An installment sale to a grantor trust is a traditionally used strategy for shifting future appreciation, primarily through (1) the grantor’s payment of the trust’s income taxes under the grantor trust rules, (2) future appreciation of the sold assets in excess of the interest rate on the note to the grantor (typically using the AFR as the interest rate), and (3)
fractionalization discounts. For a brief summary of best practices regarding sale to grantor trust transactions, see Item 14 of the “2012 Heckerling Musings and Other Current Developments” (summarizing a panel discussion by John Bergner, Ann Burns and David Handler) found here.
A corollary strategy is a sale to a “spousal grantor trust.” If a sale is made to a grantor trust for the client that is created by the client’s spouse, no gain would be recognized on the sale transfer as a result of §1041. As with “standard” sales to grantor trusts, the combined income/appreciation of the trust assets in excess of the small interest rate on the note will be excluded from the client’s estate. The client may be particularly willing to engage in transfer planning opportunities with this trust because the client is a discretionary beneficiary of the trust.
A particular tax advantage of this transaction is that the client could be given a power of appointment. If the sale results in a gift element, it would be an incomplete gift. That portion of the trust would continue to be included in the grantor’s estate, but the client would have achieved the goal of transferring as much as possible at the lowest possible price without current gift tax exposure. Gain would not be recognized on the sale, but a downside to this approach is that the selling spouse would recognize interest income when the spouse’s grantor trust makes interest payments (although the spouse would likely receive an offsetting investment interest deduction). Gibbs v. Commissioner, T.C. Memo 1997-196.
www.bessemer.com/advisor 131 A concern with this approach is that the full appreciation in the asset that is “sold/given” to the trust would be included in the grantor’s gross estate, less a §2043 consideration offset for the value of the consideration (i.e., the note amount). A preferable approach would be to use a defined value transfer approach, to transfer a fraction of an asset in the sale transaction. For example, if the asset is believed to be worth $1 million, the formula could transfer a fraction of the asset with a numerator of $1 million and a denominator equal to the finally determined gift tax value of the property. The combined defined value clause and incomplete gift trust gives protection against the gift tax and minimizes potential estate inclusion.
Another approach is to use two trusts. For example, H funds Trust A with, say, $200,000. W funds Trust B with $10. W has a testamentary power of appointment over both trusts. The trust agreement provides that transfers to the trustee will generally be allocated to Trust A, but any gifts from W will be allocated to Trust B. W sells Blackacre (which she thinks is worth $1 million) to the trusts in return for a note from Trust A for $1 million. Effects of this approach are as follows.
• Seed Gift Required. A significant seed gift to the trust will be necessary before the spouse makes the sale.
• W is a Discretionary Beneficiary and Has a Power of Appointment. W is a discretionary beneficiary and has a power of appointment over the trust, which means that W will be more comfortable selling favorable assets to the trust without fear of losing control and having no beneficial interest in the assets. Even so, all of the appreciation will be excluded from her estate (but if Blackacre is worth more than $1 million, the fractional portion of the excess value will be included in her estate).
• Income Tax. There is no gain recognition on W’s sale to H’s grantor trust. §1041. However, the selling spouse would recognize interest income when the spouse’s grantor trust makes interest payments (although the spouse would likely receive an offsetting investment interest deduction). Gibbs v. Commissioner, T.C. Memo 1997-196.
• Gift Tax. W will not make a gift even if Blackacre ends up being worth more than $1 million (because she has a testamentary power of appointment).
• Estate Tax Effect for H. The trusts are designed so that the trusts are not included in H’s estate.
• Estate Tax Effect for W. W could be a potential beneficiary of the trusts. However, even if she is a beneficiary, Trust A should not be included in her estate because she never made a gift transfer to Trust A. The advantage of using the separate Trust B is that if there is a gift element in the transfer of Blackacre the fractional portion of Blackacre represented by the gift would pass to Trust B, so that none of the appreciation in the portion equal to $1 million that passed to Trust A will be included in W’s gross estate. (If a single trust had been used, and if a portion of the transfer was deemed to be a gift, the entire appreciation in Blackacre might be included in W’s estate less a §2043 consideration offset for the $1 million note.)
www.bessemer.com/advisor 132 • Creditors. To the extent that Blackacre is worth $1 million, W has not made a gift
to a trust of which she is a discretionary beneficiary, so W’s creditors should not be able to reach the trust. To the extent that Blackacre is worth more than $1
million, the excess portion would be a gift from W to a self-settled trust that could be reached by her creditors (unless the trust is established in a “self-settled trust state”).
Possible disadvantages of this strategy are: (i) a substantial seed gift to the trust will be necessary before the client makes the sale to the trust; (ii) there is a potential step
transaction risk; and (iii) if the client is deemed to be the “transferor” of the property that is sold to the trust, the client’s creditors may be able to reach the trust assets.