Top 10 estates planning strategies.

• Author: Capassakis, Evelyn M.
• Position: Part 2

EXECUTIVE SUMMARY

* Because an IDIT is not a creature of statute or regulation, a client must be willing to risk IRS scrutiny.

* In the right circumstances, sales of assets to family members in exchange for an annuity or installment note have significant estate planning benefits.

* The Service has argued that there is no business purpose for the existence of a FLP, and that it should be ignored for estate and gift tax valuation purposes.

Every estate planner has an arsenal of favorite techniques to offer clients. Part II of this two-part article presents five more of the author's favorite methods: use of intentionally defective irrevocable trusts, private annuities and self-canceling installment notes, charitable lead trusts, charitable remainder trusts and family limited partnerships. The article discusses how these techniques work, the types of clients for which each is suitable and technical and planning considerations.

The first part of this two-part article, in the January 2001 issue, discussed five top estate planning techniques: use of lifetime gifts, insurance trusts, dynasty trusts, qualified personal residence trusts and grantor retained annuity trusts (GNATs).(19) Part II, below, examines five more strategies for reducing estate and gift taxes.

Six: Sales to IDITs

A common technique that has gained in popularity in recent years is the sale of an asset to an intentionally defective irrevocable trust (IDIT), a grantor trust created by the seller.

How They Work

The installment sale of property to an IDIT is an estate-freezing technique similar to a GNAT, but takes advantage of the differences between the estate tax rules and the income tax rules governing property ownership. The trust is intentionally drafted so that the creator is treated as the owner for income tax purposes (i.e., a grantor trust). Because of the grantor trust status, the trust is treated as the creator's alter ego; the sale of assets to the trust does not trigger gain recognition.(20)

The grantor then sells assets to the trust in exchange for an interest-bearing note. Because the transaction is structured as a sale, the note bears interest at the applicable Federal rate (AFR) under Sec. 1274, rather than under Sec. 7520 (which is typically used for gifts and thus tends to be higher). The face amount of the note is the fair market value (FMV) of the assets sold, and takes into account any lack of marketability and minority interest discounts. The primary benefit of making an installment sale to an IDIT is that, to the extent the assets generate more than the applicable interest rate in combined income and appreciation, such excess will pass to the trust beneficiaries transfer tax-free.

Suitable Clients

Appreciation Potential

An IDIT works best for a client with assets expected to appreciate significantly (similar to a GNAT), so that appreciation can shift to heirs without gift tax. Ideally, the yield on the property sold to the trust should exceed the note's interest rate.

Risk Tolerance

Because IDIT principles are not statutory or regulatory (unlike a GNAT or qualified personal residence trust), a client who uses an IDIT must be willing to risk IRs scrutiny.

GST Planning

An IDIT is a useful vehicle for a client interested in generation-skipping transfer (GST) tax planning (as opposed to a GNAT, for instance); the GST exemption may be allocated to the trust, because the grantor has not retained an interest in the trust.

Planning Considerations

Grantor Trust Status

As mentioned above, for income tax purposes only, an IDIT is treated as nonexistent if the grantor is considered to have certain interests or powers that cause the trust to be treated as a grantor trust. Care must be taken to ensure that the powers chosen have the desired income tax effect, but do not cause inclusion in the grantor's estate for estate tax purposes. Because the trust is disregarded for income tax purposes, it will inherit the grantor's basis while the grantor is alive. The grantor will continue to be taxed individually on the income and gains the IDIT generates. By paying the income tax on trust income, the grantor effectively makes additional gift-tax-free transfers to the IDIT's beneficiaries.

Bona Fide Sale

For an IDIT to work, the transfer to the trust must be structured as a bona fide sale, rather than as a gift. Therefore, the property's FMV must be accurately determined. Also, the note must have commercially reasonable terms, so that it represents adequate and full consideration for the property sold. The purchase price in the IDIT note can be expressed in terms of a formula, but it is not clear whether the IRS would respect such a formula.(21)

Estate and Gift Considerations

For estate and gift tax purposes, gifts or sales to the trust are treated as completed transactions between the grantor and the trust. Thus, property owned by the trust will not be treated as part of the grantor's estate for estate tax purposes.

