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Intra-Family Transactions in Estate Planning: Structuring Loans, Installment Sales and Sales to IDGTs Strategies to Minimize the Gift Tax and Avoid Inclusion in the Gross Estate

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TUESDAY, JUNE 17, 2014

Presenting a live 90-minute webinar with interactive Q&A

Kathryn Baldwin Hecker, Attorney, Arnall Golden Gregory, Atlanta

Christopher G. Murrer, Attorney, Venable, Washington, D.C.

Scott K. Tippett, Attorney, The Tippett Law Firm, Oak Ridge, N.C.

Michael L. Van Cise, Attorney, Arnall Golden Gregory, Atlanta

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Intra-Family Loans Presented by: Michael L. Van Cise

and Kathryn Baldwin Hecker

6464164.1

6

Circular 230

IRS Circular 230 Notice: To ensure compliance with requirements imposed by

the IRS, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein

7

Intra-Family Loans

Example: Father desires to loan son $100,000 on June 30, 2014.

What should the terms of the note be? – duration – interest rate – payment schedule – other terms

To answer this question, it would be helpful to know (1) the purpose of the loan and (2) if, how and when the son will pay the loan back. These issues and tax law will inform our decisions as to the terms of this note.

8

Intra-Family Loans

Duration – Fixed term vs. on demand

Repayment by Son – Other sources of income or assets – Performance of investments acquired via loan proceeds (rate arbitrage) – Forgiveness over time through gifts and/or bequests

Father’s Assets and Liquidity State law

– Residence of lender and borrower

Interest rates – Expected to rise, fall, or remain constant?

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Intra-Family Loans: Terminology

Terminology – Demand loan – Term loan – Below-market loan – Applicable federal rate

(“AFR”) – Gift loan – De minimis loan

Each of these terms has a given meaning within the context of the Internal Revenue Code of 1986, as amended (the “IRC” or the “Code”).

Terms used in this presentation have the meaning given to them in the Code.

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IRC § 7872(e) and (f) - Definitions

Demand loan: generally, any loan which is payable in full at any time on the demand of the lender. See IRC § 7872(f)(5) and Prop. Reg. § 1.7872-3(b)(3)

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Avoiding Characterization as a Below-Market Loan: Setting the Term

Demand Loan A demand loan must be paid upon demand by the lender. The intended use of the loan proceeds by the son or other factors might suggest the use of a demand loan. Because the minimum interest rate for a demand loan (to avoid characterization as a below-market loan) is a floating rate based upon the short-term AFR, one might choose a demand loan if interest rates are expected to decline or longer-term rates are high.

Term Loan A loan for a fixed term gives the parties predictability. Since current rates are historically low, the father might choose to specify a lengthy loan term to take advantage of low rates. If it is anticipated that rates will remain low or the son is using the money for short-term purposes, the term might be set to three years or less to obtain a near-zero interest rate.

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IRC § 7872(e) and (f) – Definitions Setting the Loan Term

Loan Duration Short-term matures in 0 – 3 years Mid-term matures in greater than 3 years – 9 years;

see § 1274(d)(1)(A) Long-term greater than 9 years Indefinite duration likely a demand loan; see IRC § 7872(f)(5)

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Duration and Interest Rate REV. RUL. 2014-16 TABLE 1

Applicable Federal Rates (AFR) for June 2014

Period for Compounding

Annual Semi-annual Quarterly Monthly

Short-term AFR .32% .32% .32% .32%

Mid-term AFR 1.91% 1.90% 1.90% 1.89%

Long-term AFR 3.14% 3.12% 3.11% 3.10%

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Payment Schedule

Most clients will choose annual interest payments There are several good reasons to require periodic interest

payments, including: – some state’s laws do not allow lenders to collect compound

interest or limit their ability to do so – the lender may have to recognize income even though no

interest payment is received; see IRC §§ 1272-1275; See also IRS Publication 550 available at www.irs.gov

– adds credence to the argument that the arrangement is a bona fide loan

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Other Terms: General

In this example, we have a father loaning money to his son As such, it may make sense to make the loan terms fairly

“friendly” However, to confront any arguments that the loan is not a

bona fide lending arrangement, you may want to include commercially “standard” terms such as the inclusion of attorney’s fees and collection costs if the borrower defaults

If it is anticipated that the loan may be repaid in a form other than in cash, it may be advisable to include language to allow such payments and how value will be determined

