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George F. Bearup, J.D. Senior Legal Trust Advisor

Time to Review Estate Freeze Strategies – Sales: Part 2

Take-Away: A sale of an appreciating asset to an irrevocable grantor trust can shift future appreciation of the asset out of the transferor’s taxable estate, but not consume any of the transferor’s federal transfer tax exemption. The sale of the appreciating asset is exchanged for a fixed, or frozen, promissory note. The sale to a grantor trust provides some benefits over a GRAT, but it also presents some drawbacks and risks when compared to a GRAT as an estate freeze strategy.

Background: This estate freeze strategy is sometimes called a sale to an intentionally defective grantor trust, or IDGT. The strategy generally involves a senior family member, i.e. parent, selling an asset, such as an interest in a closely held business, to a grantor trust that is established for the benefit of a younger family member, such as the parent’s child or grandchild. In exchange for the sale of the appreciated asset, the settlor receives a promissory note. Because the transaction involves a sale to a grantor trust in exchange for a promissory note, presumably for the asset’s fair market value, no taxable gift will result. The receipt of a promissory note in connection with the sale of the appreciating asset will constitute adequate and full consideration, and therefore it is not a gift so long as the face amount of the promissory note reflects fair market value and adequate interest is provided for the promissory note. [IRC 7872; IRC 1274.] Frazee v Commissioner, 98 Tax Court 554 (1992).

Attributes of an IDGT: The sale of an appreciating asset to an IDGT has many features that distinguishes it from a GRAT.

  • It is a Sale and Not a Gift: Since the transaction is structured as a sale and not a gift, none of the seller’s available federal applicable exemption amount is used (sort of- see ‘seed equity’ below.)
  • No Gain Recognition on Sale: The sale will not result in any gain recognition of the sale of the appreciated asset to the IDGT. [Revenue Ruling 85-13.] A grantor trust is ignored for income tax reporting purposes when the settlor sells an asset to the grantor trust: the sale is treated as a sale to oneself. However, once the grantor trust classification ends, e.g. the grantor trust ‘triggering power’ is released by the settlor, the gain will be recognized if the promissory note remains unpaid at the time the trust ceases to be classified as a grantor [Treasury Regulation 1.1001-2(c), Example 5.]
  • Growth in Sold Assets is Outside the Seller’s Taxable Estate: Any growth in the asset held by the IDGT above the repayment terms of the promissory note and the applicable federal rate of interest (AFR) occurs in the IDGT and is outside of the seller’s taxable estate- thus freezing the selling settlor’s taxable estate.
  • GST Exemption Can be Allocated to the Trust: Unlike a GRAT which cannot allocate the settlor’s GST exemption to the GRAT until the estate tax inclusion period (ETIP) comes to an end, i.e. until only after the settlor’s annuity payment period ends, with an IDGT the settlor can allocate his/her GST exemption to the IDGT when the trust is first created and funded. Thus, all growth in the IDGT’s appreciating asset is sheltered from all GST taxation. As a result, an IDGT is more tax efficient than a GRAT when viewed from a generation skipping transfer tax perspective if the IDGT is a dynasty-type of trust with the settlor’s grandchildren as trust beneficiaries.
  • An Indirect Tax-Free Gift to the IDGT Beneficiaries: As with any other grantor trust, an IDGT can be viewed as permitting the IDGT’s assets to grow in a tax-free environment, since the settlor pays the income tax on the grantor trust’s income. The payment of the IDGT’s income tax liability is, in effect, another tax-free gift to the IDGT’s beneficiaries.
  • No Deemed Gift: The sale of assets by a settlor to a grantor trust does not constitute a deemed gift under IRC 2701 as an applicable retained interest, nor is it treated as a term interest under IRC 2702. [PLR 9436006; PLR 9535026.]

Drawbacks to an IDGT: As with any estate planning strategy there are limitations and drawbacks that must be considered with the settlor’s sale of an appreciating asset to an IDGT.

  • Seed Gift Requirement: Conventional wisdom with a sale to an IDGT is that the purchasing IDGT must have sufficient ‘seed equity’ in it, prior to the sale, in order to support the debt service required under the promissory note. Folk-lore suggests that the IDGT must have a minimum 10% in equity equal to the total value of the assets intended to be sold to the trust. Consequently, the seller usually must pre-fund the IDGT with a taxable gift that is sufficient to satisfy the IDGT ‘seed equity’ requirement. If there is already in existence a grantor trust with sufficient assets, then the ‘seed gift’ to support the trust’s promissory note may not be required.

Example: Sam intends to sell his closely held business worth $9.0 million to an IDGT that is intended to benefit his children. Sam must fund the IDGT with at least $1.0 million of assets, as a taxable gift, in order to support a $9.0 million promissory note the IDGT will give him. The rational for the need for a ‘seed gift’ to the IDGT is to counter an IRS argument that the sale of Sam’s business in exchange for a promissory note was in essence some sort of retained interest held by Sam in the sold business asset, rather than debt.

  • Retained Income Interest Argument: The IRS has regularly taken the position that the value of stock sold to an IDGT should be included in the seller’s taxable estate under IRC 2036(a)(1) as a retained income interest in the asset that was sold. Estate of Woelbing v. Commissioner, Tax Court No. 30261 (2013). To avoid this type of argument, the transaction should be structured so that the payments due under the promissory note to the seller do not match or mirror the projected income that is expected to be generated by the asset the seller sold to the IDGT.
  • No Self-Adjustment Permitted: Unlike a GRAT, there is no statutory self-adjusting feature with respect to an IDGT. This creates a risk that upon an IRS gift tax audit an implied gift occurred if the subject of the sale to the IDGT is a hard-to-value asset.

