§1 INTRODUCTION
§2 QUALIFIED PERSONAL RESIDENCE TRUSTS
* [1] Common Law GRITs
* [2] QPRTs – Last of the GRITs for Family Members
* [3] A Dramatic Decline in the Value of the Residence
[a] Selling the Residence and Purchasing a Replacement
[b] Selling the Residence with Outright Distribution or Conversion to a GRAT
* [4] Death of Grantor During Retained Term
§3 GRANTOR RETAINED ANNUITY TRUSTS
* [1] Qualified Annuity Interest Requirements
* [2] Decline in the Value of Property in the GRAT
* [3] Death of Grantor During Term
[a] Inclusion under Section 2039
[b] Inclusion under Section 2036
[c] Inclusion under Section 2033
* [4] Defending Against Failure and Inclusion
[a] Selection of the GRAT Term
[b] Short-Term GRATs
[c] Marital Deduction
[d] Exchange of Assets
[e] Sale of Retained Interest in the GRAT
[f] Purchase of the Remainder Interest
[g] Term Life Insurance
[h] Tax Apportionment
§4 INTENTIONALLY DEFECTIVE GRANTOR TRUSTS
* [1] IDGT vs. GRAT
[a] Initial Gift Tax Reporting Requirements
[b] Estate Tax Inclusion
[c] Generation Skipping Transfer Tax Exemption
[d] Interest Rate Requirements
[e] Income Tax Payments
[f] The Better Vehicle
* [2] Weighing the Risks
[a] Inclusion under Section 2702
[b] Inclusion under Section 2036
[c] Proper Sale Structure
[d] Bargain Sale Risks
[e] Income Tax Implications of Grantor’s Death
[f] Planning if Grantor’s Death Imminent
§5 CONCLUSION
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1. INTRODUCTION

Three powerful and increasingly popular vehicles for transferring assets to younger-generation beneficiaries in a tax-favoured manner are Qualified Personal Residence Trusts (QPRTs), Grantor Retained Annuity Trusts (GRATs) and sales to Intentionally Defective Grantor Trusts (IDGTs). All of these four-letter-acronym devices have the potential to accomplish very significant transfer tax savings. However, the intended results of all three of these techniques may be frustrated after they are established by the occurrence of events beyond the grantor’s control. In particular, if either the grantor dies prematurely, or if the subject property declines rather than increases in value, the resulting tax effects can be quite negative.

This article examines each of these devices with a view to understanding what can go wrong, what are the consequences if something does go wrong, what measures may be taken if it appears that the worst is going to happen, and what features may be designed into the plan at the outset to guard against these vulnerabilities.

2. QUALIFIED PERSONAL RESIDENCE TRUSTS

A Qualified Personal Residence Trust typically is used to allow the owner of residential real property (the grantor) to transfer his or her personal residence to younger family members (the remainder beneficiaries) with favorable transfer tax consequences.

1. Common Law GRITs

By way of historical background, a QPRT is an exception to federal legislation banning the use of Grantor Retained Income Trusts (GRITs). Prior to the enactment of IRC section 2702, a popular method of transferring wealth was the use of a trust in which the grantor retained an income interest for a term of years, while the remainder interest was distributed to younger generations, either outright or in continuing trust, with both interests avoiding estate tax upon the grantor’s death. The grantor’s retained right to income from the GRIT for a term of years could result in a steeply discounted valuation of the gifts to the remainder beneficiaries for gift tax purposes. However, if the trust corpus declined substantially during the term of years, then the IRS, rather than the taxpayer, would benefit from the transaction. And if the grantor died during the term in which the income interest was retained, the entire value of the trust property would be includable in the grantor’s gross estate under section 2036. Nevertheless, in situations in which the trust corpus grew during the trust term and the grantor outlived the term, GRITs provided a powerful wealth transfer tool.

This arrangement turned out to be too good to last for several reasons. The income interest retained by the grantor proved to be too vulnerable to manipulation. A grantor could transfer property to the GRIT, on which the return was entirely in the form of capital appreciation, not income. Moreover, the “income” as determined by state law, could be lower than the rate assumed by the IRS, and a small part of the overall return on investment. Concern regarding understatement, for gift tax purposes, of the value of the gift of the remainder interest led to the Congressional response of section 2702. This section mandates that most transfers to family members with retained interests, if used to discount the value of a gift for gift tax purposes, must take the form of an “annuity” or “unitrust” interest defined in terms of either the initial value of the trust or the value of the trust as redetermined from year to year (grantor retained annuity trusts and grantor retained unitrusts).

2. QPRTs – Last of the GRITs for Family Members

For trusts designed to hold personal residences, Congress carved out an exception to the usual section 2702 rules requiring the grantor’s retained interest to be “qualified” as an annuity or unitrust interest to be taken into account in valuing the remainder interest. In general terms, section 2702 of the special valuation rules allows the grantor to fractionalize his or her personal residence into two interests, a present interest of a term of years and a remainder interest. The grantor transfers the personal residence to the trust and retains the right to reside in the home for a specific term of years. At the end of the term of years, the personal residence is distributed to the remainder beneficiaries.

For purposes of a QPRT, a “personal residence” is the “principal residence” of the grantor as defined by section 1034, a vacation home within the meaning of section 280A(d)(1), or an undivided fractional interest in either. A personal residence includes a house, condominium or cooperative apartment, and appurtenant structures and adjacent land which is reasonably appropriate for residential purposes.

This arrangement enjoys a favorable transfer tax treatment because the amount of the gift for federal gift tax purposes is not the current value of the personal residence, but the remainder interest at the end of the term of years. That is, because the remainder beneficiaries do not receive the property until the end of the term of years retained by the grantor, the value of the gift for federal gift tax purposes is reduced by the value of the grantor’s retained “income interest.” The value of the gift is reduced further if the grantor retains a contingent reversionary interest (so that in case the grantor dies before the end of the trust term, the residence reverts to the grantor’s estate). The bottom line is that so long as the grantor survives the retained term, the then current value of the personal residence, with all of its subsequent appreciation, can pass to the remainder beneficiaries without inclusion in the grantor’s estate for federal estate tax purposes. The gift tax cost of the transfer can be significantly lower than an outright gift, transfer taxes can be avoided on all future appreciation of the residence after transfer to the QPRT and the grantor can continue to reside in the residence for the specified period of years.

The grantor may select any period for the term for which he or she retains the right to use or occupy the residence. Obviously, the longer the retained term, the greater its value and the lower the value of the gift of the remainder interest for gift tax purposes. However, if the grantor dies during the retained term, the then fair market value of the personal residence at date of death (or the alternate valuation date, if applicable) will be included in the grantor’s estate for estate tax purposes. Thus, in order to realize the tax benefits of a QPRT, the grantor must survive the trust term.

