Installment Sales to Grantor Trusts

An installment sale to a "grantor trust" can provide valuable income, gift and estate tax benefits. If the assets sold produce a total return (income and appreciation) in excess of the interest rate on the note, substantial wealth can be removed from the seller's gross estate - gift and estate tax free.

Design:

Following is a summary of the basic structure of a sale to a grantor trust:

1. The grantor creates an irrevocable trust for the benefit of his/her descendants. The trust is specifically designed so that the grantor is taxed on the trust's income, but the trust assets are not taxed in the grantor's estate. The trust can also be designed as a generation-skipping (dynasty) trust so that any trust assets remaining at a child's death pass - estate tax free - to grandchildren (and even more remote descendants, depending upon state law). Such an arrangement protects the beneficiaries from their inability, their disability their creditors and their predators, including divorced spouses.

2. The grantor makes a gift to the trust. For estate tax purposes this gift (or so-called "seed" money) should be equal to at least 10% of the value of the assets to be sold to the trust. This gift will use up a portion of the grantor's $1 million ($2 million for married couples) gift tax exemption. The gift can be made in cash or with the same assets to be sold to the grantor trust.

3. If the trust is designed as a generation-skipping trust, the grantor must allocate a portion of his/her generation-skipping transfer (GST) tax exemption to the trust to cover the amount of the seed money gift. The GST tax exemption is the same amount as the estate tax exemption, and the allocation is reported on a gift tax return (Form 709). While there is a present lapse in the estate and generation-skipping transfer taxes, it's likely that Congress will reinstate both taxes (perhaps even retroactively) some time during 2010. If not, on January 1, 2011, the estate tax exemption (which was $3.5 million in 2009) becomes $1 million, and the top estate tax rate (which was 45% in 2009) becomes 55%.

4. The grantor then sells assets to the trust that are expected to outperform the interest rate on the note. Typically, there is no down payment, interest is payable annually on the note, and a balloon payment would be due at the end of a set term ranging generally from 9 to 20 years. Ideally, the assets sold to the trust would generate income (to make the interest payments) and would also qualify for valuation discounts for lack of control and lack of marketability. For example, non-voting interests in an LLC or a Subchapter S corporation are often good assets to sell to a grantor trust. A grantor trust is also an eligible Subchapter S stockholder.

5. The interest rate on the note is fixed for the entire note term at the lowest rate allowed under the tax law. This rate is known as the Applicable Federal Rate ("AFR") and is published monthly by the Treasury Department. There are rates for loans of three years or less, for loans between three and nine years, and for loans over nine years.

Tax Advantages:

The installment sale to a grantor trust is one of the most (if not the most) popular wealth transfer planning techniques being used today. Following is a summary of the tax benefits it provides:

1. The grantor recognizes no gain or loss on the sale. The reason is that the grantor and the trust are considered one and the same person for income tax purposes. However, the trust's basis in the assets purchased is not the purchase price paid for the assets, but instead the grantor's basis.

2. The grantor is not taxed separately on the interest payments the grantor receives. Moreover, if the trust makes payments in kind (by returning some of the assets purchased), the grantor recognizes no gain. Instead, the grantor is taxed on all of the trust's income. In essence, the grantor is making a tax-free gift to the trust's beneficiaries by paying the trust's income taxes.

3. If the total return on the assets sold to the trust exceeds the interest rate on the note, assets are transferred tax free to the trust's beneficiaries. The transfer tax benefits are enhanced by the grantor's payment of the trust's income taxes. Essentially, the trust grows income tax free. These "excess" trust assets can be reinvested as the trustee decides, including purchasing life insurance on the grantor and/or grantor's spouse's lives.

4. If designed as a generation-skipping trust, the assets in the trust can escape estate taxation in the estates of the grantor's children, grandchildren, and perhaps even great-grandchildren (depending on state law).

5. The future growth (equity) in the trust provides additional equity with which to support future installment sales within the 10% test referred to above.

Summary:

Selling assets to beneficiaries on the installment method has long been a popular estate freezing strategy, particularly in times of low interest rates. The sale works even better if it is made to a grantor trust rather than to the beneficiaries directly. Selling to a grantor trust not only enables the seller to make additional tax-free gifts (in the form of income tax payments on trust income), but also avoids any capital gains tax on the sale. If designed as a generation-skipping (dynasty) trust, the trust can benefit children, grandchildren and possibly even more remote descendants without paying estate taxes at each successive generation. These tax advantages, coupled with the asset protection afforded the beneficiaries, including protection from divorce, make the sale to a grantor /dynasty trust an outstanding wealth transfer technique.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION.

Julius Giarmarco, J.D., LL.M, is an estate planning attorney and chairs the Trusts and Estates Practice Group of Giarmarco, Mullins & Horton, P.C., in Troy, Michigan.

For more articles on estate and business succession planning, please visit the author's website, www.disinherit-irs.com, and click on "Advisor Resources".