I. INTRODUCTION

A grantor retained annuity trust (GRAT) or an installment sale to a grantor trust can be useful in transmitting wealth in a tax-efficient way, and often one of these techniques is superior to other estate planning options. These are in effect estate freeze techniques that capitalize on the mismatch between interest rates used to value transfers and the actual anticipated performance of the transferred asset. Sales to grantor trusts and many GRATs also capitalize on the lack of symmetry between the income tax rules governing grantor trusts and the estate tax rules governing includibility in the gross estate. Like most techniques, GRATs and sales to grantor trusts can be used conservatively, aggressively, or even recklessly, and some of the tax consequences are unclear. Moreover, like most techniques, their availability and usefulness must be evaluated on a case-by-case basis, with a view to the circumstances, and especially the arithmetic, in each case.

II. BASIC CONCEPTS

A. The Concept of Estate Freezing

  1. A gift is a freeze.

    1. Future appreciation escapes gift or estate tax. Thus, the best subject of a gift is a "hot asset" that will appreciate greatly over its fair market value today. [Clients usually know what these hot assets are. Lawyers don't.]
    2. Any gift tax paid also escapes tax, if the donor survives three years. Section 2035(b).
    3. An outright gift should be used as the baseline for all other freeze techniques. If a technique does not outperform an outright gift, the estate planner should carefully review the tax and non-tax reasons for recommending it.
  2. A sale is a freeze.

    1. The reasons are similar. The future appreciation escapes gift or estate tax, while the purchase price is generally frozen.
    2. An installment sale is simply a way to assist the buyer to make the purchase by allowing the purchase price to be paid in whole or in part out of the appreciation or earnings of the purchased asset (but not in such a way as to create in the seller a retained interest in the sold asset that is subject to the rules of section 2701, 2036, or 2038). In some cases, an installment sale also enables the seller to spread the taxable capital gain over several taxable periods (not applicable here).
    3. Thus, cash can be the subject of an installment sale. That is called a "loan." If the borrower invests the cash in something that produces a lot of income or appreciation, that is also a type of freeze – the income and appreciation accrue in the buyer's estate, not the seller's. A loan is an effective estate planning to the extent the borrower is able to use the loan proceeds to produce income or appreciation at a rate greater than the interest rate on the loan. But "sales" of cash are not very interesting.

B. The Concept of Leveraging, or Freezing off a Discount

  1. If what is given – or sold – has a value that is legitimately discounted, then the freeze shelters from future gift and estate tax not only the future appreciation in the intrinsic or ultimate value to the donee or buyer, but also (without regard to such future appreciation) the "appreciation" represented by the discount – that is, the difference between that intrinsic value and fair market value, the standard for estate and gift tax purposes. See Eastland, "Optimize Contribution to Grantor Retained Annuity Trust," 39 ESTATE PLANNING 3 (April 2012).
  2. See Reg. §§ 20.2031-1(b) & 25.2512-1. Reg. §§ 20.2031-1(b) & 25.2512-1; United States v. Cartwright, 411 U.S. 546, 551 (1973); Propstra v. United States, 680 F.2d 1248, 1252 (9th Cir. 1982); Estate of Andrews v. Commissioner, 79 T.C. 938, 952-53 (1982); Estate of Mellinger v. Commissioner, 112 T.C. 26 (1999), acq., AOD 99-006, 1999-35 I.R.B. 314; Rev. Rul. 93-12, 1993-1 C.B. 202.
  3. In the case of a GRAT, an additional "discount," in effect, is provided by the way the present value of the remainder interest, which is the measure of the taxable gift, is calculated. In the case of an installment sale, a similar economic effect is produced by the way the note is valued.

C. The Use of a Grantor Trust

  1. For this purpose, a grantor trust is a trust as to all of which the grantor is treated as the owner under section 671.
  2. Obvious advantages of using a grantor trust.

    1. No capital gain is realized on a sale. Rev. Rul. 85-13, 1985-1 C.B. 184.
    2. Since there is no tax, there is no concern about the additional interest under section 453A on deferred tax liability in excess of $5,000,000.
    3. No income is realized when the trust pays interest on an installment obligation to the grantor.
    4. No gain is realized if property is transferred to the grantor in kind in payment of any part of the annuity obligation in the case of a GRAT or the installment obligation in the case of a sale.
    5. The trust may be a shareholder of an S corporation, under section 1361(c)(2)(A)(i).
    6. The grantor, not the trust or the beneficiaries, will pay all the income taxes on income attributable to the trust.
    7. If a residence is held by a grantor trust, the grantor-beneficiary will be treated as the owner of the residence and the exclusion rules of section 121 will apply. See Reg. § 1.121-1(c)(3)(i).

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