16

Other Terms: Prepayment

For intra-family loans, it may make sense to include express provisions that allow prepayment – Given the relationship between the parties and the desire to

benefit the borrower, generally it makes sense to give the borrower the flexibility to pay the loan off early without penalty

– Allowing prepayment may allow the borrower to re-finance the loan at a lower rate if interest rates decline

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Other Terms: Choice of Law

The choice of law may be dictated by state law and the domicile of the lender and borrower

There may be reasons to be silent as to state law However, there may also be compelling reasons to specify

governing law For example, in Georgia, you can specify any governing

law you want, even if there is no nexus with the other state – O.C.G.A. §7-4-13. See also, Christiansen v. Beneficial Nat’l

Bank, 972 F. Supp. 681, 684 (S.D. Ga. 1997) (“[T]he Georgia usury statute expressly provides that choice-of-law clauses will be honored”).

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Other Terms: Security

Often intra-family loans will be unsecured, but there may be advantages to securing a loan, for example: Home mortgage interest deduction

– General rule, personal interest is nondeductible; see IRC § 163(h)

– As an exception to this rule, “qualified residence interest” is deductible; see IRC § 163(h)(2)(D)

– In order to be qualified residence interest, the loan must be secured by the residence; see IRC § 163(h)(3)

– Note also that trust beneficiaries can sometimes get the deduction; see IRC § 163(h)(4)(D)

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IRC § 7872 - Overview

Section 7872 re-characterizes, for federal tax purposes, a below-market loan as a loan made at the applicable Federal rate (“AFR”) and a transfer of funds from the lender to the borrower and a subsequent transfer from the borrower to the lender

See I.R.C. § 7872(a)(1)

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Example of IRC Section 7872: Individuals

Actual Transaction

father son

obligation to re-pay

no interest loan $100,000

No-Interest Promissory

Note $100,000

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Example of IRC Section 7872: Individuals

IRC § 7872 Treatment of Gift Loan

father son gift in amount of foregone interest

interest payment

$100,000

No Interest Promissory

Note $100,000

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Example of IRC § 7872: Corporation/Shareholder

Actual Transaction

Corporation Shareholder

obligation to re-pay

no interest loan $100,000


Note $100,000

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Example of IRC § 7872: Corporation/Shareholder

IRC § 7872 Treatment corporation shareholder

dividend in amount of foregone interest

interest payment

$100,000


Note $100,000

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Bona Fide Loans

Presumption that transfers between family members are gifts, as opposed to loans

See e.g., Estate of Lockett v. Comm’r, T.C. Memo 2012-123

Determination of gift versus loan based upon whether: – (1) there was a promissory note or other evidence of

indebtedness; – (2) interest was charged; – (3) there was any security or collateral; – (4) there was a fixed maturity date;

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Bona Fide Loans

Factors (continued): – (5) a demand for repayment was made; – (6) any actual repayment was made; – (7) the transferee had the ability to repay; – (8) any records maintained by the transferor and/or the

transferee reflected the transaction as a loan; and – (9) the manner in which the transaction was reported for

Federal tax purposes is consistent with a loan.

Key: formalities should be observed and transaction should be well documented and treated consistently by all parties

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State Law Considerations

Enforceability requirements, including electronic signatures

Usury laws and other restrictions on promissory notes designed to protect the borrower

State taxes, such as an intangibles tax

For more information, please contact:

Michael L. Van Cise [email protected]

404.873.8790 or

Kathryn Baldwin Hecker [email protected]

404.873.8530

171 17th Street, NW Suite 2100

Atlanta, GA 30363

6464164.1

Intra-Family Transactions in Estate Planning: Self

Cancelling Installment Notes Presented by:

Scott K. Tippett The Tippett Law Firm, PLLC

7504 Summerfield Road Summerfield, NC 27358

28 ©The Tippett Law Firm, PLLC 6/17/2014

Self-Cancelling Installment Notes SCIN is a variation of an installment note. Note contains provisions that cancel the balance of any

payments remaining outstanding as of the date of death, as a result, none of the assets sold in a SCIN transaction are included in the Seller’s gross estate.

SCINs are best used where the Seller wishes to retain an income stream which will not continue past the Seller’s death and may end sooner.

29 ©The Tippett Law Firm, PLLC 6/17/2014

Self-Cancelling Installment Notes

• Unlike a private annuity, a SCIN permits the Buyer to depreciate the assets based on the purchase price paid and deduct the interest portion of the payments made.