Example: Sam sells a minority ownership interest in a closely held business to an IDGT. Sam sells his stock in exchange for an installment promissory note for $8.0 million. The sales price is based upon an independent appraisal of that business interest that is the subject of the sale. However, the value of the sold minority business interest is adjusted to $10.0 million on a subsequent IRS gift tax audit. Sam will have made an implied gift of $2.0 million due to the ‘overage’ after IRS audit. By comparison, if Sam had contributed the stock to a GRAT, where the value of the gift of $8.0 million in stock was adjusted up to $10 million on the gift tax audit, under the GRAT self-adjustment provisions, the annuity amount that Sam would receive from the GRAT would automatically be increased, but the adjustment would not result in an additional gift tax that had to be paid by Sam.

  • Is the Promissory Note Equity or Debt?: Critical to the success of a sale to an IDGT is that the promissory note given to the seller is respected as a valid The rationale that the sale to a IDGT transaction does not result in a taxable gift is that the seller sold the asset in exchange for a promissory note in a fair market value exchange. However, if the promissory note is not respected as a valid debt and it is disregarded by the IRS as illusory, then the transaction could result in a gift rather than a sale of the asset. The IRS has challenged the promissory note received on a couple of different grounds as either being (i) a second class of equity or (ii) as a transfer to a trust with a retained interest.

Transfer-in-Trust Argument: In Karmazin the IRS argued that the sale of limited partnership interests in a family limited partnership in exchange for a promissory note was a ‘transfer-in-trust.’ Thus, the IRS sought to claim that the transfer was within IRC 2702 (the zero value of the retained interest in a trust Tax Code section). The IRS argued that the sale of the limited partnership interest in exchange for the promissory note was actually a deemed transfer in trust with a retrained income interest by the seller that did not qualify as a qualified interest under IRC 2702. Consequently, the value of the seller’s retained interest was worth $0.00 and the value of the sold LP interests should be re-characterized as a gift to the IDGT in exchange for an interest that was valued at $0.00, thus resulting in a taxable gift of all of the LP interests that were sold by the settlor, with no reduction for the value of the promissory note that was  received by the seller in the exchange.

IRS also raised the argument in Karmazin  that IRC 2701 applied to the sale of the limited partnership interests to the trust, and that the promissory note was not debt but rather a form of disguised equity.  If IRC 2701 applied it would result in the amount of the taxable gift being the value of the asset transferred, less the value of any qualified payment rights. In other words, the IRS argued that the  seller made a transfer of subordinate limited partnership interests to the IDGT and retained a senior interest in the form of a re-characterized equity promissory note, as the retained interest included a distribution right, primarily because the note payments made to the seller were neither ‘fixed’ nor required to be paid annually. To support its argument that the promissory note was a form of equity in the limited partnership, the IRS focused on the following facts: (i) the trust’s debt-to-equity ratio was too high; (ii) there was insufficient security for the note; (iii) it was unlikely the limited partnership interests would generate sufficient income to make the note payments; and (iv) no commercial lender would have made a loan under these conditions. Karmazin v. Commissioner, Tax Court, No. 21270-03 (2003.)

In Woelbing (litigation that was subsequently settled) Don and Marion sold stock in their family business to a grantor trust in exchange for a promissory note with a face value of $59 million. That trust at the time of the sale held assets worth $12 million. The note given to Donald and Marion carried the appropriate AFR interest rate and there were personal guarantees given by two trust beneficiaries for 10% of the purchase price. The IRS challenged the value of the stock that was sold and argued that the stock was actually worth $117 million, in short, an indirect gift occurred. Again the IRS based its arguments on IRC 2702 that the sale of the stock to the IDGT was considered a transfer-in-trust with a retained interest- a retained interest that was not a qualified interest, meaning no value was ascribed to the promissory note. Thus, the IRS claimed the settlors’ gift was of the entire $117 million. Estate of Donald Woelbing, Tax Court, No. 32 0261-13 (2013); Estate of Marion Woelbing, Tax Court, No. 30260-13 (2013).

Conclusion: A sale of an appreciating asset to an IDGT is an effective estate freeze transaction that has features different from a GRAT. The appreciating asset is exchanged, tax-free, for a frozen promissory note. Only the unpaid note balance is included in the seller’s taxable estate.  The principal risk associated with the sale of a hard-to-value asset to the IDGT is that the IRS may dispute the value used to support the face amount of the promissory note, claiming that an indirect taxable gift was made. Added to that risk of a taxable gift is the IRS’s apparent position that either IRC 2701 or 2702 applied to the transaction, and the entire value of the transferred asset was the subject of the gift (with no off-set for the value of the promissory note that the seller received in the exchange that is included in the settlor’s taxable estate at death.) The best way to mitigate against the claim of an indirect gift is to structure the sale using either a formula allocation clause, so that the excess amount, i.e. the gift portion, flows to a GRAT or a charity, or use a defined value formula sale, to eliminate the exposure to a deemed gift in excess of the seller’s then available federal gift tax exemption. That said, there is still a lot of concern among many estate planners that the use of a defined value clause in a sale to a grantor trust is ‘waving a red flag’ in front of the IRS and an invitation for an audit.