Prior to the enactment of The Economic Growth and Tax Relief Reconciliation Act of 2001, advisors often suggested that their wealthy clients make large lifetime gifts (including taxable gifts) to family members in order to remove rapidly appreciating assets from their estates.  Although the gift and estate tax rates were about the same, it was actually more cost efficient to pay gift tax since the tax was levied on a tax exclusive basis, while estate tax was levied on a tax inclusive basis. Now, in the current environment of estate tax uncertainty resulting from the 2001 law changes, paying gift tax may not be as advantageous because the potential exists that estate tax may never be due as a result of the growth in (or future adjustments to) the applicable exclusion amount as well as the possibility of estate tax repeal. 

So now, more than ever, the estate planning process places a premium on techniques that leverage the use of annual exclusion gifts and/or lifetime gift tax applicable exclusion amounts. For wealthier clients, who are already gifting and have little or no exclusions and applicable exemption amounts left, the next planning step is often a technique known as “estate freeze.” Here the goal is to freeze the value of the asset to be included in the donor’s estate at its current value while minimizing or avoiding current gift or income tax.  Grantor Retained Annuity Trusts (GRATs) and the Intentionally Defective Grantor Trusts (IDGT) are two effective estate freeze techniques.

GRATS, In General.  To establish a GRAT, the donor/grantor creates an irrevocable grantor trust in which he/she retains the right to a fixed payment for a specific term (an annuity).  At the end of the annuity term, any remaining assets in the GRAT (the remainder interest) are typically passed outright or in trust to the grantor’s heirs.  However, should the grantor die during the annuity term the transferred assets will be included in the grantor’s estate. 

The GRAT technique allows the grantor to transfer substantial value to the trust with low immediate gift tax consequences as the grantor is treated as having made a completed gift equal to the value of the property transferred less the value of the retained annuity interest.  The value of this annuity interest is determined by: (1) the length of the annuity term, (2) the amount of the retained annuity, and (3) the interest rate used to determine the present value of the annuity payments. This interest rate is equal to 120% midterm applicable federal rate (AFR) and is reset monthly according to the rules in IRC § 7520.  An asset that is transferred to a GRAT that outperforms the Section 7520 rate can pass tremendous wealth to younger generations with transfer tax savings.  And, the lower the rate the more attractive GRATs are as an estate planning technique. 

In general, the longer the GRAT term the greater the retained income interest and the lower the applicable federal mid-term rates, the lower the taxable “remainder interest” gift made to the family member.  Minimizing the value of the “remainder interest” gift passing to family members is important as the gift produced with the creation of a GRAT is a future value gift and does not qualify for the gift tax annual exclusion.

Zeroed Out GRAT/or the Walton GRAT.  By adjusting the various components of the GRAT, a GRAT can be structured so that there is no gift when the trust is created, i.e. the GRAT has a high enough stated annuity interest and/or a long enough term of years that the gift tax value of the remainder interest is “zeroed out”.

For years, advisors argued that a zeroed-out GRAT was not disallowed by Code, but the IRS relying on Reg. § 25.2702-3(e), Ex. 5, took the position that there always had to be some gift when the GRAT was created as the possibility of the grantor’s death had the effect of reducing the value of the annuity and, together with other valuation requirements, made it impossible to create an annuity in a GRAT with a value equal to the property transferred. 

Finally, in Walton v. Commissioner, 115 T.C. 589 (2000), the Tax Court settled the dispute by invalidating the regulation on which the IRS had been relying. The IRS did not appeal the Walton case and three years later issued Notice 2003-72, 2003-44 IRB 964, in which it acquiesced on the case and agreed to revise the gift tax regulations. In July 2004, the Treasury issued proposed regulations addressing GRAT valuation issues (Reg-16379-02, 69 F.R. 44476-44480 (July 26, 2004); 2004-35 IRB 390 (August 30, 2004)).   These new regulations reflect the holding of the Walton case permitting zeroed-out GRATs and clarify regulations relating to revocable spousal annuities. While the proposed regulations are effective for trusts created after July 26, 2004, the IRS has indicated that it will not challenge any prior application of the Walton decision. 

The zeroed-out/Walton GRAT is a great gift technique for times of estate tax uncertainty. It potentially allows the grantor to transfer significant amounts of property out of his/her estate with minimal or no taxable gift. If the grantor survives the term of the trust, but dies while estate tax is applicable, the GRAT can reduce significantly any tax that might be owed. If the estate tax is repealed, there are no lost dollars, because no transfer tax was “prepaid.” 

A GRAT works best with assets that are appreciating rapidly. Effectively, a zeroed-out GRAT returns to the grantor in the form of an annuity all the property originally transferred to the trust plus some appreciation on the property. Any excess appreciation stays in the trust and passes to the remainder beneficiaries. This makes the GRAT a great tool for transferring closely held stock, rental real estate, and even some marketable securities. It works particularly well with S corporation stock where there are distributions to shareholders for taxes and appreciation. 

The tax savings from making a gift to a GRAT can be further maximized through the use of discounted assets, such as limited partnership units or closely held stock. The discount has the effect of increasing the effective rate of return on the GRAT assets. 