Example: Assume a 60-year-old grantor transfers a personal residence with a value of $1,000,000 into a QPRT on October 1, 1999 (when the section 7520 rate for purposes of valuing the interest retained by the grantor was 7.2%), retaining a term of 10 years and a contingent reversion. The value of the grantor’s retained interest and contingent reversion is $583,770 and the value of the remainder interest is $416,230. If the grantor lives out the 10-year term, he or she will have transferred a residence worth $1,000,000 and all its subsequent appreciation at the end of the 10-year period (at an assumed annual growth rate of 4%, the residence will have appreciated to $1,480,244 at the end of the term) to his or her beneficiaries at a federal gift tax value of $416,230. In addition, the value of the residence and all of its appreciation will not be included in the grantor’s taxable estate. Thus, the transfer tax savings of using the QPRT over transferring the residence at death could exceed $500,000.

Of course, there are some disadvantages to QPRTs. First, the grantor loses the current use of the property at the end of the retained term. If the grantor retains the right to income from the trust or the use of the trust property after the end of the retained term, the property will be included in the grantor’s taxable estate under section 2036(a)(1). If the grantor desires to continue to live in the residence at the end of the retained term, he or she can lease the residence from the remainder beneficiaries for fair market rent. The residence will not be included in the grantor’s taxable estate under sections 2033 and 2036 if the trust instrument allows the grantor to continue to live in the residence after the term of the trust for fair market rent. However, failure of the remainder beneficiaries to charge fair market rent will cause the residence to be included in the grantor’s estate for federal estate tax purposes. The requirement that the property be rented back to the grantor after the trust term ends at a then fair market rent can cause substantial discomfort to a grantor facing the prospect of losing ownership and control of his or her principal residence.

Another distinct disadvantage to the QPRT is that the remainder beneficiaries do not get the stepped-up basis for income tax purposes that they would have been entitled to had the residence been held by the grantor until death and included in the grantor’s taxable estate. Instead, the remainder beneficiaries receive a carry-over basis in the residence (the basis of the property as it was in the hands of the grantor, increased only by any gift tax paid on the transfer). If it is reasonable to expect that the remainder beneficiaries will want to sell the residence at some point after the grantor’s trust term ends, the capital gain cost must be weighed against the transfer tax savings of using a QPRT. Use of a QPRT in this situation certainly is less compelling (even considering the transfer tax and capital gain marginal rate differential), especially when the transaction costs, the risk of the grantor dying within the trust term and the grantor’s potential loss of use of the residence after the trust term all are taken into account. Of course, if it is not expected that the remainder beneficiaries will sell the residence (such as in the case, for example, of a family vacation home), these considerations may not be relevant.

3. A Dramatic Decline in the Value of the Residence

The purported tax advantages of a QPRT also may not pan out where the value of the residence dramatically declines during the trust term. Such a scenario certainly is not beyond the realm of possibility, especially considering the hyper-inflated residential real estate markets which currently exist in some parts of the country. A drastic downturn in the economy certainly could have a deflationary effect on any residential real estate market.

If such a decline is sufficiently probable prior to establishing the QPRT, the grantor probably should not use this type of planning. If, however the value of the residence declines unexpectedly after it is transferred to the QPRT, only a few options are available to salvage the grantor’s tax savings objectives. One thing the trustee cannot do is end the trust early and divide the property actuarially in accordance with the relative values at that time of the grantor’s term interest and the remainder interest (so called “commutation” must be prohibited by the governing instrument). On the other hand, the trustee does not have to sit by idly and watch the value of the residence decline.

a. Selling the Residence and Purchasing a Replacement

If a dramatic decline in the value of the home is on the horizon, the trustee may want to cut his or her losses by selling the residence and purchasing a replacement. The trust instrument may provide for the sale of the residence during the grantor’s retained term, if the instrument specifically prevents such a sale to the grantor, the grantor’s spouse or an entity controlled by the grantor or the grantor’s spouse, and if the instrument provides that the proceeds from such a sale are held in a separate account.

If the governing instrument permits the trust to hold the sale proceeds in a separate account, it must also provide that the trust cease to be a QPRT with respect to the sale proceeds on the earlier of (1) two years after the date of sale; (2) the termination of the term holders interest in the trust; or (3) the date on which a new residence is acquired by the trust. Finally, the governing instrument must provide that, within 30 days after the date on which the trust has ceased to be a qualified personal residence trust with respect to certain assets, the assets must be distributed outright to the grantor or converted to a qualified annuity interest and held for the balance of the retained term (i.e. the trust converts to a grantor retained annuity trust).

Example 6 under Treasury Regulation section 25.2702-5 illustrates the way in which these rules work. In that example, the grantor transfers a personal residence to a QPRT, retaining a term of 12 years. On the date the residence is transferred to the trust, its fair market value is $100,000. After six years, the trustee sells the residence, receiving net proceeds of $250,000. The trustee then invests the proceeds from the sale in common stock. After an additional eighteen months, the common stock has paid $15,000 in dividends and has a fair market value of $260,000. On that date, the trustee purchases a new residence for $200,000. On the purchase of the new residence, the trust ceases to be a QPRT with respect to any amount not reinvested in the new residence. The trust instrument provides that the trustee, in the trustee’s sole discretion, may elect either to distribute the excess proceeds or to convert the proceeds into a qualified annuity interest. The trustee elects the latter. So long as the amount not reinvested in the new residence is converted into a qualified annuity of which the amount of the annuity payment is calculated under Treasury Regulation section 25.2702-5(c)(8)(ii)(C)(3), the actions taken by the trustee are permissible under the QPRT rules.

This example illustrates the options that are available if the value of the residence dramatically declines. If the instrument permits the trustee to hold the sale proceeds in a separate account, the trustee can wait out a downturn in the real estate market by hanging on to the sale proceeds for up to two years after the date of sale and then reinvest such proceeds in a new residence when the real estate market begins its recovery. Example 6 also reveals that the trustee need not be passive while waiting out a downturn in the real estate market. The trustee can aggressively invest the sale proceeds instead of letting them sit in a simple interest bearing account.

However, waiting out a downturn in the real estate market may not be a viable option if the grantor has nowhere to live in the interim. While the trustee could always purchase a new residence right after the sale of the old residence, this approach also has its drawbacks. Downturns in residential real estate markets tend to affect broad geographical areas. Thus, the trustee may have to look outside the geographical area in which the grantor lives to find a replacement residence that is not declining in value. For these reasons, sale of the residence with reinvestment in a replacement residence is not always an acceptable solution.

b. Selling the Residence With Outright Distribution or Conversion to a GRAT

The trustee also may throw in the towel by selling the residence and distributing the proceeds of sale out of the trust to the grantor. However, as noted above, the trustee must distribute the sale proceeds outright to the grantor within 30 days after the date on which the trust has ceased to be a QPRT with respect to such proceeds. The grantor then can start over with a new QPRT or embark upon a gifting program to transfer the sale proceeds to his or her beneficiaries. Of course, the sale proceeds will be included in the grantor’s taxable estate to the extent that they are not otherwise transferred or consumed by the grantor prior to death.

Alternatively, the trustee could choose to sell the residence and convert the trust into a GRAT. In order to convert a QPRT to a GRAT, the governing instrument must contain all the provisions required by Treasury Regulation section 25.2705-3 with respect to a qualified annuity interest. In addition, the governing instrument must provide that the right of the grantor to receive the annuity amount begins on the date of sale of the residence, the date of damage to or destruction of the residence, or the date on which the residence ceases to be used or held for use as a personal residence. However, the trustee may defer payment of the annuity amount until 30 days after the conversion date, if the deferred payment bears interest at a rate not less than the section 7520 rate in effect on the cessation date. This GRAT option permits salvage of the valuation discount planning purposes of the original QPRT when continuing to hold the residence during the trust term is no longer viable because of market forces beyond the control of the grantor.

