GRATs,Sales,Grantor,Trusts,Pri law GRATs, Sales to Grantor Trusts, or Private Annuities: Which

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Because these techniques produce little, if any, taxable gifts, even those clients who anticipate estate tax repeal (or reform) should not be reluctant to use them. All three techniques also provide the transferor with an income stream for a fixed period. Finally, all three techniques take advantage of the actual rate of return on the transferred assets as compared to the assumed rate of return utilized by the IRS to value the transferred asset. Yet each technique has its advantages and disadvantages when compared to the others.Grantor Retained Annuity Trust (GRAT).In the typical GRAT, the grantor contributes income-producing assets (i.e., Subchapter S stock or an interest in an FLP or FLLC) to a trust and receives a fixed payment (the annuity) from the trust each year. Whatever remains in the trust when the GRAT term ends passes to the remainder beneficiaries tax free. For the year the GRAT is created, the grantor has made a taxable gift equal to the difference between the amount contributed (after considering valuation discounts) and the present value of the annuity payments that the grantor will receive. This present value calculation is computed using the IRC Section 7520 rate for the month the GRAT is established. The Section 7520 rate is 120 percent of the annual mid-term applicable federal rate (AFR). Savvy planners will select the combination of annuity payment and trust term that will result in the present value of all future annuity payments equaling the amount initially contributed to the trust. Thus, no (or little) gift tax will be levied. If the GRAT's actual rate of return exceeds the Section 7520 rate, the excess appreciation will pass to the GRAT remaindermen free of transfer taxes. Additional transfer tax savings occur because the grantor is not separately taxed on the annuity payments, but instead is responsible for paying all of the GRAT's income taxes. This is because the GRAT will be a "grantor" trust. Rev. Rul. 2004-64. This tax payment is effectively a tax-free gift to the GRAT's remainder beneficiaries to the extent the GRAT's income exceeds the annuity payments.If the grantor dies during the GRAT term, a portion of the GRAT's assets are included in the grantor's estate. The portion so included in the amount necessary to produce the retained interest in perpetuity (as if the annuity amount were the annual income of the GRAT's assets) using the IRC Section 7520 rate in effect on the date of death (or the alternate valuation date). Generally, if a GRAT's assets have substantially appreciated, there will be a significant tax-free transfer of wealth even if the grantor dies during the term.Intentionally Defective Irrevocable Trust (IDIT).An intentionally defective irrevocable trust is an irrevocable trust that the grantor purposely creates to be "defective" for income tax purposes, but "effective" for transfer tax purposes. If properly designed, the IRS treats the grantor as the owner of the trust's assets only for income tax purposes (a so-called "grantor" trust). After the IDIT is established and a small gift (i.e., seed money) is made to the trust, the grantor sells income-producing assets (i.e., Subchapter S stock or interests in a family LLC) to the trust in exchange for the trust's installment note. The sales price will consider valuation discounts.In the typical sale to an IDIT no down payment is made, the IDIT pays the grantor annually interest only at the AFR for the month of the sale, and there is a balloon payment at the end of nine or more years. Because the sale is between the grantor and his/her grantor trust, the IRS does not recognize any gain or loss on the sale. Under Rev. Rul. 85-13, transactions between a grantor and his/her grantor trust are disregarded for income tax purposes. If the assets in the IDIT appreciate greater than the AFR, such excess value is removed from the grantor's estate. Additional transfer tax savings occur because the grantor is not separately taxed on the interest payments, but instead is responsible for paying all of the IDIT's income taxes. This tax payment is effectively a tax-free gift to the beneficiaries of the IDIT to the extent the IDIT's income exceeds the interest payments. Rev. Rul. 2004-64.Private Annuity.A private annuity is a contractual arrangement that is very much like an installment sale, except that the payments must continue until the seller's death. In the typical private annuity, a parent (seller) sells income producing assets (i.e., Subchapter S stock or interests in a family LLC) to a child (buyer). The sales price will consider valuation discounts. The buyer takes legal title to the property and promises to make payments (the annuity) to the seller for the rest of the seller's lifetime. The amount of the annuity is determined by IRS actuarial tables established under IRC Section 7520. Until April 18, 2007, the annuitant (seller) was able to report the built-in gain on the property sold piecemeal as part of each annuity payment. Under current law, the entire amount of the seller's gain or loss (if any) must be recognized at the time of sale. Thus, part of each payment will now be a tax-free return of basis and part will be interest income. Each payment made by the purchaser is added to his/her basis in the property and no portion of the payment is deductible to the seller. If the value of the private annuity received by the seller equals the transferred property's fair market value, then no gift tax will be incurred.How They Stack UpMortality Risk. In a GRAT, if the grantor does not survive the fixed term, a portion of the assets in the GRAT are included in the grantor's estate. In contrast, there is no such mortality risk with