The main risk with using a GRAT is that the grantor must outlive the annuity term for assets to be excluded from the estate. The risk of inclusion can be mitigated by selecting an annuity term that the grantor is likely to survive; by using a series of shorter GRATs; or by purchasing life insurance on the life of the grantor to offset the impact of the estate tax if inclusion should occur.  With the zeroed-out GRAT technique, where no gift tax has been paid, the grantor may have little to lose but a lot to gain.

Sale to an Intentionally Defective Grantor Trust (IDGT).  An estate freeze technique that bears similarities to a GRAT is the sale to IDGT. Under the sale to and IDGT technique, a wealthy individual looking to rid his/her estate of future appreciation and income from rapidly appreciating assets without incurring gift tax, would combine an arms-length installment sale with an irrevocable grantor trust. 

Here’s a quick step-by-step summary:

• Step 1: Create an IDGT. The grantor creates a trust that is structured so that it is excluded from the grantor’s estate for federal estate tax purposes, but is considered owned by the grantor for income tax purposes – that is, it is an intentionally defective grantor trust (IDGT). This is accomplished by intentionally violating one or more of the grantor trust rules found in IRC §§ 671-679, which, while insuring that the grantor will be taxed on all trust income whether or not it is distributed to the grantor, do not trigger inclusion of the trust property in the grantor’s gross estate. Proper draftsmanship is important so that the transfer does not violate the estate inclusion rules found in IRC §§ 2036-2038.  Essentially, the grantor needs to retain enough control for grantor trust status, but not enough to cause the transferred assets to be included in the grantor’s estate.  The benefit of creating an IDGT is that any tax paid on the trust income by the grantor is essentially a gift tax-free transfer to the trust beneficiaries to the extent the grantor is not reimbursed (The IRS confirmed this position in Rev. Rul. 2004-64, 2004-27 IRB 7).  And, of course these payments further reduce the grantor’s estate for estate tax purposes.

• Step 2: The Grantor Pre-Funds the Trust.  Before the installment sale occurs, the IDGT should be pre-funded with meaningful assets to support the position that the trust has economic substance independent of the sale i.e. the trust has sufficient assets such that it can repay the loan. The seed money can be transferred through gifts to the trust, through the use of a GRAT, or a carefully structured guarantee (If the trust does not pay a fair price for the guarantee, the person giving the guaranty may be treated as making an indirect contribution to the trust, which might result in the trust not being treated as wholly owned by the grantor).  In PLR 9535026, the IRS found that trust equity of at least 10% of the installment price was sufficient to create a valid arms-length transaction.

• Step 3: Sale for an Installment Note. The grantor sells property to the wholly owned grantor trust in return for an installment note for fair market value with appropriate valuation discounts where applicable. The note is secured by the sold asset(s), but is a full recourse note. The note can be structured many ways, but what is often seen is that it provides for interest only payments with a balloon payment of principal at the end of the note term.  The interest on the note is generally structured to bear interest at the applicable federal rate (AFR) under IRC § 1274(d) to avoid the application of the below market interest rules found in IRC § 7872.  In order to avoid gain recognition on a sale to a grantor trust, the grantor must be treated as wholly owning the assets of the trust. The IRS takes the position that when the trust is treated as a wholly owned grantor trust, that grantor and the trust are treated as the same entity and transactions between the grantor and the IDGT have no income tax consequences. As a result, no gain or loss is recognized when assets are sold to the IDGT, and the grantor is not taxed separately on interest payments made on the note (Rev. Rul. 85-13 subsequently reaffirmed in PLR 9535026).

• Step 4: Plan to Repay the Note During the Grantor’s Lifetime.  Provisions should be made to make it “more likely than not” that the note will be repaid before the grantor’s death.  It is clear that if the grantor dies with the note outstanding, the balance of the note and any accrued interest will be included in the grantor’s estate. What isn’t clear is the income tax effect of the grantor’s death. Planners agree that when the grantor dies, the IDGT loses its grantor tax status. But precisely when does this occur?  Depending on when the deemed transfer occurs, gain might be recognized at this time.  Presumably, the amount of gain would be based on the outstanding note balance at the date of death. Lack of clarity on this issue emphasizes the need of extinguishing the note prior to the grantor’s death.  Some advisors substitute a self-canceling installment note (SCIN), or a private annuity for the basic promissory note to avoid the possibility of estate inclusion.  With a SCIN, should the grantor die during the term of the note, the value of the note is zero in the grantor’s estate; however the grantor must recognize any unrealized gain as there has been a cancellation of the installment obligation. In addition, uncertainly still exists on how much interest or principal premium is needed to compensate for the self-canceling feature of the note.  Similarly, a private annuity ensures that should the grantor die during the term of the note, there is zero value included in the estate, but the offset is that if the grantor lives longer than his actuarial life more value builds up in the grantor’s estate than under either the promissory note or the SCIN approach. 

