The sale to a grantor trust is an estate planning strategy that has been used by practitioners for years. 1 In recent years, however, the IRS apparently has set its sights on this technique. In Karmazin, 2 the Service challenged the sale strategy on several fronts—among them, that the promissory note issued to the grantor by the trust was equity and not debt. The Service argued that a nine-to-one debt-to-equity ratio was high, that there was insufficient partnership income to support the debt and thus the note should be considered equity.
Although the Service settled Karmazin with the taxpayer in October 2003, the case validates the concern that practitioners have voiced over the years regarding the debt-to-equity ratio in sales transactions. This article focuses on a unique technique to increase the equity of a trust, without triggering gift tax—"incomplete equity."
In a sale to a grantor trust, the grantor sells assets (e.g., stock, partnership interests) to the trust in exchange for a promissory note issued by the trust. As long as the note bears interest at the appropriate "applicable federal rate" ("AFR"), the value of the note for gift tax purposes is its face amount, and no gift occurs upon the sale. 3 Because the sale is made to a grantor trust with respect to the grantor, the loan evidenced by the note is treated as being between the grantor and himself for income tax purposes. 4 As a result, the grantor does not recognize gain on the sale or interest income on account of the note.
All income earned by, and all appreciation in the value of, the property held by the grantor trust in excess of the interest and principal payable by the trust under the promissory note will accrue to the benefit of the trust beneficiaries free of gift and estate taxes. Furthermore, as in the case of all grantor trusts, the grantor's payments of income tax in respect of income earned by the trust are, in effect, gift tax-free transfers to the trust. 5
Debt-to-equity ratio. Even prior to Karmazin, practitioners cautioned that, if the debt-to-equity ratio of the grantor trust was too high, the Service could argue that the transaction should be treated as a gift (or a part gift/part sale) on the theory that, because the trust was undercapitalized (making the note a riskier investment), no seller in an arm's-length transaction would agree to sell his assets, for a note, to a purchaser lacking creditworthiness. If such an argument were to succeed, part or all of the property could be includable in the grantor's estate under Section 2036, because the grantor would have made a transfer with a retained life interest. Moreover, because the payment due under the note to the grantor would not be a "qualified interest," the grantor's retained interest (the note) could be given a value of zero under Section 2702, resulting in a taxable gift of the property "sold."
In light of the foregoing risks, many practitioners have recommended that the debt-to-equity ratio of the grantor trust should be kept as low as possible, commonly no more than 9:1, so that the debt is no more than 90% of the trust assets after the sale. 6 Limiting the debt of the trust in this manner is an attempt to ensure that the trust has equity—i.e., other property, the income or principal of which can be used to make payments on the note payable to the grantor. The debt-to-equity ratio of the trust goes to the creditworthiness of the trust. The trust's equity lessens the "link" between the note to the grantor and the assets sold to the trust, and presumably reduces the risk that the Service would succeed in arguing that the grantor had "retained" an interest in the assets sold to the trust.
The concerns of practitioners were confirmed in Karmazin. Mrs. Karmazin had formed a grantor trust for her children and then both gifted and sold units in a limited partnership to the trust. The trust issued a promissory note payable to the grantor at an interest rate equal to the AFR of 5.8%. The Service contended that the promissory note was equity and not valid debt—a characterization that would have made Section 2702 applicable and treated the sale to the trust as a gift.
The Service made several arguments in support of its claim. It argued that: (1) commercial lenders would not permit borrowing equal to the face amount of the promissory note without personal guarantees or a larger down payment, (2) the debt-to-equity ratio of 9:1 was too high (suggesting undercapitalization), and (3) there was insufficient partnership income (the trust's only asset was limited partnership units) to support the debt. Because the promissory note should be deemed equity rather than debt, the Service continued, the interest payments demonstrated that the grantor retained a right to the income from the transferred property. Moreover, the Service noted that, because the undercapitalized trust was not able to make payments on the note without the contribution of additional assets, the grantor had a retained interest, making Section 2702 applicable to the transaction.
Although it has been reported that the case was settled on terms favorable to the taxpayer, Karmazin illustrates the importance of the trust's having adequate equity when involved in a sale to a grantor trust transaction. Nevertheless, it remains unclear what constitutes "adequate" equity. In addition, the equity requirement can substantially limit the extent to which a sale to a grantor trust can be used in larger estates. For example, an individual who funded a trust with his $1 million gift tax exemption may sell only $9 million of additional assets to the trust in order to maintain a 9:1 debt-to-equity ratio. Worse, if a more conservative debt-to-equity ratio were desired, fewer assets could be sold to the trust.
The `incomplete equity' strategy
To reduce the debt-to-equity issues discussed above, a grantor could increase the equity to a trust for purposes of a sale, without triggering gift tax, by creating "incomplete equity." Incomplete equity is created through the use of a grantor retained limited power of appointment. To illustrate:
Grantor creates an irrevocable trust for the benefit of his descendants. The trust instrument provides that the trust consists of two shares, a limited power of appointment share ("LPA share") and a non-limited power of appointment share ("non-LPA share"). Upon funding the trust, the grantor allocates the initial trust principal between the LPA share and non-LPA share.
Each share is administered pursuant to the same terms, except that the grantor has a testamentary limited power of appointment 7 over the LPA share, allowing the grantor to appoint the LPA share property to anyone other than himself, his creditors, his estate, or the creditors of his estate.
Under Reg. 25.2511-2(c), a gift is incomplete if the donor reserves a power to himself to name new beneficiaries or change the interests of the beneficiaries as between themselves. As a result, the grantor's limited power of appointment prevents the transfer of property allocated to the LPA share from being a completed, taxable gift for purposes of Section 2501. 8 However, the trust assets of the LPA share still should constitute trust principal or "equity."
