The current economy has created a great opportunity for individuals to transfer assets, and future appreciation of such assets, with little to no transfer tax. This opportunity is created by the depressed asset values and historic low applicable federal interest rates (“AFRs”), which are the minimum interest rates, set monthly, permitted by the IRS. (The current AFR for a loan with a term under three years is 0.19%, three to nine years is 1.17% and over nine years is 2.63%.)
The federal gift tax is imposed on all lifetime gifts that exceed the annual exclusion from gift tax (currently $13,000 per person), and the federal estate tax is imposed on the value of all assets and property that an individual owns at the time of death. Each individual, however, has an exemption of $5,120,000 against the gift and estate tax.
A gift during life of an appreciating asset can reap great transfer tax advantages. The gift in essence “freezes” the value of the asset because all post-gift appreciation is excluded from the individual’s estate. For example, if an individual gifts an asset worth $1,000,000, $1,000,000 of his or her gift tax exemption is applied against the gift resulting in no current gift tax and the use of a portion of his or her estate tax exemption available at death. If the value of the gifted asset increases to $1,500,000 by the time of the individual’s death, the individual succeeded in removing $500,000 of appreciation from his or her estate.
An individual can also take advantage of depressed asset values and low AFRs to pass some or all of the interest in an asset without using any applicable exemption against federal gift and estate tax. This is accomplished by selling all or a portion of the asset through an installment sale to an income tax defective grantor trust. An interest in a closely held business or other non liquid assets are good candidates for this technique.
An income tax defective grantor trust is simply an irrevocable trust created for the benefit of an individual’s (the “Grantor’s) beneficiaries (typically his or her children and descendants) (the “Trust”). The terms of the Trust provide the Grantor with certain powers that cause the Trust assets to be owned by the Trust for federal gift and estate tax purposes, yet owned by the Grantor for federal income tax purposes. Therefore, the Trust assets are not taxed as part of the Grantor’s estate, but the Grantor remains responsible for income tax related to the assets.
The Trust is typically funded with some cash, which gives the Trust economic viability and is used as a down payment to purchase the asset from the Grantor. The remaining purchase price of the asset is then financed through an installment note at the prevailing AFR, and the term of the note can be selected to take advantage of the most favorable AFR (short-term, mid-term or long-term).
Because the Trust is disregarded for income tax purposes, no gain or loss is recognized by the Grantor on the installment sale to the Trust, and the interest paid on the installment note is not taxable to the Grantor as the seller. As the owner of the Trust for income tax purposes, however, the Grantor reports all of the Trust’s income, deductions and credits on his or her income tax return, even though the Trust receives the income.
Since the Grantor receives cash and an installment note for the fair market value of the asset, the value of the Grantor’s taxable estate is the same as before the sale. The Trust asset (which could be discounted based on various ownership restrictions depending on the type of asset), however, is not included in the Grantor’s taxable estate, and thus any post-installment sale appreciation is excluded from the Grantor’s estate. The Grantor gains the same result as shown in the example of the lifetime gift without using any of his or her applicable exemption. Further, the Grantor’s total estate may decrease further because: (1) the value of the installment note will decline each year, dropping to zero if the installment note is paid in full; (2) the Grantor is more likely to use the cash provided by the installment note; and (3) the Grantor will continue to pay the income tax for the Trust.
The installment sale transaction does have a number of risks. The IRS could contest the valuation of the asset, causing gift tax liability to the Grantor. Second, the IRS could challenge the grantor trust status of the Trust, causing the Trust to be treated as the owner for both gift and estate tax and income tax purposes and resulting in capital gain tax liability on the sale. Last, the IRS may try to attack this type of transaction as an incomplete transfer or as a retained life interest by the Grantor, causing the asset to be included in the Grantor’s estate. Therefore, to reduce these risks, it is very important to obtain a good appraisal of the asset to establish the proper value, to ensure the Trust is properly drafted to include all required terms to separate the tax treatment and to follow the proper procedures for the installment sale.
The advantages of the installment sale transaction are seen when the note is paid in full. The Trust could continue as a family investment vehicle or could terminate with outright distributions of the asset to the beneficiaries of the Trust.
In summary, the advantages of the installment sale to the Trust are:
1. The fair market value of the property sold to the Trust is the value of property at the time of the sale, reduced by any applicable discounts due to the lack of marketability and lack of control inherent in the asset;
2. The value to the Grantor is “frozen” at the sales price, meaning any future appreciation in the asset passes to the beneficiaries of the Trust free of estate and gift tax;
3. No capital gain is recognized upon the sale of the asset to the Trust, and there is no income tax on any installment note interest paid by the Trust;
4. The Grantor is responsible for paying the income tax on the income earned by the Trust, which is the equivalent of making a gift of the income tax amount to the Trust each year;
5. Since the sale is for fair market value, the Grantor does not use any applicable exemption against gift and estate tax and is not required to file a gift tax return; and
6. Both substantial current value and future appreciation is shifted from one generation to the next, while significantly reducing estate and gift tax, and substantial transfer tax savings can be achieved when coupled with a well-implemented estate plan.