The situation:
With all the uncertainty about the future of the estate tax, Mrs. Smith, a hypothetical wealthy individual, does not currently want to make an outright transfer that will incur a large gift tax liability, and is looking for an another way to transfer her wealth.
The solution:
Since low asset values and low interest rates make certain estate-planning techniques very attractive, she and her adviser are considering a sale of assets to an intentionally defective grantor trust for the benefit of multiple younger generations, in exchange for a promissory note that pays interest periodically with a single balloon payment of principal at the end of the period.
The transfer to the IDGT essentially freezes the value of the transferred assets of an individual for estate tax purposes, but the transfer is not recognized for income tax purposes, because the trust is intentionally defective; that is, the trust agreement contains terms to make it deemed owned by the taxpayer for income tax purposes. This ensures that no capital gains are recognized on the transfer. Moreover, the individual continues to pay the income taxes of the trust.
The client has bank stocks that are worth $10 million, which has dropped as a result of the recent battering financial stocks have received.
Mrs. Smith and her investment adviser believe that the stocks are worth holding long-term and have the potential to appreciate significantly in value over the next five to seven years.
The transferred asset’s value that will be includable in the taxpayer’s estate is frozen because it is limited to the value of the promissory note and the interest earned on the note, and all future appreciation and income from the stocks escape estate tax.
For the technique to work, the future appreciation and future income have to exceed the interest rate charged on the note. Consequently, the lower the interest rate that has to be charged on the loan, the better the results.
Promissory notes between related parties have to bear market interest rates to avoid the imposition of imputed interest for income or gift tax.
The Internal Revenue Service calculates and publishes every month interest rates commonly known as “applicable federal rates,” which when properly applied to notes act as a safe harbor and avoid the imposition of imputed interest for income or gift tax.
Since the AFRs are linked to Treasury obligations (they are based on the weighted average market yield for marketable Treasury obligations), they are currently low from a historical standpoint.
For example, for a promissory note executed in August 2008 (with semiannual compounding of interest), the AFR for a short-term loan (duration of three years or less) or a demand loan is 2.52%.
The AFRs for mid-term loans (duration four to nine years) and long-term loans (duration greater than nine years) are 3.52% and 4.53%, respectively.
One simple alternative is for Mrs. Smith to sell the stock directly to her children in exchange for, say, a nine-year promissory note. However, if it is a direct sale of publicly traded stock to the children, she will have to recognize capital gains on the sale immediately.
A sale of the stock to a trust set up for the benefit of younger generations produces much better results. The trust is structured such that it is deemed to be owned by Mrs. Smith for income tax purposes (although she does not retain any obvious benefits such as the right to principal or income distributions from the trust).
The trust, however, is not considered owned by her for estate purposes. As a result, all of the income and expenses of the trust are reported by the client yearly, but the trust assets are not includable in Mrs. Smith’s estate at death.
The sale to the IDGT does not generate capital gains for her (the IRS has ruled so). In addition, Mrs. Smith is liable for the taxes on the earnings of the trust, so this allows her to deplete her estate further — by paying the income taxes from her remaining funds — without gift tax consequences.
The sale to an IDGT is a complex transaction that has to be carefully structured and implemented.
This case study only provides a broad overview of the technique. Please discuss with an attorney who is well-versed in such planning techniques.
Tax INsight is prepared by experts who are active members of the American Institute of Certified Public Accountants. Tax INsight appears on the web and in IN Daily every Tuesday. Comments are welcome at
IN_Editor@InvestmentNews.com.