• SCINs are economically feasible where the estate tax savings achieved by excluding the unpaid principal from the Seller’s estate exceed the income tax cost of the risk premium for the cancellation feature.

• Buyer must pay to Seller a “risk” premium in a SCIN transaction as consideration for the cancellation feature.

©The Tippett Law Firm, PLLC 30 6/17/2014

Self-Cancelling Installment Notes

The risk premium can be reflected as an increased sales price or an increased interest rate.

If the asset(s) sold appreciate in value, then the SCIN freezes the future estate tax by shifting that appreciation outside the Seller’s estate.

Estate tax savings diminish if the Seller retains the payments in a SCIN transaction.


Self-Cancelling Installment Notes • If the Seller dies before the end of the SCIN term, the SCIN

produces significant estate tax savings.

• Permissible to secure payment with pledges, security agreements, or other guarantees without jeopardizing installment sales reporting.

• Interest may be deductible by Buyer, depending upon the identity of the Buyer and the type of asset being purchased.


Self-Cancelling Installment Notes • Important that the term of a SCIN not extend beyond the

seller’s life expectancy, otherwise the SCIN will be treated as a private annuity.

• No minimum sales price is required. • Installment sale treatment is automatic unless the taxpayer

elects not to have installment treatment apply. IRC § 453(d). • A sale can be made on an installment basis even though the

selling price is contingent. IRC § 453(j); Treas. Reg. 15A.453-1(c).

• No payment must be made in the year of the sale. The only requirement is at least one payment must be made in a taxable year after the year of the sale. IRC § 453(b).


Self-Cancelling Installment Notes Legal Citations

• Estate of Moss, 74 T.C. 1239 (1980), acq. in result, 1981-2 C.B.1 • Rev. Rul. 86-72, 1 C.B. 253 • GCM 39503 (5/7/86) • Treas. Reg. § 1.1275-1(j) • Estate of Musgrove, 33 Fed Cl. 657 (1995) • Estate of Kite, T.C. Memo. 2013-43 • CCA 201330033; Treas. Reg. § 25.2512-8 • Estate of William M. Davidson, U.S. Tax Court Docket No.

013748-13


Self-Cancelling Installment Notes • Estate of Moss, 74 T.C. 1279 (1980)

• Decedent (Moss) owned 231 of 586 shares of a closely held

corporation. Remaining shares were owned by employees who had either shares or received shares as gifts. Decedent also owned improved real property, which was leased to the company. All employees were parties to a buy-sell agreement requiring them to sell their shares to the corporation or pro rata to the other shareholders upon retirement.

• Shareholders and BoD considered Moss’ offer to sell his shares and the real property to the corporation.


Self-Cancelling Installment Notes • Moss offer to sell his shares for 184k and the real property for

290k. At this time Moss was owed approximately 176k by the corporation.

• Parties understood that Moss would remain president and a

director until the notes were paid in full. • All three notes contained this provision: Unless sooner paid, all sums, whether principal or interest, shall be deemed cancelled and extinguished as though paid upon the death of J.A. Moss.


Self-Cancelling Installment Notes • On the date of the special meeting, Moss’ physical and mental

condition was average for a man 72 years old (Moss’ age at the time). Nothing to indicate a shorter than expected life expectancy according to generally accepted mortality tables.

• Almost eights months later to the day, Moss was admitted to the hospital where it was discovered he had cancer in his lymph nodes. Moss died approximately nine months later.

• Moss received payments from the beginning of the notes until his death. The self-cancelling notes were assigned a zero value as of Moss’ DoD based on the self-cancelling provision.

• Service challenged and assessed a deficiency.


Self-Cancelling Installment Notes • Service, relying on Estate of Buckwalter v. Comm’r, 46 T.C. 805

(1966), contended cancellation feature amounted to only an agreement to make a gift therefore the unpaid balance of the notes should have been include in Moss’ estate.

• Parties stipulated that sale as a bona fide sale for adequate

and full consideration.

• Court observed that the cancellation was part of the bargained for consideration, distinguishing it from the situation where decedent provides for forgiveness of a debt in the will.


Self-Cancelling Installment Notes • Rev. Rul. 86-72, 1986-1 C.B. 253

• Issue was whether gain is recognized when an installment

obligation terminates because of the death of the payee.