3. Death of Grantor During Retained Term

The tax advantages of a QPRT will be lost if the grantor dies during the retained term. If the grantor does not survive the retained term provided by the trust, the fair market value of the residence as of the date of death or the alternate valuation date will be included in the grantor’s gross estate under section 2036 (a)(1) because the grantor will have retained an interest for a period that did not in fact end before his or her death. However, the estate of the grantor will be entitled to a credit for gift taxes payable, which will be computed on the value of the remainder interest as of the date of the transfer of the interest in the residence to the QPRT, but using the gift tax rates in effect as of the date of death. Unfortunately, nothing can be done to prevent this inclusion upon the death of the grantor once the trust has been established.

Nevertheless, proper planning can reduce the probability of inclusion due to the death of the grantor during the term. While a longer retained term means a larger discount on the remainder interest for gift tax purposes, it also increases the probability that the grantor will die during the term. The grantor and his or her advisors are well advised to use caution and not get greedy when selecting the term of the QPRT at the outset.

Example: Assume a 60 year old male (grantor) wants to establish a QPRT with a residence with a value of $1,000,000 on October 1, 1999, while retaining a contingent reversion in case of his death within the term. If the grantor retained a 20-year term, the value of the taxable gift would be $137,030.00, assuming a section 7520 rate of 7.2%. Assuming, further, an after tax growth rate of 4%, the value of the property at the end of the 20-year term would be $2,191,123. The grantor will have saved an enormous amount in estate and gift taxes. However, the probability of the grantor dying within the 20-year term is 50.7%. On the other hand, assuming the same facts, if the grantor retained a 10-year term, the taxable gift would be $146,230.00 and the value of the residence at the end of the term would be $1,480,244. The grantor still will have saved a significant amount in estate and gift taxes and his probability of dying during the term is only 19.2%.

Some additional planning options may be available for married couples. A property agreement could be used to transfer the house at no gift tax cost to the spouse with a longer life expectancy, who then could establish a QPRT with that spouse as the grantor. To avoid a dispute over potential application of a “step transaction” analysis by the IRS, the parties should have no binding agreement between them that would require the spouse receiving the residence to subsequently transfer it to a QPRT, and there should be a significant lapse of time between the two transfers. However, consideration should be given to the possibility that the transferee spouse will later decide not to transfer the residence to the QPRT. Moreover, if the marriage is dissolved before the transferee spouse conveys it to the QPRT, the residence may be awarded to the transferee spouse in the divorce proceedings.

Alternatively, if a married couple jointly owns a residence, two separate trusts can be established for each spouse’s interest in the property. Compared with the QPRT established for one spouse, this arrangement spreads the risk of inclusion of the residence between the two spouses, should one of them die during the term. Moreover, each spouse may be able to claim a further valuation discount for the transfer of fractional interests.

The estate tax effect of failure of the QPRT can be mitigated by the use of a contingent spousal remainder. The grantor can provide a gift of a remainder interest in the residence to his or her spouse, or a trust for the spouse’s benefit which qualifies for the estate tax marital deduction, if he or she dies during the trust term. Such a remainder interest would be contingent on the grantor dying prior to the end of the term. Granted, this will not save the QPRT planning if the grantor dies within the term, but it will delay any estate tax liability on the residence until the surviving spouse’s death. In addition, if the gift is outright to the spouse, he or she can establish a new QPRT or use other estate planning techniques to transfer the property to the intended beneficiaries.

Finally, the planner should make sure that the tax clause in the grantor’s estate planning documents takes into account the possibility of the residence being included in the grantor’s estate because of his or her death prior to the end of the retained term, and that the liquidity needs of the estate in such a case are addressed. To provide this liquidity to pay estate tax attributable to the residence, the grantor may wish to consider acquiring term life insurance on his or her life for the period of the QPRT term if such insurance is available and at a premium cost acceptable to the grantor, given the age and health of the grantor. Use of an irrevocable life insurance trust may be warranted so that the policy proceeds are not included in the grantor’s estate or the grantor’s spouse’s estate.

4. GRANTOR RETAINED ANNUITY TRUSTS

A Grantor Retained Annuity Trust (GRAT) is an irrevocable trust in which the grantor retains the right to receive a fixed annuity for a specified term. At the end of the term, the trust assets are distributed to the remainder beneficiaries.

A GRAT can be a highly effective estate planning tool from a valuation discount standpoint. The value of a transfer to the GRAT for gift tax purposes is the fair market value of the asset transferred less the value of the grantor’s retained annuity interest determined under section 7520. If during the term of the GRAT, the assets in the trust outperform the section 7520 assumptions at the time the trust is established, the GRAT can result in very substantial transfer tax savings.

Like the QPRT, the GRAT is a creature of the special valuation rules added as Chapter 14 of the Internal Revenue Code (§§2701-2704) by the Revenue Reconciliation Act of 1990. The GRAT is an important exception Congress carved out to the general rule of section 2702 that when a grantor transfers an asset with a retained interest to a family member, the retained interest of the grantor is disregarded for purposes of valuing the gift unless it is a “qualified interest.” A GRAT is such an interest.
Example: Assume a 60-year-old grantor transfers $1,000,000 worth of appreciating assets into a GRAT on October 1, 1999, when the section 7520 rate was 7.2%, retaining the right to receive an annuity of 5% of the initial fair market value of the assets transferred to the trust ($50,000) paid annually for 10 years, after which time the trust assets will be distributed to the grantor’s children. The grantor’s retained right to receive $50,000 per year for 10 years is a qualified interest with a value of $325,250. Accordingly, the value of the gift of the remainder interest to the grantor’s children upon creation of the gift is $674,750.

Any appreciation in the value of the assets after transfer to the GRAT can be passed on to the remainder beneficiaries without transfer tax cost. However, the assets in the GRAT need to appreciate at a rate higher that the section 7520 assumptions (used to value the grantor’s retained interest at the outset) during the trust term for the GRAT to be a truly effective wealth transfer tool. Ideally suitable for GRATs are assets that either can be legitimately valued very low or for which other valuation discounts may apply at the time they are transferred to the GRAT (such as limited partnership or LLC interests which can be valued with marketability and minority discounts), as well as assets which are reasonably expected to appreciate substantially during the trust term.

1. Qualified Annuity Interest Requirements

The IRS sanctions GRATs only if the terms of the trust instrument satisfy the requirements of Treasury Regulation section 25.2702-3(b). The first requirement is that the annuity amount must be payable to (or for the benefit of) the holder of the annuity interest for each taxable year of the term. The annuity must be a fixed amount in terms of a fixed dollar amount or a fixed percentage of the initial fair market value of the property transferred to the trust, as finally determined for federal tax purposes. The fixed annuity amount need not be the same each year. However, the regulations require that an amount payable in one year cannot exceed 120% of the amount payable in the prior year.