To achieve this result, the sale and the trust must be structured so that the grantor does not retain any "strings" over the property that would trigger inclusion in the estate under Sec. 2036 or 2038. In addition, as mentioned above, because the sale is at FMV, no gift occurs. If a gift is involved, the entire property could be included in the gross estate under Sec. 2036(a). Thus, an appraisal should be obtained to substantiate FMV.

Trust Capitalization

In addition, if no assets are available to finance the interest payments on the note other than income from the assets sold, it is easier for the Service to argue that the grantor transferred assets to the trust and indirectly retained the right to their income, causing inclusion of the trust property in the grantor's estate under Sec. 2036.(22) Accordingly, it is advisable either to use an existing grantor trust as the IDIT sale vehicle, or to transfer other assets to the trust. Of course, the transfer of other assets is subject to the gift tax rules. Generally, the trust should be capitalized with assets having a value of more than 10% of the note's face amount. Otherwise, the Service has a better argument that the note is not true debt but, rather, equity contributed by the grantor with a retained income interest.

Commercial Reasonableness

In determining FMV, numerous other factors should also be considered. In particular, whether the note is commercially reasonable is a factor in determining whether the transaction is bona fide and at arm's length, as opposed to a gift.

For example, is the note secured? In commercial transactions, a note is often secured by the debtor's property, so that the lender can be better assured of repayment. Lack of security is evidence that the transaction is not at arm's length. On the other hand, if the note is secured by the property sold to the trust (particularly when the income generated by the property is closely tied to the payments on the note), it can be argued that the transferor transferred the property and retained the right to income therefrom, in the form of the interest stream from the payments on the note. Thus, it might be argued that the property should be included in the transferor's estate for estate tax purposes under Sec. 2036.

One possible way to support the commercial reasonableness of the sale without using the property as security is to have the principal trust beneficiary (assuming a competent adult) guarantee the note. In this way there may be someone with greater assets than the trust (or at least, an individual with potential access to trust income) responsible for note payments, thereby bolstering its value. However, the gift and estate tax consequences to the guarantor of such a guarantee (if any) are not clear. If the beneficiary is not compensated for the guarantee, it can be argued that the beneficiary has made a gift of the guarantee's FMV to the trust.

Another issue is whether the note has a fixed term or is a demand note, and the interest rate it bears. Generally, the shorter the term, the lower the interest rate. A demand note is treated as a short-term note, and thus has the lowest interest rate. Arguably, although a demand note bears the lowest rate of interest, it is not the ideal form. The Service ,nay take the position that the continuing failure to exercise the demand is not commercially reasonable and is a gift under Sec. 7872 in the amount of the forgone higher interest that could have been received based on changing interest rates over time. One way around this might be to have a term locked in for one year. At the end of the year, the note could be callable for a limited time, and, if not called, extended with a current interest rate.

Income Tax Considerations and Mortality Risk

What are the income tax consequences if the grantor dies while the note is outstanding? Although no gain is triggered on the sale or from any other transaction between the grantor and the trust during the grantor's life, the IRS may argue that the grantor's death (which causes grantor trust status to cease) results in a deemed sale, triggering income equal to the FMV of the amount unpaid under the note.(23)

The Service made a similar argument in Letter Ruling (TAM) 200011005,(24) in which the termination of a GRAT'S grantor trust status triggered gain to the grantor in the amount of any outstanding note. This factor argues in favor of ensuring that the trust pays off the note while the grantor is still alive, so that the trust stays a grantor trust.

Satisfying the Note

There are several methods of satisfying the note, including the following:

* The trust can borrow from another source.

* All or a portion of the purchased trust property (including income earned thereon) can be returned to the seller in satisfaction of the note (although an independent appraisal will most likely be necessary if the property is not publicly traded).

* The remainder of the note can be discharged in the form of a gift.

* The trustee can...