Tax consequences of reducing the principal and/or interest of a note issued in an intrafamily sale by a grantor trust.

• Author: Wells, Thomas O.
• Position: Real Property, Probate and Trust Law

A common estate planning technique is for a client to contribute property to a limited partnership, and for the client then to sell the limited partnership interest he or she owns to a grantor trust (1) in exchange for a promissory note. This kind of planning is often referred to as an intrafamily installment sale. (2) Under current law, the limited partnership interest being sold could be subject to an appraised aggregate discount ranging from 10 to 40 percent for lack of marketability and minority interest. If the fair market value of the assets owned by the partnership were $1 million, a 35 percent discount would result in the limited partnership interest having a $650,000 fair market value. The principal amount of the promissory note is equal to the discounted sale amount of the limited partnership interest with an interest rate equal to the applicable federal rate (the AFR) for the month of sale promulgated under I.R.C. [section] 1274(d) (1986), as amended. The interest accruing on the promissory note is typically lower than the anticipated earnings of the partnership's assets. With this technique, the discounted portion of the partnership interest and the earnings and appreciation that exceed the interest payable on the promissory note pass to younger generations free of transfer taxes (i.e., estate, gift, and generation skipping transfer taxes).

With the recent decline in the value of real estate and marketable securities and the decline in the AFR, what should a client do when the unpaid principal amount of the promissory note exceeds the current value of the limited partnership interest that was sold, or if the current AFR is less than the stated interest rate on the note? For example, assume that your client created a family limited partnership and contributed $1 million worth of marketable securities to the partnership. Assume that a third-party appraiser determined that the value of the limited partnership interest owned by the client was $650,000. The client created a grantor trust and transferred $65,000 to the trust as a gift. (3) In November 2007, the client sold the limited partnership interest to the grantor trust in exchange for a nine-year balloon promissory note with interest payable annually. The promissory note bears interest at the mid-term AFR for November 2007 (which was 4.39 percent), resulting in annual interest payments by the trust to the client of $28,535. The promissory note is collateralized by a pledge of the limited partnership interest. In March 2009, the assets owned by the partnership are valued at $500,000. (4) The client wants to decrease the principal amount of the note either to $325,000 or $390,000 (5) and decrease the interest rate payable on the note to 1.94 percent, (6) which would reduce the annual interest payable to $6,305.

This article addresses the federal transfer tax and income tax consequences that the client may incur if the principal amount or the interest rate of the promissory note issued by a grantor trust in an intrafamily installment sale is decreased.

Transfer Tax Consequences

A tax is imposed on the transfer of any property by gift or testamentary transfer by a citizen or resident of the U.S. (7) A gift is a transfer for less than adequate and full consideration in money or money's worth. (8) An additional generation skipping transfer tax (the GST tax) is imposed on such transfers that are made to a trust in which all beneficiaries are persons who are two or more generations below the generation assignment of the transferor (defined as skip persons). (9) The GST tax may be an issue because the trust that purchases the limited partnership interest typically includes skip persons. For purposes of this article, transfer taxes mean federal estate, gift, and GST taxes.

* Reduction in the Interest Rate on the Note--The promissory note issued in the intrafamily sale should have an interest rate at least equal to the current AFR. A note with an interest rate that is lower than the AFR is a "gift-loan" under I.R.C. [section] 7872(f)(3). The AFR is established monthly by the Treasury. (10) Although there are no published rulings, cases, or administrative pronouncements by the IRS on the reduction of the interest rate of a promissory note issued in an intrafamily sale, some practitioners have concluded that such reduction of the interest rate on the promissory note to the current AFR does not result in any transfer taxes provided the promissory note allows for prepayments. (11) The theory is that each note has a value equal to its stated face amount. Since the old note and the new note each have the same stated principal indebtedness, no transfer has taken place for transfer tax purposes.

* Reduction in the Principal In debtedness of the Note--There is little tax law addressing whether a reduction in the principal amount of a promissory note issued in an intrafamily sale under the facts of the example set forth above constitutes a gift by the seller/creditor or cancellation of debt (COD) income to the purchaser/borrower. (12) In the absence of services, such reduction is either a gift or COD income taxable to the maker of the promissory note under I.R.C. [section]...