Example: A grantor’s right to receive a fixed dollar amount of $20,000 for the first three years, $24,000 for the following four years and $28,000 for the last three years of a 10-year GRAT term is a qualified interest which fully meets the requirements of the regulation.

If the annuity is stated in terms of a fraction or percentage of the initial fair market value of the trust property, the governing instrument must contain provisions meeting the requirements of section 1.664-2(a)(1)(iii) which requires an adjustment of annuity amounts previously paid if an error was made in determining the initial fair market value of the trust property.

The trust instrument must also require the proration of annuity payments made in taxable years of less than 12 months.

During the term of the grantor’s qualified interest, no distributions can be made from the GRAT to anyone other than the grantor. The term of the grantor’s qualified interest must be fixed by the trust instrument and can be for the grantor’s life, a specified term of years, or the shorter of those periods.

As with a QPRT, commutation (or prepayment) of the grantor’s retained interest in the GRAT is not allowable. Thus, the trustee cannot terminate the GRAT before expiration of the term of the grantor’s qualified interest by distributing to the grantor and the remainder beneficiaries the actuarial value of their term and remainder interests, respectively.

The governing instrument also must prohibit additional contributions to the trust once the GRAT is established.

2. Decline in the Value of Property in the GRAT

For the most part, a GRAT is successful if it outperforms the section 7520 rate which is applicable at the time the GRAT is created. If the GRAT assets decline in value, the objective of the GRAT is not met, as the depreciating property is returned to the grantor via the annuity payments. Moreover, the grantor also may have wasted a portion of his or her applicable credit amount, or even paid gift tax, on the initial gift of the remainder interest at the value at the time of establishment of the GRAT.

This result can be minimized or even avoided by using a series of short term, high annuity pay out GRATs, with a low gift tax value. If the GRAT assets decline in value, they still are returned to the grantor via the annuity payments, but with no or a minimal amount of applicable credit amount being used or gift tax being paid. Thereafter, the grantor can start over with the same property or different property and a new section 7520 rate. Often, grantors choose to “roll” their annuity payments into new GRATs. Thus, a series of short term GRATs will do limited, if not negligible, damage in bad years, while catching the appreciation on the assets in good years.

3. Death of Grantor During Term

The consequences of the grantor dying during the term of the GRAT are arguably different than those of the QPRT. The death of the grantor during the QPRT term results in the entire trust corpus being included in the grantor’s gross estate at its then current fair market value. In contrast, the grantor’s death during the term of his or her qualified interest in a GRAT may result only in the inclusion of a portion of the trust property. Unfortunately, however, it is unclear how much of the trust corpus should be included in the grantor’s gross estate. Inclusion of some or all of the GRAT assets may be predicated on one or more of sections 2033, 2036 and 2039.

a. Inclusion under IRC Section 2039

The IRS has taken the position that the grantor’s death during the term will cause the value of the entire trust corpus to be included in the grantor’s estate under section 2039(a). Section 2039, in relevant part, provides that a decedent’s gross estate includes the value of an annuity or other payment received by any beneficiary “by reason of surviving the decedent” under any form of contract or agreement if under the contract or agreement, an annuity or other payment are payable to the decedent. Thus, if the governing instrument provides that the grantor’s right to receive annuity payments terminates upon the first of the end of the term or the death of the grantor, the requirement of section 2039(a) will have been met if the grantor, in fact, dies.

However, it should be possible to circumvent section 2039(a) by providing that the annuity payments continue to the grantor’s estate if he or she dies before the end of the term. Presumably, section 2039(a) will not apply because the remainder interest will not have been “receivable by any beneficiary by reason of surviving the decedent.” Instead, the remainder beneficiary will receive the remainder interest by reason of surviving the specified term. However, providing for a continuing term may preclude use of a contingent disposition to the surviving spouse if the grantor dies during the term in order to utilize the unlimited marital deduction to defer estate tax on the GRAT assets until the surviving spouse’s death.

b. Inclusion under Section 2036

Notwithstanding the possibility of avoiding section 2039 inclusion, if the grantor dies possessing the right to receive annuity payments from a GRAT, part or all of the trust corpus may be includable in his or her gross estate under section 2036. Section 2036(a) provides that a decedent’s gross estate will include the value of all property the decedent transferred during life, if the decedent retained an interest in such property for life or a period not ascertainable without reference to the decedent’s life. Arguably, the grantor’s retained right to receive an annuity payment from the GRAT is akin to the right to receive income for life from a trust.

However, because an annuity is not income generated from the corpus of a trust, some controversy has developed as to what portion of the corpus of the GRAT is includable under 2036. The amount included in the grantor’s estate probably should be that portion of the corpus which would be required to generate the annuity at the section 7520 rate in effect on the date of the grantor’s death.

Example: Assume a grantor transfers assets worth $1,000,000 to a GRAT retaining the right to receive an annuity of $100,000 per year for the lesser of 10 years or her remaining lifetime. In the third month of the ninth year of the GRAT, the grantor dies, while the trust corpus has a value of $2,000,000 and the section 7520 rate is 10%. Under section 2036, $1,000,000 would be included in the grantor’s gross estate because it is the amount of corpus required to be invested at 10% to generate income equal to the $100,000 annuity.

In general, then, it may be far preferable for estate inclusion to be premised on section 2036, rather than 2039, if the grantor dies during the GRAT term. Arguably, much less of the GRAT corpus may be includable under section 2036.

However, GRATs are often structured at the outset to “zero out” the value of the remainder interest at the time of creation. If so, the distinction between 2036 and 2039 inclusion may not be relevant. A GRAT is completely zeroed out when the grantor’s retained annuity interest is equal to the value of the property transferred to the trust, resulting in a remainder interest valued at zero for gift tax purposes. By adjusting the GRAT term and the amount of the retained annuity interest at the outset, the value of the remainder interest may be reduced to nothing.

The IRS contends that a GRAT cannot be completely zeroed out. Pursuant to Treasury Regulation section 25.2702-3(e), Example 5, if the grantor retains the right to receive payments for a fixed term, meaning that such payments will continue to the grantor’s estate for the balance of the term should he or she die during the term, the qualified interest will be valued at the shorter of the fixed term or the grantor’s death. The result of this regulation is that the value of the retained interest is decreased because the value of the right to receive the annuity for the shorter of the grantor’s life or the fixed term is less than the value of the right to receive the annuity for the fixed term. Commentators argue that the position of the IRS in regard to Example 5, which is that an annuity retained by the grantor’s estate is not a qualified interest because it is not retained by the grantor, is an incorrect interpretation of section 2702 because the right to receive the annuity for a fixed term which continues to the grantor’s estate if he or she dies during the term is a qualified interest under Treas. Reg. section 25.2702-3(b).

The IRS also contends that a GRAT cannot be zeroed out where the trust fund will be exhausted before the last possible annuity payment is made in full, using the section 7520 rate at the date of transfer. In such a case, the value of the retained annuity is adjusted by reducing the period for which the value is determined to the shorter of the retained term and the grantor’s death. In addition, the annuity is further adjusted to account for the potential exhaustion of the trust during the retained term.

