trust with 10-20% of value of asset to be purchased -
“seed money” (this will be a taxable gift). • 10% seed money was acceptable in PLR 95-35026, but no
other authority to establish this as a minimum, or even sufficient in all circumstances
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Seed Money • Can grantor or beneficiaries loan the trust the seed money? • This has been suggested to minimize taxable gift of seed
money • Criticism is that this is not commercially reasonable, trust must
be able to service BOTH loans, and deal may be seen as a sham
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Seed Money • Can grantor or beneficiaries guarantee the loan in lieu of seed
money? • This has been used to minimize or avoid taxable gift of seed
money • Again, is this commercially reasonable? Why would a grantor
guarantee that the trust will pay the seller, who is also the grantor?
• May be reasonable for beneficiaries to guarantee if a guarantee fee is paid
• Failure to pay a sufficient guarantee fee can make guarantor another grantor
• Some practicioners have spouse provide a guarantee, but this might not pass muster
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Sale of Asset(s) • Optimal assets are those which • - produce income and grantor wants to keep
in the family • - outperform the interest rate of the loan so
increased value can be removed from estate • - life insurance policy to avoid transfer for
value rule (grantor is buying from grantor) • - leveraged, such as stock and limited
partnership interests
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Sales Contract
• Usual formalities should be followed, with contract, promissory note, security for note if appropriate, etc.
• Price paid must be FMV • Good practice to establish FMV via
appraisal or other third party verification
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Sales Contract
• Can description of asset be defined using a conclusion, e.g. “that portion of the limited partnership that has a fair market value of $13,000”.
• This was acceptable in TAM 8611004 to limit an annual gift
• Has met with mixed success in the installment sale context
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Financing Terms • Tension exists between a commercially
reasonable transaction and one that can be serviced by the assets in the trust
• IRS indicates Section 7872 applies in determining appropriate interest rate
• Section 7872(f)(2)(A) provides for Applicable Federal Rate compounded semiannually, but many installment sales use annual compounding and this is common.
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Financing Terms
• Applicable Federal Rate divides loans into • Short term (0-3 years) • Mid-term (>3years-9 years) • Long-term (>9 years)
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Financing Terms
• Disagreement as to whether a promissory note can be renegotiated when interest rates go down
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Financing Terms
• Term of Note should be reasonable, e.g. 15-20 years max
• Payment schedule need not be regular, balloon note is acceptable but again must be commercially reasonable
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Financing Terms • Can use SCIN (Self-Cancelling Installment Note) to
remove value of unpaid note from grantor’s estate • Note can expire at earlier of term certain or death of
holder • But this must be commercially reasonable as to interest
rate or other premium (7520 will no longer apply) • Level payments probably required, e.g. probably can’t
combine balloon payment with SCIN
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Caveat
• Since grantor pays tax on all trust income, grantor can face significant taxes on extraordinary income in trust, e.g. when trust sells asset
• Making promissory note due-on-sale or demand note may allow for trust to pay grantor amount owed which reduces sting of income tax
• Still, Grantor Trusts should not be for the cash poor client
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Tip
• Can structure sale to allow for diverting payments to a purely discretionary trust or other asset protection trust if Trustee determines creditors trying to attack payments made to grantor
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Intentional Grantor Trusts
•By Karen L. Brady, J.D. •5400 Ward Road V-170
•Arvada CO 80002 •(303)420-2863
•www.coloradoestateplanning.com
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