Using a GRIP in Anticipation of the Transfer Tax Sunset

While the 2017 Tax Act effectively doubled the federal transfer tax exemption per person, it also provided that the lower transfer tax exemption would automatically drop beginning in 2026. That scheduled sunset of the higher federal transfer tax exemption has produced among many wealthy individuals a “use-it-or-lose-it” mindset when it comes to estate planning these days.

One planning technique that has not received much attention is a Grantor Retained Interest Partnership (GRIP). A GRIP locks-in the currently large federal gift and estate tax exemption, “freezing” the value of the transferor’s estate, while preserving transferor’s access to the income generated by the “transferred” assets. A GRIP sounds almost too good to be true.

This planning strategy intentionally exploits one provision of the Tax Code, much like the planning strategy of a sale of an appreciated asset to an intentionally defective grantor trust. In a GRIP strategy’s most basic form, a wealthy individual establishes a partnership with two types of interests: a preferred interest and a common interest, and then gifts the common partnership interest to family members.

A bit of background on the Tax Code helps to understand how this estate freeze strategy works. About 30 years ago, the Tax Code was amended to add Section 2701 in order to regulate, or more accurately deter, certain types of asset freeze transactions that reduced an individual’s exposure to the federal estate tax.  In effect, Section 2701 treats the transferor or donor as having made a significant taxable gift when what was actually transferred was a common interest in the partnership entity which has no, or minimal, value. The donor retains the preferred interest in the partnership entity and gives away the common interest as a taxable gift.

An example explains how the GRIP estate planning strategy works. Don has a $11.7 million transfer tax exemption. Don wants to fully use that exemption before it drops to $6.0 million starting in 2026. Don transfers an investment portfolio worth $10 million to a preferred partnership that he creates. Don initially takes back all of the preferred and common partnership interests. The partnership agreement provides that on the partnership’s liquidation the preferred partnership interest possesses the right to receive the return of at least $9.9 million capital. The preferred partnership interest also holds the right to receive an annual non-cumulative 7% return. Don gifts the common partnership interests, worth $100,000, to his children. Section 2701 operates to value Don’s retained preferred partnership interest at $0.00 and it attributes all of that interest’s value to the common partnership interests Don just gifted to his children. Accordingly, Don’s children’s common partnership interests, which will grow but only in excess of the 7% preferred’s annual return, will be valued at $10 million.

Don will use $10 million of his available federal gift tax exemption to shelter his gift of the common partnership interests to his children, valued at $10 million, when, in fact, the actual value of Don’s retained preferred partnership interest is worth $9.9 million and the common partnership interest is worth $100,000. When Don dies, his preferred partnership interest will be included in his taxable estate. However, because Don already was treated in the year of the gift as having gifted $10 million of value when he gifted the common partnership interests to his children, section 2701 applies a mitigation rule that provides a reduction in Don’s taxable estate of $9.9 million.

To summarize a GRIP, the preferred partnership interest enables the donor to use today’s currently large federal gift tax exemption to offset the value of the preferred interest included in the donor’s estate on his later death, whatever the available federal transfer tax exemption is at the time of the donor’s death. In addition, the preferred partnership interest retained by the donor provides the donor access to and use of that interest during the donor’s lifetime, e.g. the 7% distribution. The donor will retain control to decide who will receive his retained preferred partnership interest at the time of his death. And if the current rules still apply when the donor dies, his preferred partnership interest, because it was included in the donor’s taxable estate, will qualify for an income tax basis adjustment on the date of the donor’s death equal to the interest’s fair market value.

Like the intentionally defective grantor trust, the GRIP works because the donor intentionally violates one of the rules of IRC 2701. Specifically, the preferred partnership interest must not be a qualified payment. Key to this is to make sure that the preferred partnership interest only holds a non-cumulative return, meaning that if the partnership does not have sufficient earnings in a particular year to pay the specified return (in Don’s example, 7%) the return lapses and does not cumulate into the next year’s preferred payment. By intentionally violating the rules to not have a qualified payment the donor’s retained interest in the partnership is valued at zero.

A fair number of technical rules were skipped over in this summary. What is important to remember is that a subsequent decrease in the donor’s available federal transfer tax exemption will not impact the benefits of the GRIP. Key to the success of the GRIP strategy is the donor’s estate reduction, which offsets the inclusion of the preferred interest in the donor’s taxable state. So while individuals wonder what Congress will do to the current federal transfer tax exemption, or they understand that even if Congress does nothing, come 2026 the transfer tax exemption amount will dramatically drop, there is something that they can do today to “use their exemption before they lose it” while still having access to the wealth represented by their retained preferred partnership interest.