Regardless of the soundness of the IRS position, even if it is followed, it still may be possible to reduce the value of the remainder interest to near zero. If the grantor dies during the term of a GRAT which either has been zeroed out, or meets the requirements of Example 5 and is as close as possible to being zeroed out, the entire trust corpus may be included in the grantor’s estate pursuant to section 2036. The amount included in the grantor’s estate under section 2036 is that portion of the corpus which is required to generate the annuity at the applicable section 7520 rate at date of death. The entire trust corpus may be needed to generate the high annuity rate of a zeroed out GRAT. Thus, the entire trust corpus of a zeroed out GRAT may be included in the grantor’s estate if he or she dies during the term, even under section 2036.

c. Inclusion under Section 2033

Notwithstanding application of sections 2036 or 2039, if the grantor dies before the end of the term, a portion of the GRAT corpus may be includable in his or her estate under section 2033. Section 2033 provides that the value of a decedent’s gross estate shall include all property which the decedent had an interest in at the time of death. Thus, if the GRAT provided for the balance of the annuity payments to be paid to the deceased grantor’s estate, the actuarial value of these payments will be includable in the grantor’s estate under section 2033.

4. Defending Against Failure and Inclusion

Regardless of which section of the code triggers estate tax inclusion, the benefits of using a GRAT certainly are lost to the extent the grantor dies during the term and some or all of the appreciation of the value of GRAT assets are included in his or her gross estate. However, there are other ways to reduce the risk of the grantor’s death during the GRAT or, at least, minimize the impact if death is imminent. While commutation is tempting, it is not possible since the GRAT instrument must prohibit it to qualify under section 2702.

a. Selection of the GRAT Term

As with a QPRT, careful selection at the creation of the GRAT of the term for which the grantor is paid the qualified annuity interest can minimize the risk of the grantor dying during the term. While a shorter term will increase the gift tax value of the remainder interest, it also may avoid all of the GRAT planning going to waste because the grantor dies prematurely triggering estate tax inclusion of some or potentially all of the GRAT assets.

b. Short-Term GRATs

A series of short term GRATs may be the best way to accomplish the grantor’s planning objectives while guarding against inclusion due to the grantor’s death during the retained term. For example, if the grantor dies in the 11th month of the 9th year of a 10-year retained term, a substantial portion or even all of the GRAT corpus will be included in the grantor’s estate under IRC sections 2033, 2036 or 2039. On the other hand, if the grantor had accrued a series of five successive two-year GRATs, the grantor’s death in the 11th month of the 9th year would only have caused the last GRAT to be included in the grantor’s gross estate. Aside from minimizing the risk of death during the retained term, a series of short term GRATs with high annuity pay-out rates to the grantor (to keep the value of the gifted remainder interest as low as possible) will minimize the risk that the economic performance does not materialize by quickly returning assets to the grantor who then can start over with another GRAT or other planning.

An approach of using a series of short term “zeroed out” GRATs (even taking into consideration Example 5), with relatively high annuity payments to the grantor and a correspondingly very low value for the gift of the remainder interests probably is the best defensive strategy. The risk of estate tax inclusion or poor economic performance of GRAT assets can be minimized and contained, at relatively little cost in terms of using the grantor’s applicable credit amount or paying gift tax on the value of the gifted remainder interest.

However, some commentators argue that where assets appreciate at a steady pace, a series of short term GRATs may produce inferior results to a single long term GRAT. This is especially true if the grantor waits until the end of the preceding GRAT to create a new GRAT. Each time the grantor creates a new GRAT, the section 7520 rate may have risen enough to make the new GRAT less likely to succeed. In addition, a series of short term GRATs will likely result in a larger total of taxable transfers than one long term GRAT. Nevertheless, especially if the grantor is older and substantial risk of death during the term is a concern, it may be wise to use the short term method.

c. Marital Deduction

If the grantor is married, the GRAT could provide that in the event that the grantor dies during the retained term, the portion of the GRAT which is includable in the grantor’s estate will convert into a section 2056(b)(7) qualified terminable interest property (QTIP) trust if the grantor’s spouse survives and is married to the grantor. The personal representative of the grantor’s estate then would have the option to elect to have the portion which is includable in the grantor’s estate qualify for the marital deduction. As discussed above with respect to QPRTs, this approach does not avoid transfer taxes on the appreciated value of assets originally transferred to the GRAT, but it defers the tax liability until after the surviving spouse’s death.

d. Exchange of Assets

If death of the grantor within the term is likely, the grantor may exchange high basis property of an equivalent value or cash with the GRAT in order to get low basis property into the grantor’s estate. No gain will be recognized on the exchange because the GRAT is a grantor trust and a transfer of trust assets to a grantor who owns the entire trust for income tax purposes is not recognized as a sale for federal income tax purposes. Such an exchange will not accomplish much if the entire GRAT corpus is included in the grantor’s estate under section 2039 or 2036 and gets the full step up in basis anyway. However, if only a portion of the GRAT is includable in the grantor’s gross estate under section 2033 or 2036, such an exchange may produce positive tax results by obtaining the stepped-up basis for the assets included in the grantor’s estate and shifting cash or high basis assets to that portion of the GRAT that will be excluded and distributed to the remainder beneficiaries.

e. Sale of Retained Interest in the GRAT

Theoretically, a grantor may be able to avoid estate tax inclusion by selling his or her retained interest in the GRAT. The sale proceeds will be included in the grantor’s gross estate, but this amount, equivalent to the present value of the annuity at the time of sale, will almost certainly be less than the amount included if the grantor dies owning the entire GRAT. Such a sale should not result in inclusion under section 2036(a)(i) because the grantor would not have retained the right to possession, enjoyment or income. Moreover, the grantor should avoid inclusion under section 2039(a) because no payments will be payable to the grantor at the time of his or her death. If the sale is to the grantor’s spouse, no gain should be recognized for income tax purposes.

This technique is not without its peril. If the grantor dies within three years of the sale, the GRAT may be included in the grantor’s gross estate under section 2035. If the grantor sells the retained interest, but has a reversionary interest which is contingent on he or she dying during the term, the property subject to the contingent reversion will be includable in the grantor’s gross estate under section 2033.

Most importantly, a sale of the retained interest may place the status of the annuity as a “qualified” annuity under section 2702 in jeopardy. Treasury Regulations require that the annuity amount be paid to, or for the benefit of, the “holder” of the annuity and that the governing instrument of a qualified annuity prohibit distributions from the GRAT to anyone other than the “holder” of the qualified annuity. It is not clear whether the sale of the retained interest to a third party would result in the GRAT failing to meet the requirements of this section. The IRS could conceivably argue that the term “holder” means the original transferor, not the person entitled to receive this annuity payment.

