(Although an early ruling viewed the payment by father of the income tax liability of the trust as a taxable gift to trust beneficiaries, that argument was abandoned.) Moreover, the income tax liability of the family trust - perhaps $20,000 - will be paid by father, since the trust is a wholly grantor trust with respect to father. Since the trust is obligated to make only a $15,000 interest payment, $35,000 in growth is shifted out of the estate. If the property produces annual income of 10 percent, the value of the underlying assets in the partnership interest purchased by the family trust would increase by $50,000 in year one.
The note requires interest in year one of $15,000, which is 6 percent of $250,000. Thus, the principal amount of the note is $250,000. Although 50 percent of the value of the real estate is $500,000, the discounted value is $250,000. Upon the advice of appraiser, father takes a 50 percent discount for the real estate within the FLP. The note bears interest at the AFR of 6 percent, pursuant to IRC § 1274(b). Father sells a 50 percent limited partnership interest to family trust in exchange for a 15-year interest only, balloon principal, promissory note. To illustrate, assume FLP owns appreciating real estate worth $1 million. The reduction in purchase price will further enhance the estate planning attributes of the transaction by stemming “leakage” back into the grantor’s estate. If discounted partnership assets are sold to the trust, the sale price - and consequently the principal amount of the note as well as interest payments - can be reduced.
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The sale accomplishes the following: (i) the asset, as well as future appreciation, is shifted out of the estate (ii) “leakage” back into the estate is minimized by reason of the low interest rate of the note (iii) the obligation to pay trust income tax remains that of the grantor, thereby enabling trust assets to grow without diminution for income taxes - accomplishing a gift-tax free payment of the trust’s income tax liability by the grantor (hence, the term “defective”) and (iv) asset protection against potential creditors of the grantor and trust beneficiaries. Assets (which could include partnership interests) are sold by the grantor to the trust in exchange for a promissory note. Sales to “defective” grantor trusts are useful where the size of the estate exceeds the $2 million lifetime exemption. The largest discounts, which may exceed 50 percent, arise with respect to family entities owning real estate. Various discounts, which reflect the lack of control and the lack of transferability of the transferred interests, as well as built-in capital gains tax liability, have enabled the estate planners to leverage both the $1 million gift tax exemption and the $2 million lifetime exemption. Gifts of partnership interests shift wealth and future appreciation, and are effective in transferring management and control of family businesses to younger generations. The IRS has been most successful where the transactions with not imbued with a sufficient quantum of non-tax objectives, or the economics of the transaction were questionable, most often because the grantor had not left himself with sufficient assets to live according to his accustomed standard without receiving partnership (or trust) distributions. The IRS has been successful in arguing that IRC § 2036(a) requires the inclusion in the decedent’s estate of (i) partnership assets if the decedent continued to derive benefits from the partnership, or of (ii) trust assets, if the decedent continued to receive distributions, disguised in the form of a note, from assets sold to a “defective” grantor trust. However, the IRS discovered a potent weapon in IRC § 2036(a), which provides that the value of the gross estate includes the value of all property to the extent the decedent has made a transfer but has retained (i) the possession or enjoyment of, or the right to income from, the property, or (ii) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.
Until recently, most IRS arguments had been rather unsuccessful. The IRS has advanced many theories to challenge the gift and estate tax savings occasioned by the use of family entities and grantor trusts in estate planning.
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Printer-friendly PDF Memorandum: The IRC § 2036 Trap in Planning With FLPs & Grantor Trusts.wpd
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