Self-Cancelling Installment Notes • GCM 39503 (5/7/86)

• In GCM 39503 the Service reviewed the circumstances in

which a SCIN would be treated as an installment note and when it would be treated as a private annuity.

• GCM 39503 addressed three fact patterns.


Self-Cancelling Installment Notes • Situation 1 • Seller transfers property to Buyer and takes back a note that

requires Buyer to pay Seller annual payments of $10,000x until Seller’s death

• Treatment: • Where the Seller receives the right to payment for a period

not longer than her life, with no monetary limit, the payments represent an annuity and are governed by IRC § 72. See Rev. Rul. 69-74, 1969-1 CB 43. The Installment Sales Revision Act of 1980, which changed IRC § 453(b) does not require a different result.


Self-Cancelling Installment Notes • Situation 1 – Tax Consequences • Estate Tax Consequences • Neither private annuities nor the remaining balance on

installment sales are included in the Seller’s gross estate for federal estate tax purposes, so the result is the same.

• Gift Tax Consequences • There is a gift to the extent the FMV of the asset transferred

exceeds the present value of the annuity. Taxpayer must use the mortality tables in treas. Reg. § 20.2031-10. See Rev. Rul. 80-80, 1980-1 CB 194.


Self-Cancelling Installment Notes • Situation 2 – Income Tax Consequences • Transferor’s Treatment of Gain 1. Determine value of annuity using tables in Treas. Reg. § 20.2031-10. If value of annuity is less than value of property transferred, then there is a gift in the amount of the excess. 2. Determine allocation of each payment among capital gain, return of basis, and annuity income. a. Gross income does not include that part of any amount received as an annuity which bears the same ration to such amount as the investment in the contract bears to the expected return. IRS § 72(b).


Self-Cancelling Installment Note • Situation 2 – Income Tax Consequences-Determining Allocation

• a. The investment in the transferor’s basis in the transferred property. Rev. Rul. 69-74.

The exclusion ratio (amount of each payment deemed a return of basis and not taxed) is the ratio of the transferor’s basis in the transferred property to the expected return of the contract (life expectancy multiplied by amount of the annuity). Exclusion ratio I applied to each payment.


Self-Cancelling Installment Notes • Situation 2-Income Tax Consequences-Determining Allocation

• b. Determine the capital gain portion of each payment. Calculated by determining difference between annuitant’s basis and value of the annuity (the expected return). Gain recognized ratably over the annuitant’s/transferor’s life expectancy.

• c. Remainder of payment is the annuity income taxed at ordinary income rates for the duration of the annuity.


Self-Cancelling Installment Notes • Situation 2 – Income tax Consequences • Transferee’s Basis

$ For depreciation purposes, the buyer’s basis is in the property prior to the annuitant’s death is the present value of the prospective payments under the contract based on the specified life expectancy tables. • Any payments in excess of the value of the annuity contract are added to basis as they are made. Upon annuitant’s death, buyer’s basis becomes the total of the payments made to the annuitant.


Self-Cancelling Installment Notes • Situation 2 – Buyer’s and Seller’s Treatment of Interest • Unlike treatment under the installment sale rules, where

interest is fully deductible, under the private annuity rules no portion of the payment may be deducted as interest. See Bell v. Commissioner, 76 TC 232 (1981), aff’d, 668 F.2d 448 (8th Cir. 1982).


Self-Cancelling Installment Notes • Situation 3 • Facts: Seller transfer property to Buyer in exchange for

Buyer’s agreement to make annual payments of $10,000x to Seller until $100,000x is paid or until Seller’s death, whichever first occurs. Seller’s life expectancy based on the applicable tables is 11 years.


Self-Cancelling Installment Notes • Estate of Musgrove, 33 Fed. Cl. 657 (1995) • FACTS: Less than a month before the decedent died he

transferred approximately $250,000.00 to his son in exchange for an interest free unsecured promissory note, which by its terms was to be cancelled upon decedent’s death.

• BUT… The attorney that drafted the promissory note wrote to the decedent and the decedent’s son stating the son (obligor under the note) “will not use any of the monies for any other purpose without prior approval from [the decedent].”


Self-Cancelling Installment Note • Estate of Musgrove – cont’d • HELD: Decedent maintained control of the funds and

funds were properly includable in decedent’s estate under IRC § 2033, 2035, and 2038.