Although the trust consists of two shares, the LPA share and the non-LPA share, only one trust exists for purposes of determining the debt-to-equity ratio. 9 The property is transferred to a single trust and held subject to the terms of the trust agreement creating such trust. The transfer of ownership of the property is "complete" for property law and trust law purposes. The grantor has no right to reacquire the gift property from the trustee without consideration. Rather, it is only a technical provision of the Code that treats the transfer as incomplete for gift tax purposes. The grantor simply is able to change the interests of the beneficiaries as between themselves with respect to certain trust property (i.e., the LPA share).
For purposes of determining the debt-to-equity ratio of the trust, property with respect to which the grantor has an LPA should be taken into account as long as the income or principal of such property can be used to service the note payable to the grantor. (To the extent that such property is in fact used to service the note, the LPA will lapse and the grantor will be treated as having made a gift.)
Planning for using the incomplete equity strategy. In using the incomplete equity strategy, practitioners should consider the following drafting points:
Ideally, the LPA share would consist of specific property that is not expected to realize substantial growth. However, the LPA share also could consist of a percentage of the trust property, in which case the LPA share would participate equally in the growth of all trust property.
The grantor should consider executing a new will in which he exercises the limited power of appointment in favor of a marital trust if his spouse survives him. If the spouse does not survive the grantor, the property will be included in the grantor's gross estate and thus will be subject to federal estate tax.
A power of appointment held by a beneficiary over the trust must be limited to the non-LPA share.
In the case of an existing trust, the grantor should be able to carry out the incomplete equity strategy by retaining a limited power of appointment with respect to the transferred property in a deed of gift to the trust. The analysis for the stipulations with the gift is similar to the validity in using a net gift agreement.
A sale to a grantor trust continues to be an oft-used estate planning strategy. However, considering the Service's arguments in Karmazin, the debt-to-equity ratio should be carefully analyzed by all practitioners who use the sale strategy. The "incomplete equity" technique discussed here may reduce some concerns raised that the trust is a subterfuge rather than a bona fide purchaser, by increasing the equity of a grantor trust, without triggering gift tax.
1 See generally Mulligan, "Sale to a Defective Grantor Trust: An Alternative to a GRAT," 23 ETPL 3 (Jan. 1996) ; Oshins, "Defective Trusts Offer Unique Planning Opportunities," CCH—Financial and Est. Plan. (8/20/98); Aucutt, "Installment Sales to Grantor Trusts," 4 Bus. Entities 28 (Mar./Apr. 2002); Hesch and Manning, "Deferred Payment Sales to Grantor Trusts, GRATs and Net Gifts: Income and Transfer Tax Elements," Tax Mngm't Est., Gifts and Tr. J. (Jan./Feb. 1999); Weinberg, "Reducing Gift Tax Liability Using Intentionally Defective Irrevocable Outstanding Trusts," J. Asset Protection (Jan./Feb. 1999); Lewis and Lanning, "Estate Freezes and Grantor Trusts for Business Owners," 1 Bus. Entities 10 (Mar./Apr. 1999); Travers, "Sale of Stock to a Defective Irrevocable Grantor Income Trust," J. Financial Service Professionals (Jan. 2000); Hatcher, Jr. and Manigault, "Freeze Partnerships Against the World—Is My Freeze Better than Your Freeze?," Est. & Personal Financial Plan. (Part One—Aug. 2000, and Part Two—Sept. 2000).
2 U.S. Tax Court Docket #002127-03.
3 See IRC Section 7872.
4 Rev. Rul. 85-13, 1985-1 CB 184.
5 See Rev. Rul. 2004-64, 2004-27 IRB 7. This Ruling states that a grantor's payment of tax on income generated by a grantor trust is not a gift to the trust beneficiaries. In contrast, if the trust agreement or local law requires the trust to reimburse the grantor for payment of such taxes, all the trust property is includable in the grantor's gross estate under Section 2036. However, if the trustee has discretion to reimburse the grantor for such taxes, then the existence of such discretion in the trust agreement will not cause the trust to be includable in the grantor's gross estate absent evidence of an implied agreement to reimburse the grantor.
6 The authors have found that the minimum 10% has no basis in the Code or precedent, but merely is derived from the requirement in Section 2701(a)(4) that the junior equity interests in a corporation or partnership be valued at no less than 10% of the sum of the total value of all equity interests plus the total amount of all indebtedness of such entity. See also Mulligan, supra note 1, citing Ltr. Rul. 9535026, in which its author, who was involved in handling the ruling request, reports that the Service required the taxpayers to accept at least a 10% "equity" as a condition of issuing the ruling. In Karmazin, however, the Service challenged the transaction where there was a 9:1 debt-to-equity ratio.
7 See Reg. 25.2511-2(b), which sets forth an example of a donor transferring property to another in trust to pay the income to the donor, with the donor retaining a testamentary power to appoint the remainder among his descendents. According to this Regulation, "no portion of the transfer is a completed gift." This example suggests that a testamentary LPA is as effective as a lifetime LPA in rendering a transfer incomplete for gift tax purposes.
8 One of the authors co-wrote an article that discussed a similar use of an LPA to reduce the risk of gift revaluations by the Service. See Handler and Dunn, "The LPA Lid: A New Way to 'Contain' Gift Revaluations," 27 ETPL 206 (June 2000).
9 This is analogous to making a partial QTIP or reverse QTIP election for a trust, or to granting a trust beneficiary a power of appointment over a certain percentage of trust property—a commonly accepted trust structure.