Further, the Treasury Regulations require that a qualified annuity must be for the life of the term holder, for a specified term of years or for the shorter of those periods. Again, the IRS could argue that upon the sale of the retained interest, the annuity is no longer “qualified” because the term would no longer be based upon the life of the original term holder. A determination that the retained interest is no longer qualified under section 2702 could result in a revaluation of the initial gift of the remainder interest. If the grantor’s retained interest is valued at zero, none of the original valuation discount objectives of the GRAT will be accomplished.

f. Purchase of the Remainder Interest

If it appears the grantor will not survive the end of the retained term, he or she also may consider purchasing the remainder interest from the remainder beneficiaries. Although this alternative will result in full inclusion of the trust corpus in the grantor’s gross estate, the sale proceeds paid to the remainder beneficiaries will be removed from the grantor’s estate, free from gift tax, if the grantor pays adequate consideration in money or money’s worth.

The remainder beneficiaries will recognize gain on the sale of the remainder interest to the grantor to the extent that their interest exceeds the trust’s basis in its assets. However, if the basis of trust assets is low, the recognition of gain may be substantially reduced or even eliminated if the grantor exchanges high basis assets for the trust’s low basis assets. If the grantor has retained the power to exchange trust assets for other assets which he or she may own of an equivalent value, the grantor is treated as the owner of the entire trust for federal income tax purposes. The grantor will not recognize gain by exchanging his or her assets with the trust’s assets, if such assets are of an equivalent value. Thus, prior to purchasing the remainder interest, the grantor can substitute cash or high basis assets of an equivalent value for the GRAT’s appreciated, low basis assets without recognizing gain. Thereafter, the grantor can purchase the remainder interest. The cash or high basis assets transferred to the trust prior to the purchase will serve to reduce or even eliminate any gain to the remainder beneficiaries. In addition, the appreciated, low basis assets which were transferred out of the GRAT prior to the purchase of the remainder interest will be included in the grantor’s gross estate and will receive a step-up in basis to fair market value upon the grantor’s death pursuant to section 1014.

Example: Assume a grantor created a GRAT to which he transferred stock with a fair market value and basis of $1,000,000, retaining a ten year annuity of $100,000, with the remainder going to his daughter at the end of the term. The grantor is treated as owner of the entire trust under the aforementioned grantor trust rules and has the power to exchange trust property with his own property. At the beginning of the ninth year, the remainder interest has a value of $2,000,000 and the grantor’s death is eminent, which could result in full estate tax inclusion. If the grantor purchases the remainder interest from his daughter in order to reduce his gross estate by the purchase price, his daughter will recognize gain to the extent that remainder interest exceeds the trust’s $1,000,000 basis in the stock. Therefore, prior to the purchase of the remainder interest, the grantor could transfer $2,000,000 in cash to the trust in exchange for the appreciated stock contained therein. This exchange will not result in recognition of gain by the grantor. Thereafter, the grantor can purchase the remainder interest from his daughter without her recognizing any gain because the value of her remainder interest will not exceed the basis of the trust assets.

There certainly are risks involved in such planning. For example, if the exchange of trust assets and purchase of the remainder interest occur contemporaneously or within a short period of time, the IRS may apply the step-transaction doctrine in order to recharacterize the transaction as a purchase of the remainder interest and a withdrawal of the trust assets. Alternatively, the IRS may argue that the retention of the power to exchange assets causes the original transfer of such assets to the trust to be an incomplete gift. The IRS could revalue the original gift of the remainder interest upon creation of the GRAT without allowing the discount for the grantor’s retained interest.

g. Term Life Insurance

The purchase of term life insurance on the life of the grantor may be one way to offset the impact of estate tax of GRAT assets due to the grantor’s death during the retained term. A policy which spans the retained term can provide the liquidity necessary for the payment of estate taxes in such an event. As part of this defensive strategy, the grantor may set up an irrevocable life insurance trust to purchase the policy to avoid inclusion of the policy proceeds themselves in the grantor’s gross estate.

h. Tax Apportionment

In structuring an estate plan involving a GRAT, careful consideration should be given to the allocation of any estate tax burden attributable to inclusion of all or a portion of the GRAT property in the grantor’s gross estate if he or she does not outlive the term. The remainder beneficiaries of the GRAT may be different than the beneficiaries of the grantor’s other assets. In particular, GRATs often provide for children only and not their issue, because of generation-skipping transfer tax considerations. If a child of the grantor dies before the GRAT term ends, his or her issue may not share in the GRAT remainder. Moreover, the grantor’s other assets may not be sufficient to pay the estate tax on GRAT assets, necessitating that the tax be paid from GRAT assets. This result may make continuation of the GRAT for the remaining term impossible. Careful drafting of the grantor’s tax apportionment clause and equalizing gifts, if necessary, is often critical when incorporating a GRAT into the grantor’s estate plan.

9. intentionally defective GRANTOR trusts

Another popular estate planning technique involves a sale by the grantor of an asset to an irrevocable intentionally defective grantor trust (IDGT). The IDGT is structured so that it is excluded from the grantor’s estate for federal estate tax purposes, but considered owned by the grantor for income tax purposes. Such ownership is accomplished by intentionally violating one or more of the grantor trust rules of sections 671-679, which do not trigger inclusion of the trust property in the grantor’s gross estate. As a result, the grantor will be taxed on all trust income whether or not it is distributed to the grantor.

The grantor then sells assets to the IDGT, in exchange for a promissory note. Typically, the grantor funds the trust as an initial gift with sufficient cash for a down payment to be made back to the grantor as part of the purchase price, with the grantor taking a promissory note for the balance secured by the assets sold to the trust. The note can provide for payments of interest only, on at least an annual basis. The payments generally are made for a specified term of years, with a balloon payment of principal at the end of the specified term, and a right to prepay the balance at any time without penalty.

Since all transactions between the grantor and the trust generally will be ignored for income tax purposes, no gain or loss is recognized on the sale of assets by the grantor to the IDGT, and the grantor is not taxed on the interest payments on the note. The grantor, however, is taxed on all trust income during the period in which the trust is defective.

This technique can produce substantial transfer tax savings if the asset sold to the IDGT has a total return in excess of the interest rate on the note. Thus, for example, an asset expected to appreciate very substantially and then be sold to an unrelated third party (such as stock in a private company expected to be sold sometime in the future) is an ideal candidate for this type of planning. Very substantial transfer tax savings also can result if the fair market value of the asset sold by the grantor to the trust can be legitimately discounted at the time the transaction is entered into (such as when lack of marketability or minority interest discounts also apply).

1. IDGT vs. GRAT

The GRAT and IDGT sale techniques are very similar in their intended purposes. An asset that is transferred to a GRAT or sold to an IDGT which outperforms the section 7520 rate (in the case of a GRAT) or the promissory note interest rate (in the case of an IDGT) can be passed on to younger generation beneficiaries at tremendous estate and gift tax savings. However, there are important differences between a GRAT and IDGT sale.

a. Initial Gift Tax Reporting Requirements

The transfer of an asset to a GRAT is an immediate gift which must be reported on the grantor’s federal gift tax return for the year in which the trust is funded. If the asset transferred is difficult to value, or if valuation discounts are taken, the IRS can challenge the grantor’s valuation and make adjustments based on an audit of the grantor’s gift tax return.