an IDIT. However, with an IDIT there is a risk that if the grantor dies before the note is paid off, any gain on the outstanding note must be recognized. With a private annuity, a short life span simply enhances the efficacy of the transaction. It must be noted, however, that the actuarial tables cannot be used to determine the amount of the private annuity where the seller is "terminally ill" (i.e., has at least a 50 percent probability of dying within one year of the sale).Disadvantage: GRAT. Taxable Gift. As a result of the Tax Court's holding in Walton, 115 T.C. 589, it is now possible to "zero-out" a GRAT so that no taxable gift occurs. For sales to an IDIT, most planners believe that the IDIT should have some equity (seed money) to avoid potential transfer tax issues. Therefore, it is advisable for the grantor to make a gift to the IDIT in the range of 10 percent of the value of the property to be sold to the trust. Private annuities can be easily structured without incurring a taxable gift.Disadvantage: IDIT. Hard To Value Assets. Where hard to value assets are involved, or where valuation discounts are being taken, the GRAT offers a significant advantage over an IDIT or a private annuity. The reason is that the GRAT regulations allow the annuity to be set forth as a percentage of the initial value of the assets transferred to the GRAT. Therefore, if the GRAT's assets are revalued as a result of a gift tax audit, the amount of the annuity automatically adjusts thereby minimizing any unexpected gift tax.Advantage: GRAT. Generation Skipping Tax Exemption. Because of the estate tax inclusion period (ETIP) rules, the grantor's generation skipping tax (GST) exemption cannot be allocated to the initial contribution to the GRAT. Instead, the grantor must wait until the end of the GRAT term to allocate his/her GST exemption. With an IDIT, the grantor can allocate his/her GST exemption, but only has to do so to the extent of any seed money gifted to the IDIT. Since a private annuity does not usually generate a taxable gift, there are no GST implications to that technique.Disadvantage: GRAT. Grantor Trust Status. As mentioned above, the grantor's payment of income taxes on behalf of a "grantor trust" is effectively a tax-free gift to the trust's beneficiaries. Since GRATs and IDITs are both grantor trusts, to the extent that their income exceeds the annuity payment (for GRATs) or the interest payment (for IDITs), such excess is transferred to the trust's beneficiaries tax-free. No such opportunity is available with a standard private annuity transaction, unless the sale is made to a private annuity trust designed as an IDIT.Disadvantage: Private Annuity.Interest Rates. The lower the assumed interest rate the more leverage possible. For GRATs and private annuities the assumed interest rate is the IRC Section 7520 rate which is 120 percent of the mid-term AFR. In comparison, the installment note used in a sale to an IDIT need bear interest at only the AFR.Advantage: IDIT.Backloading. With a GRAT, the annuity payment can increase annually, but not more than 20% over the previous year. A private annuity requires equal periodic payments. In contrast, most installment sales to IDITs are structured as interest-only with a balloon payment. Therefore, the less paid out annually to the grantor, the more appreciation passing to the grantor's heirs.Advantage: IDIT.Security. A private annuity cannot be secured. Thus, the seller must rely on the buyer's ability to pay. In comparison, with GRATs and IDITs, the grantor is protected because the transferred assets are held in trust until the end of the term (with GRATs) or until the note is fully paid (with IDITs).Disadvantage: Private Annuity.Overpayment. The total amount to be paid to the grantor with either a GRAT or IDIT is fixed. However, with a private annuity, if the seller lives past his/her life expectancy, it is possible that all of the assets sold (plus the appreciation thereon) will be returned to the seller, and possibly some of the purchaser's assets as well. ôEUREUR¹ Disadvantage: Private Annuity. Gain Recognition. GRATs and IDITs (where the installment note is paid prior to the grantor's death) involve no gain recognition to the grantor. In contrast, private annuities cause the transferor to recognize gain at the time of the sale.Disadvantage: Private Annuity.Certainty. A GRAT is a statutory technique governed by IRC Section 2702. Private annuities are generally governed by the regulations under IRC Section 7520. In comparison, installment sales to IDITs are based upon an amalgamation of public and private revenue rulings and case law.Disadvantage: IDIT.Life Insurance Applications. Life insurance can add value to all three wealth transfer techniques. In the context of a GRAT, a policy on the grantor's life owned by an irrevocable trust can be used as a "hedge" to provide the liquidity - both income and estate tax free - to pay the estate taxes due if the grantor does not survive the GRAT term. With the typical IDIT, the income earned by the trust (in excess of the interest payments due the grantor) can be used to purchase life insurance thereby "leveraging" the grantor's GST exemption. Finally, with a private annuity, a policy on the buyer's life can provide a source of funds to "assure" the annuity payments continue in the event the buyer predeceases the seller.Advantage: Life Insurance.Conclusion. Whether a GRAT, IDIT or private annuity should be used in a particular situation is fact specific. Each technique, while similar in many ways, has advantages and disadvantages when compared to the other two strategies. Thus, a careful analysis of each strategy must be made (preferably with the client's involvement) before implementing a particular course of action.THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.