Self-Cancelling Installment Notes • Estate of Kite, T.C. Memo. 2013-43 – How To Do It Right.

• FACTS: Decedent was the income beneficiary of several

trusts ( two QTIP trusts, one marital deduction trust, and one revocable trust). The QTIP trusts and marital deduction trusts were liquidated and the trusts’ assets, which consisted entirely of FLP interests were transferred to Mrs. Kite’s revocable trust. The revocable trust then sold the FLP interests to Mrs. Kite’s children in exchange for a 10 year deferred private annuity agreement (note court’s language).


Self-Cancelling Installment Notes • Estate of Kite – cont’d

• FACTS: Court noted “Mrs. Kite was a savvy

businesswoman who actively participated in managing her assets…She would meet with her trust advisor at least quarterly to discuss the financial activities of her many trusts and their investments.”

• The SCIN: Three 10 year deferred private annuity agreements, with a self-cancellation provision in the event of Mrs. Kite’s death.



• MORE FACTS: The SCIN proposal was presented by the

family attorney to Mrs. Kite’s children. Mrs. Kite’s trust advisor was also present. Mrs. Kite was not. Mrs. Kite agreed to the SCIN after consulting with her family attorney and her trust advisor to make sure she could maintain her lifestyle without the income from the FLP interests being transferred.


Self-Cancelling Installment Notes • Estate of Kite – cont’d • Mrs. Kite’s Health: Mrs. Kite, who was 74 at the time,

consulted her physician, who, on March 6, 2001, wrote a letter stating: o I examined Mrs. Kite and interviewed her recently in her home * * * I

would anticipate that her longevity and health outlook is good for the next several years * * * I am of the opinion that Mrs. Kite is not terminally ill and that she does not have an incurable illness or other deteriorating physical condition that would cause her to die within one year and that there is at least a 50% probability that she will survive for 18 months or longer.

o Mrs. Kite’s physician did not testify at trial.


Self-Cancelling Installment Notes • Estate of Kite cont’d

• Mrs. Kite died on April 28, 2004. Court noted the Service did

not challenge the physician’s letter or present evidence contradicting Mrs. Kite’s physician. The Court observed that while increased medical costs and home health care indicate a decline in health, which costs the Service introduced from her prior years’ tax returns, and which ranged from $131,100 to $176,982 per year, such increased expenses do not suggest a terminal or incurable illness.



• Court noted Mrs. Kite’s children did not transfer the

underlying assets back to their mother after the annuity transaction was completed and in fact did not make any distribution from the FLP but instead allowed the FLP assets to appreciate.

• HELD: Transfers were for full and adequate consideration, therefore transfer was not a taxable gift.


Self-Cancelling Installment Notes • CCA 201330033

• The SCIN transactions: Two SCIN transactions were at issue.

Both SCINS were interest-only loans with the principal being due on the last day of the term in a single balloon payment.

• One SCIN had an increased purchase price, the other had an increased interest, each to account for the self-cancelling feature of the note.

• The value of the notes was based on the table in IRC § 7520. • Shortly after the second SCIN transaction, the decedent was

diagnosed with cancer and died less than six months later.


Self-Cancelling Installment Notes • CCA 201330033 • Chief Counsel opined that the § 7520 tables should not be used, but

instead the notes should be valued based on a willing buyer-willing seller under Treas. Reg. § 25.2512.8, taking into account decedent’s medical history on the date of the transaction.

• The Chief Counsel’s Office found that decedent should have paid gift tax, but not estate tax, on the difference in value between the SCINS and the higher value of the property for which the SCINs were issued.

• The Chief Counsel noted that “a SCIN signed by a family member is presumed to be a gift, and not a bona fide transaction.”


Self-Cancelling Installment Notes • Estate of William M. Davidson, U.S. Tax Court Docket No.

013748-13 • -Stay tuned. • One fact appearing in the Tax Court Petition, but not in the

CCA is that Mr. Davidson’s health, as determined by his physicians at the time of the SCIN transactions ,was good. However, unlike Estate of Kite, Mr. Davidson did not get a letter stating he had at least a 50% chance of surviving more than a year (the standard under § 7520 for creating a presumption the taxpayer is not terminally ill and therefore entitled to use the § 7520 mortality tables), until the audit was in progress.