• Step 5: The Life Insurance Sale.  And last, but not least, a portion of the income generated by the trust assets can be used to fund a life insurance policy on the grantor’s life. The policy can be used to repay the balance of the note and/or to help defray estate costs at the grantor’s death. 

IDGT vs. GRAT. While the GRAT and the IDGT approaches are very similar in what they intend to accomplish, there are important differences between the two techniques. 

Consideration of the following factors is important in determining which technique is most appropriate for a particular planning scenario:

• Actual Life Expectancy. For the GRAT, the actual life span must be sufficient to allow the grantor to survive the GRAT term to escape estate tax inclusion. Life expectancy is also important for the IDGT scenario, because of the risk of gain recognition if the grantor dies during the term of the note. 

• Assumed Interest Rates. The sale to the IDGT mirrors the GRAT in that it transfers appreciation above a given rate. The lower the assumed rate the more leverage possible. For GRATs, the assumed rate of return as established by IRC § 7520 is 120 % of the mid-term AFR, while the assumed rate of return for sales to an IDGT is the AFR. Thus sales to an IDGT maximize the opportunity for leverage.

• Required payments. With a GRAT, the annuity payments cannot increase more than 120% in any year, requiring that substantial annuity payments be paid in each and every year.  However, an installment note can be structured as an interest-only note with a balloon payment of principal at the end. The IDGT approach allows appreciating assets to remain in the trust and accumulate for the heir’s benefit for the maximum period again generating greater leverage.

• Income Tax Advantages. The estate freeze is completed without having to recognize any income tax on the sale of the assets to an IDGT as long as the note is repaid during the seller’s lifetime. In addition, the interest payments will not have to be reported by the grantor/seller as income.

• Gift Tax Avoidance. As previously discussed, minimizing any gift to the trust becomes an issue where the grantor has already made maximum use of exclusions and exemptions. Proposed regulations now support the position that a GRAT can be zeroed-out. If the sale to the IDGT is structured as a bona fide sale, there will be no gift tax when the assets are transferred.  However, to support the position that the trust has economic substance i.e. is capable of repaying the loan, the grantor may need to pre-fund the trust. This pre-funding could result in a taxable gift if gift tax exclusions and exemptions are not available.

• GST Avoidance. Where the ultimate heirs are grandchildren, the sale to IDGT is favored because the GST exemption can be allocated immediately, exempting all future appreciation following the sale from GST tax. In contrast, with the GRAT, the annuity term qualifies as an estate tax inclusion period (ETIP) since death during this time results in assets inclusion in the Grantor’s estate. Under the GST rules, the GST exemption can only be allocated at the end of the ETIP period.

• Valuation Issues. If limited partnership interests or other discounted assets are used in these estate freeze techniques, there is always the possibility that the IRS will try to revalue the assets. A GRAT can minimize this risk of revaluation if the annuity is expressed as a percentage of the initial trust assets. Should the assets be revalued, a higher annuity has to be paid, but no additional gift tax (or a minimal amount of gift tax) will be owed.  With the IDGT, if the IRS is successful in their revaluation, the seller would be deemed to have made a gift of the difference between what was paid and the actual value of the assets sold.  This can result in substantial gift tax being owed.

• Statutory Guidance. The rules for GRAT are well defined under IRS regulations, rulings and case law. IRC § 2702 is intended to prevent the use of trusts to artificially reduce the value of interests passing to younger generations. This is generally accomplished by not recognizing for tax purposes the value of a parent-grantor’s life estate interest, so that the full value of the transfer to the trust becomes a gift to the ultimate beneficiaries i.e. the life estate (retained annuity) is valued at zero. There is less risk that the Section 2702 rules will be applied to a GRAT because Code provides a road map (qualifying trust rules) that explicitly outlines how to structure the retained annuity to achieve gift tax certainty.  There is no statutory road map for an IDGT sale. Without this “safe harbor” the risk remains that the IRS may argue that what looks like a sale is really the  retention of an annuity subject to the rules of IRC § 2702; or a retained life interest under IRC § 2036. To avoid the risk of Section 2702 application or Section 2036 estate inclusion, it is critical that the sale be structured as a bona fide arms length sale. The grantor should not be the trustee, nor be placed in a position to make decisions regarding the trust’s role in the transaction. The interest rate on the note should never be driven by the income produced by the assets. As previously noted, steps should be taken to give the trust economic substance. And, to avoid IRS challenge, some assets may require the use of a qualified appraiser.

• Life Insurance Sale. The life insurance need is present with either planning technique. For the GRAT, life insurance provides the certainty that should the grantor die during the GRAT term funds will be available to help pay the estate taxes resulting from the asset inclusion.  Similarly, where the sale to the IDGT is the favored technique, life insurance not only provides additional leverage but also can be used to help repay the balance of the note and/or to help defray estate costs at the grantor’s death.

Summary.  GRATs and sales to IDGTs are techniques that can be highly effective in transferring wealth to the next generation with minimal transfer taxes. However, a failure of the transferred assets to perform, IRS challenge, premature death etc. can create havoc with the intended results. 

These are complex planning techniques, and it is important that clients seek the advice of their tax and legal counsel when implementing these estate freeze techniques.