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Estate Freeze Techniques

January 1, 2000

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Estate freeze techniques range from simple installment sale arrangements to complex arrangements involving private annuities, “grantor retained annuity trusts” (GRATs) and “intentionally defective grantor trusts” (IDGTs). No one approach fits all situations.

Installment Sales
Perhaps the easiest way to freeze asset value for estate tax purposes is to simply sell the asset for its current value, but structure the sale as an installment sale. With an installment sale, the sale price is paid in periodic installments over a fixed period of time, thus providing the seller with a stream of future income. If the asset that is sold appreciates in value over time, the appreciation is removed from the seller’s estate. A disadvantage of an installment sale is that, as with any sale, the seller must pay tax on the capital gains realized on the sale. (The buyer will have a basis in the property equal to the price paid for it.) The seller must also feel comfortable that the buyer, who might be a child or other family member, will have the necessary financial resources to make the periodic payments over time.

Use in family businesses.
Stock in a privately held company can be a good asset to transfer through an installment sale, particularly if the buyer is a family member who is working in the business or if the seller anticipates that there might be dramatic appreciation in value after an initial public offering. The seller will have locked in current value to protect his or her future cash flow, but will have also allowed the upside potential to be realized by the buyer.

Historical Note.
Prior to 1990, the more typical estate freeze technique used with family businesses was to split the ownership interests into two types: a preferred interest, which would retain a fixed right to income and a right to sell the ownership interest back to the company at a fixed value, and a common interest, which would have no such rights, but which would share in the ultimate growth of the business. Because the common interest had limited rights, for gift tax valuation purposes it would have a low value relative to the preferred interest. This freeze technique was curtailed by amendments to the Internal Revenue Code in 1990, which now requires that the common interest be valued without regard to the preferred interest unless specific requirements are met.

Flexibility.
An installment sale can be plain vanilla or uniquely tailored to specific circumstances. For example, instead of equal annual or monthly installments, the payment stream can increase or decrease in amount over time. The interest rate can be fixed or variable, although, generally, the seller will want to use an interest rate that is at least equal to the IRS minimum rate so as to avoid falling into the “bargain sale” tax rules. The promissory note can include a “self-canceling” feature, rescinding the sale if the seller dies before the full price is paid. Notably, however, in most cases, the seller does not need to survive the term of the installment note in order to ensure that future appreciation will escape tax. If the seller dies while an installment note is outstanding, then usually only the note, not the property, is included in the sellers estate. The continuing payments on the note can be a source of financial protection for the seller’s spouse or other survivors.

Installment Sale to an “Intentionally Defective Grantor Trust”(IDGT)
A more complex variation on the installment sale theme involves an installment sale to a grantor trust. Some families find this technique to be useful in transmitting wealth in a tax-efficient way because future appreciation can pass to the next generation without triggering a current capital gains tax on the sale.

Grantor Trusts.
A “grantor” trust is a trust where the creator of the trust is treated as the owner of the trust property for income tax purposes. In its simplest form, a grantor trust is one that you, as the grantor, create for your own benefit, that is funded with your own assets. However, you can also create a grantor trust with other beneficiaries, for whose benefit you pay the trusts income tax liabilities. This type of trust is called an “intentionally defective grantor trust” or “IDGT.” By paying the income taxes, the grantor is, in effect, making an additional gift to the trust beneficiaries.

If you make an installment sale of property to an IDGT, no capital gain would be realized on the sale, and no income would be realized when the trust pays interest on the installment obligation. Thus, for example, you could sell property to an IDGT created to benefit one of your children, and the trust could use earnings from the property to make the installment payments back to you, all without current capital gains or income tax consequences.

As an estate freeze technique, the use of an installment sale to an IDGT is considered to be fairly aggressive, and the intended tax results cannot be determined with absolute certainty. This technique has come under scrutiny from the IRS, so should only be entered into with a full understanding of the possible risks.

Annuity Interests
In lieu of selling property, another way of freezing value is to give property to beneficiaries. However, instead of making an outright gift, a gift coupled with a retained annuity or unitrust interest (i.e., a right to payments over time, often generated by the property being gifted) can protect the donor from the possible adverse financial consequences of giving away too much property too soon, as well as reduce the taxable value of the gift for gift tax purposes.

Grantor Retained Annuity Trusts (GRATs) and Grantor Retained Unitrusts (GRUTs)
One technique for gifting property away, but retaining cash flow from it is to use a “grantor retained annuity trust”(“GRAT”). To implement a GRAT, you would transfer property to a trust, which then pays you an annuity based on a percentage of the value of the property you transferred to the trust. Since the trust pays you an annuity amount based on the initial value of the property, any future appreciation in the value of the property will pass to the ultimate trust beneficiaries, who may be family members.

A variation on the GRAT technique is a “grantor retained unitrust” (“GRUT”). A GRUT is just like a GRAT, except that the amount paid out to the donor is re-calculated each year, based on a percentage of the then fair market value of the property owned by the trust.

GRATs and GRUTs continue for a fixed term of years. Because the ultimate beneficiaries do not get the trust property until after the term expires, the donor can claim a discount on the value of the property being transferred to the benefi-ciaries. The amount of the discount will depend on the term, the donor’s age at the time of the gift, and the IRS interest rates in effect at the time the trust is established. However, if the donor does not survive the trust term, the property will be included in the donors estate for tax purposes and the advantage of the discount will be lost.

GRATs and GRUTs will not be successful estate planning tools unless the earnings of the trust property, plus future appreciation, exceeds the amount to be paid out to the donor in annuity or unitrust payments. The type of property being transferred will also affect whether a GRAT or a GRUT is a better choice. For example, rental real estate in a hot real estate market may be a good asset for a GRAT, because the income stream is likely to be reliable, whereas if the trust property consists of a portfolio of speculative or growth stocks, a GRUT is probably a better choice.

As with other gifts, GRAT or GRUT benefi-ciaries receive a carryover basis in the property. That is, they will have the same cost basis in the property as the donor.

Private Annuity
An annuity arrangement does not require the creation of a trust. In a typical private annuity transaction, a parent transfers property to a child in return for that child’s unsecured promise to pay the parent an annuity amount for life. If the fair market value of the property transferred equals the present value of the annuity under IRS valuation tables, there is no gift tax due. However, if the property transferred does not grow at least as quickly as the required interest rate (for example, 8% in February 2000), or is not an income-generating asset, the child may end up having to pay the annuity with some of the property received.

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