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© 2012 Venable LLP

Intra-Family Transactions in Estate Planning: Structuring Loans, Installment Sales and Sales to

IDGTs Christopher G. Murrer

575 7th Street, NW Washington, DC 20004

202.344.4742

[email protected]

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Sales to Intentionally Defective Grantor Trusts

The Set-Up – Individual owns an asset that is expected to

appreciate in value – Individual wants to avoid having this

appreciation in value from being included in his or her estate and/or wants to pass benefits of this asset to his/her descendants, but

– Individual does not want to lose all financial benefits of the asset

© 2014 Venable LLP

62 © 2014 Venable LLP


Individual can sell the asset to an Intentionally Defective Grantor Trust in exchange for an installment note

Combines previously discussed concepts – Promissory note/loan – Installment sales – Transfers for the benefit of family members

Technique used to – “Freeze” an asset’s value that is likely to appreciate

greatly over time for transfer tax purposes, while – Allowing the Grantor a “stream of income,” and – Does not create additional income tax consequences

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Intentionally “Defective” Grantor Trust – Trust assets are treated as being owned by

Grantor for Income Tax purposes. See IRC §§ 671-679. The Trust is not a separate taxpayer

– (For our purposes) the Grantor is the person who transfers assets to a Trust and he/she retains certain discrete powers over the Trust or the Trustee has certain powers over the Trust

– But those powers are designed so that they do not cause the Trust to be included in the Grantor’s estate

© 2014 Venable LLP

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Permissible power to create Grantor Trust status without triggering adverse transfer tax consequences – Substitution Power: Grantor’s retained power,

exercisable in a non-fiduciary capacity, to acquire property in the trust by substituting property of equivalent value. I.e., sell property to the Trust

– Trustee must have fiduciary obligation to ensure swapped property is equivalent in value

– The substitution power cannot be exercised in a way to shift benefits among trust beneficiaries

– See Rev. Rul. 2008-22 and Rev. Rul. 2011-28 (dealing with insurance policy) © 2014 Venable LLP

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Who should be Trustee? – Grantor is not a great choice

• Must have limited powers to avoid estate inclusion

• Exercise of substitution power may be called into question

– Beneficiary is a better option but powers must be limited to avoid inclusion in the beneficiary’s estate

– Independent third party is best practice: extended family member, trusted family friend or institutional trustee

• Gives more credence to arm’s-length nature of planned sale to Trust

• Full flexibility with respect to making distributions before and after Grantor’s death

© 2014 Venable LLP

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Recap: Intentionally Defective Grantor Trust – Transfers to Grantor Trust are completed gifts – Trust assets are not included in Grantor’s

taxable estate – But, Grantor reports all Trust income on

his/her Income Tax Return and pays tax on this income

• Trust Agreement should prohibit the Trust from reimbursing the Grantor for income taxes paid attributable to income earned by Trust assets

– Best practice is to have independent third party serve as Trustee

© 2014 Venable LLP

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Choose asset(s) to be transferred

Create Grantor Trust

Fund Grantor Trust with “seed gift” of liquid assets equal to 10% of assets’ FMV

Sell asset to Grantor Trust in exchange for the promissory note equal to the FMV of the asset – Grantor Trust then owns the asset – Grantor holds a promissory note from the

Grantor Trust that pays the Grantor in installments

© 2014 Venable LLP

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First Phase:

© 2014 Venable LLP

Grantor Trust

Seed gift

Asset

Grantor



Second Phase:

Seed gift

Grantor

Grantor Trust

Promissory note


Grantor Trust


Third Phase:

Installment payments

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Income Tax effects: – Sale of asset to Grantor Trust does not trigger

any income tax because the Grantor is treated as the owner of the Grantor Trust for income tax purposes

– However, this means that no change in basis after sale

– Interest paid on the note paid to the Grantor is not income to Grantor or deductible by Grantor Trust

– Grantor reports all income from Trust assets and pays income taxes

© 2014 Venable LLP


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Gift Tax consequences: – Seed gift will be a taxable gift – However, sale of asset to Trust should not

trigger any gift tax if made for full and adequate consideration

• FMV of asset equals face amount of note • Interest is equal to AFR

– Payment of income taxes by Grantor is a de facto, but tax-free, gift to the Trust beneficiaries

© 2014 Venable LLP


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Estate tax consequences – Grantor Trust assets (including their

appreciation in value) will not be included in Grantor’s estate

– Principal and interest payments on note and/or value of unpaid note will be included in Grantor’s estate