In contrast, only the assets actually transferred as a gift to the IDGT (typically, cash to be used for the initial down payment on the assets sold) need to be reported on the grantor’s federal gift tax return. If the IDGT pays full fair market value for the assets purchased from the grantor, the assets purchased and the sale transaction itself need not be reported for gift tax purposes. Although a conservative approach may be to substantially disclose the sale transaction on the gift tax return at a zero gift value to start the three-year gift tax statute of limitations running, such disclosure should not be required if a reasonable appraisal indicates a full fair market purchase price.

b. Estate Tax Inclusion

An IDGT sale also can have substantial advantages over a GRAT if the grantor dies prematurely. As discussed above, if the grantor of a GRAT dies during the retained term, some or all of the trust property, including post-transfer appreciation, will be included in the grantor’s gross estate under section 2033, 2036 or 2039. On the other hand, if the grantor dies while the promissory note from a properly structured IDGT remains outstanding, arguably only the balance owed on the promissory note as of date of death is includable in the grantor’s gross estate. All post-sale appreciation in the asset sold may be excluded from the grantor’s gross estate.

The IDGT assets should not be included in the grantor’s gross estate under section 2036 so long as the interest rate on the promissory note held by the grantor is not tied to the income generated by the IDGT. Accordingly, the IDGT installment sale may offer superior estate freezing advantages over a GRAT if the grantor dies within the trust term.

c. Generation Skipping Transfer Tax Exemption

An IDGT can be a vehicle for using and leveraging the grantor’s generation-skipping transfer tax (GST) exemption. Allocation of the grantor’s GST exemption to a GRAT (or a QPRT) at the time of their establishment is prohibited by the estate tax inclusion period (ETIP) rules. IRC section 2642(f) precludes allocation of a grantor’s GST exemption to a transfer during any period during which the value of the transferred property would be included in the transferor’s estate, other than under section 2035, if the transferor were to die. The retained term during which the grantor receives his or her annuity from a GRAT (or the QPRT term during which the grantor has the right to occupy the residence) is an ETIP. As a result, the grantor’s GST exemption cannot be allocated to a GRAT (or QPRT) until the end of the retained term. Appreciation on the property transferred to a GRAT (or QPRT) does not escape Chapter 13 in the manner it escapes Chapters 11 and 12 of the Internal Revenue Code.

The ETIP rules of section 2642(f) should not apply to the IDGT because it should not be included in the grantor’s estate. Therefore, GST exemption can be allocated to the IDGT immediately upon funding of the trust, and all post-transfer appreciation should be covered by the initial allocation of exemption. Since the IDGT can be funded with just enough cash to provide a down payment for the assets to be purchased, a relatively small amount of GST exemption may be needed to insure a zero inclusion ratio for generation-skipping transfer tax purposes for the IDGT.

d. Interest Rate Requirements

The interest rate required for the grantor’s note from an IDGT may be lower than the rate for determining the grantor’s retained annuity interest in a GRAT. To qualify as a GRAT, the grantor’s retained interest must be valued under section 7520, which uses an interest rate of 120 percent of the federal midterm rate in effect under section 1274 on the date of the gift.

In contrast, the promissory note in an IDGT sale may bear interest at the applicable rate under Section 1274. Even when the promissory note is a long term note (more than nine years), the federal long term rate under section 1274 may be less than 120 percent of the federal mid-term rate.

A lower interest rate lowers the bar for the transferred asset to outperform the return assumptions used at the outset. Thus, the IDGT sale may be more likely than a GRAT to produce the tax benefits intended by the transaction (i.e. to pass post-transfer appreciation to younger generation beneficiaries free of transfer tax).

e. Income Tax Payments

Both the GRAT and IDGT sale techniques may offer additional leverage benefits if any of the trust assets are sold to a third party. Since both the GRAT and IDGT may be wholly grantor trusts for purposes of Subchapter J, if trust assets are sold to a third party during the GRAT term or while the IDGT remains a defective trust for income tax purposes, the grantor should be taxable on the gain. Accordingly, trust assets are not depleted by the tax on the gain and the grantor’s taxable estate can be reduced by the tax paid.

In LTR 944033, the IRS took the controversial position that if the grantor was not entitled to be and actually was reimbursed from the trust for taxes paid on trust income, the taxes paid by the grantor would be deemed to be additional gifts. Not surprisingly, a firestorm of criticism of this position erupted on the basis that the Code requires the grantor to pay the tax, and the Service subsequently deleted the controversial language in PLR 9543049. However, this ruling may not be the final word on this issue.

f. The Better Vehicle

Although other important differences exist between GRATs and IDGT sales, the IDGT sale may be a superior vehicle to the GRAT, at least in considering the possibilities that the economic performance of trust assets are less than expected or that the grantor will die during the term. However, there are significant risks associated with IDGT sales.

7. Weighing the Risks

Unlike QPRTs and GRATs, there is no statutory support for an IDGT sale, and substantial uncertainty exists about the tax effects of the technique. There is no iron clad protection against the Service arguing that what purports to be a sale really is a retention of an annuity not meeting the requirements of section 2702, or a retained life interest under section 2036.

a. Inclusion under Section 2702

If the IDGT sale is characterized as an annuity under section 2702, the section 7520 interest rate would apply in determining whether, and to what extent, there is a taxable gift. In addition, the IDGT would have to meet all the requirements of section 2702 which are imposed on GRATs, including the 120% rule regarding payments. Only the interest payments on the note from an IDGT may meet such requirements. A balloon payment at the end of the term of the note, on the other hand, probably would not meet the requirements of section 2702, and may therefore result in a significant gift tax value upon funding of the trust.

Nevertheless, logically, section 2702 should not apply to IDGT sales. The promissory note is not a beneficial interest in the IDGT retained by the grantor. In Letter Ruling 9535026 the IRS ruled that promissory notes issued by separate IDGTs were debt, not retained interests under section 2701 or term interests under 2702. A word of caution, however: Letter Ruling 935026 also indicates that the determination of the inapplicability of section 2702 will be considered void if such promissory note is later determined to be an equity interest rather than a debt instrument. Thus, IDGTs may involve a substantially greater risk of audit than QPRTs or GRATs.

b. Inclusion under Section 2036

Internal Revenue Code section 2036 provides that the decedent’s gross estate will include the value of all property the decedent transferred during life, if the decedent retained the right to income from the property. The IRS might rely on principles developed in resolving debt/equity classification to treat the grantor’s interest in the promissory note as a retained (income) interest in the assets transferred to the IDGT, rather than as the right of a creditor.

If section 2036 applies, the grantor’s death during the term of the note would cause the entire trust corpus to be included in the grantor’s gross estate at its date of death value. Moreover, the IDGT would lose its GST tax advantage because the period when the note is outstanding would be an ETIP. Thus, the grantor’s GST exemption could not be allocated to the IDGT until full payment of the note.

c. Proper Sale Structure

To avoid the risk of section 2702 application or section 2036 inclusion, it is critical that the sale between the grantor and an IDGT be properly structured as a bona fide arms length sale. The grantor should not be the trustee of the IDGT, be in a position to make decisions regarding the trust’s participation in the transaction or make decisions regarding payments of interest or principal on the note. The interest rate on the promissory note should not be tied in any manner to the income produced from the assets sold to the IDGT or any other trust assets.