– Net benefit is excluding appreciation or accumulated income out of the Grantor’s estate—but that benefit is increased if Grantor is able to spend the principal and interest payments before his/her death

© 2014 Venable LLP




Conclusion:

– Effective manner to transfer assets to descendants at current value without incurring much gift or income tax

– Value of future income and appreciation is excluded from Grantor’s estate

– Grantor still has some “stream of income” from the asset via payments on installment note

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Alternatives to IDGT sales, SCINS and Installment Sales

Grantor Retained Annuity Trust (“GRAT”)

IRC § 2702 provides for valuation of gifts involving retained interests – Generally, a gift is the value of the transferred

asset less the value of the retained interest, except where the donee is a family member of the donor

– Then the retained interest is deemed to be zero. In other words, the value of the gift is the entire asset, except if the retained interest is an annuity

© 2014 Venable LLP

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Qualified Annuity is an irrevocable right to receive

a fixed amount

Not a right of withdrawal

May be stated as a dollar amount or a fixed fraction or percentage

Present value of retained interest includes “7520 rate,” which is 120% of the federal mid-term rate

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Required Restrictions of GRATs – No additional contributions – No distributions to anyone other than annuity

holder – Annuity interest must be fixed: life of term

holder, term of years, etc. – No commutation of interest of annuity – Trustee may not use a note, option, or the like

to satisfy annuity payment – Annuity must be at least 2 years long

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Goal of a GRAT – Transfer income and appreciation of assets to

beneficiaries, gift tax-free – With little risk or complication

Structuring the GRAT – Trust provides for 2-year term – Two annuity payments back to donor – After 2 years, GRAT terminates and any remaining

assets are distributed to children – Value of annuity payments is set so high that it is

almost equal to the value of the transferred property – Assets are transferred to GRAT – Value of gift to GRAT equals value of transferred

property less the retained annuity interest. I.e., basically zero © 2014 Venable LLP

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Results of the GRAT – Two annuity payments made equal to original

amount transferred plus 7520 rate – Assets remaining, if any, pass to remainder

beneficiaries – If Assets appreciate at greater than 7520 rate,

they pass free of gift tax to remainder beneficiaries after payment of annuity

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Advantages – Minimal gift tax liability; no seed money required – If assets fail to appreciate, donor receives assets

back as if the transaction never happened – Blessed by Regulations

Disadvantages – GRAT assets are includable in donor’s estate if he

or she dies during GRAT term – Judgment call must be made on term of GRAT – Donor cannot allocate GST tax exemption at time

of transfer

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Financed Net Gifts

Net Gift: is a gift where the donee assumes obligation to pay gift tax (assumption of obligation must be condition of gift)

Therefore, amount of gift is reduced by amount of gift tax the donee has to pay. Rev. Rul. 75-52 – Formula: Amount of tax equals tentative tax of gift

divided by 1 + rate of tax – Ex: Assume $1,000,000 gift and 40% gift tax – $400,000 / 1 + .40 = $285,714 in net gift tax. – In other words the net gift is equal to $1,000,000 -

$285,714 net gift tax (or $714,286)

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Financed Net Gifts

Instead of selling assets to grantor trust, transfer entire asset to a Trust on a net-gift basis

$1,000,000 transfer but valued at $714,286 for gift tax purposes

Donor then lends $285,714 in cash to Trust to pay the gift tax in exchange for a promissory note

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Financed Net Gifts

Benefits of Financed Net Gift – Transfer entire $1,000,000 at transfer tax cost

of $714,286 Trust – Also, the Trust needs less income to service

note obligation back to Donor; lower investment risk

– No need to worry about debt-to-equity – Smaller revaluation risk

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Financed Net Gifts

Disadvantages of Financed Net Gift – Donee has to pay tax in cash – If donor dies within 3 years, gift taxes paid by

donee are included in donor’s estate via Section 2035

– If transfer is made to a non-Grantor Trust, donor recognizes income to the extent the gift tax exceeds the donor’s adjusted basis in the property

– Transfer is treated as if donor sold property for less than its FMV, with income recognized to extent gift tax obligation exceeds basis and balance is a gift

© 2014 Venable LLP

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Intra-Family Transactions in Estate Planning: Structuring ...media.straffordpub.com/products/intra-family-transactions-in... · Intra-Family Transactions in Estate Planning: Structuring