In addition, it is highly advisable for the grantor to make an initial gift of cash or other assets to the IDGT to “prime the pump”, and give the transaction economic reality. Although no statutory requirement exists, the trust probably should have assets equal to 10% of the purchase price to provide adequate security for payment of the acquisition obligation. Typically, some or all of this contribution is returned to the grantor as an initial down payment on the purchase price.

Adequate security for the trust’s obligation also should be provided in the form of a perfected security interest in trust assets. If the size and nature of the transaction warrants it, it also may be advisable to arrange for a line of credit from a commercial lender to back up the trust’s ability to make its note obligations.

Alternatively, one or more beneficiaries of the IDGT may personally guarantee the payments on the promissory note in order to provide the necessary security. If the beneficiary guaranteeing payments has sufficient personal wealth to satisfy his or her potential personal liability on the guarantee, the security may be adequate.

Carefully structuring the sale transaction as a debtor/creditor relationship between the IDGT and the grantor can go a long way in avoiding problems with potential section 2702 or 2036 arguments about the nature of the grantor’s interest in the trust.

d. Bargain Sale Risks

Notwithstanding the structure of the sale transaction, there still may be a risk that the Service will view the transaction as a bargain sale. The determination of whether or not the sale price accurately reflects the fair market value of the assets sold is critical. An undervaluation may result in a large taxable gift. Few options may be available once the IRS labels the transaction a gift because of an undervaluation.

One possible approach may be an adjustment clause in the sale documents which adjusts the amount of the purchase price and promissory note, or returns some of the sold assets to the grantor if it is determined that the assets were undervalued. However, a provision requiring property transferred to an inter vivos trust to be returned to the transferor if the transaction was deemed a gift was determined void in Commissioner v. Procter. The IRS also rejected two different adjustment clauses which were contained in grant deeds. The first reduced the amount of the property transferred to the extent the IRS determined that the value transferred exceeded the $10,000 annual exclusion. The second required the transferee to pay consideration for the transfer to the extent the IRS determined the transfer to exceed the $10,000 annual exclusion.

The Procter case and Revenue Ruling 86-41 involved gift transactions which may be distinguishable from a bona fide sale transaction where the parties are attempting to avoid a gift. Accordingly, it may be prudent to couch the sale documents in terms of a formula based on a dollar amount of assets being sold. If the purchase price for the assets is later found to be inadequate, a portion of the assets can be returned to the grantor. Nevertheless, it is by no means certain that such an adjustment clause would be effective to avoid gift tax liability. Moreover, the mere existence of such a clause may suggest that the transaction was entered into at least partly as a donative transfer. Such adjustments in value would only result from an IRS determination of inadequate consideration, which is not a typical concern of a true arms length sale transaction.

It has been suggested that a statement in Revenue Ruling 86-41 which approves a clause requiring a purchase price adjustment based on an appraisal by an independent third party for that purpose should be recognized. Such an adjustment clause might avoid some of these problems because it would not require an IRS determination of inadequate consideration.

Of course, the best way to avoid all of these issues is to make certain that the value of the assets sold to the IDGT is properly determined. It can be very foolish to be overly aggressive about the sale price. Appraisals by qualified experts should be a critical component of this type of planning, especially if the valuation includes any discount analyses.

e. Income Tax Implications of Grantor’s Death

Another concern with a sale to an IDGT is the income tax effect of the grantor’s death. It is clear that when the grantor dies, the IDGT loses its grantor trust status. What is not entirely clear are the income tax consequences.

It is possible that gain must be recognized at the time the trust ceases to be a grantor trust. The amount of the gain presumably is based on the note balance outstanding at date of death.

Commentators disagree as to whether the deemed sale takes place immediately before or immediately after the grantor’s death. If the sale is deemed to have occurred immediately before the grantor’s death, gain may be realized to the extent the note balance exceeds the seller’s basis in the assets sold. The assets deemed sold would receive a new income tax basis equal to the balance due on the note. On the other hand, If the transfer is deemed to have occurred immediately after death, the assets would have to be considered owned by the grantor at death and therefore the amount due on the note would be entitled to a step-up in basis under section 1010(a).

It also is possible that there are no income tax consequences if the grantor dies while the note remains outstanding. Since the sale is ignored for income tax purposes, the grantor’s death may only cause the note to be included in his or her gross estate, without triggering any income tax consequences. However, the lack of clarity on this issue underscores the necessity of extinguishing the note prior to the grantor’s death.

f. Planning if Grantor’s Death Imminent

The risk of recognition of gain and opening up the entire sale transaction to IRS scrutiny should be avoided by extinguishing the note if it is likely the grantor will not survive the note term. One way of extinguishing the note is, of course, prepayment in cash. However, the IDGT may not have the liquidity necessary for such a prepayment. If this is the case, the IDGT may satisfy the note by transferring all or a portion of the property originally sold to the IDGT back to the grantor. As discussed above, such a transfer would not result in a taxable gain to either the IDGT or the grantor under Revenue Ruling 85-13. If the anticipated appreciation occurred on the original transfer to the IDGT, all such appreciation would still go to the beneficiaries of the IDGT. Of course, valuation of the assets transferred back to the grantor in payment of the note may pose difficulties depending on the particular circumstances.

The grantor also could exchange low basis property with the IDGT prior to the IDGT’s payment of the note. In turn, the IDGT could satisfy its payment obligation with the low basis assets. Thus, this low basis property would be included in the grantor’s gross estate and receive a stepped-up basis which it would not have otherwise received had it been in the IDGT upon the grantor’s death. However, it is important to appreciate the uncertainties involved in these types of transactions and the risk that the IRS may attempt to collapse them.

Ideally, the promissory note will be completely repaid prior to the death of the grantor. In addition, it would be highly desirable for all powers which cause the trust to be defective from an income tax standpoint to be released prior to the death of the grantor and the trust completely distributed and terminated prior to the grantor’s death. Completely folding down the IDGT vehicle before the grantor dies may completely avoid dealing with issues regarding the trust on the grantor’s estate tax return. First, since the note will have been completely repaid, it will not appear as an asset on the estate tax return. In addition, if the IDGT has been terminated and distributed prior to the grantor’s death, the trust will not need to be disclosed on the federal estate tax return. The only trace of the transaction then will be the initial gift of the cash down payment to the trust on the grantor’s gift tax return for the year in which the gift was made. Accordingly, all issues regarding a potential bargain sale analysis being applied to the initial purchase transaction, the income tax effect of note payments and the amount to be includable in the gross estate of the grantor all can be avoided by paying off the note and terminating the trust before the grantor’s death.

7. CONCLUSION

QPRTs, GRATs and sales to IDGTs are all techniques which can be highly effective in transferring wealth to the next generation at a minimal amount of transfer taxes. However, with all three of these vehicles, a failure of the transferred assets to economically perform as expected, or the premature death of the grantor can wreak havoc with the intended results. Accordingly, it is very important to carefully consider these possibilities in structuring the plan and retain as much flexibility as possible to deal with these events if they occur.

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Thomas J. Stikker and Jeffrey T. Antonchuk are partners with Dudnick Detwiler Rivin & Stikker LLP in San Francisco, CA. Reprinted with permission from New York University 58th Institute on Federal Taxation 2000, 2000