Consider a not uncommon scenario. The date is Jan. 1, 2008. Bob Savvy is the sole shareholder of Family Fortune, Inc., an S corporation. Family Fortune was recently appraised at $10 million, but the investment bankers Bob has spoken to believe that an investor could be found who'd be willing to pay up to $40 million. If the business climate changes, it also could decline in value to $1 million. Bob is married to Sue Savvy; they have two children. His objective is to transfer — with the least risk and the least tax cost — as much of his Family Fortune stock as possible to his children.
There are two conventional solutions to this dilemma: (1) an outright gift or (2) a transfer to a short-term zeroed-out grantor-retained annuity trust (GRAT). Both have their downsides. Instead, Bob should consider what I call a “disclaimer QTIP trust” — but only after carefully evaluating this strategy's advantages and disadvantages. Note: it works best for owners of closely held businesses that have the potential for growth, and it only works for married donors.
The first conventional approach would have Bob making an outright gift of all his Family Fortune stock to his children. If neither he nor Sue have made any prior taxable gifts and Sue consents to split the gift, the gift tax will be about $3.6 million. If the company is later sold for $40 million, the proceeds will accrue to the children, free of further gift tax. If, however, it declines in value to $1 million, then Bob and Sue will have wasted $2 million in gift tax exemption and paid $3.6 million in gift tax.
To protect himself against the latter risk, Bob might consider transferring the stock to a zeroed-out GRAT with a two-year term. To zero-out the GRAT (that is, reduce the taxable gift to zero), Bob would have to retain an annuity of about $5.47 million.1
If the stock declines in value, Bob is protected. He has not made a taxable gift on the GRAT's creation, so he will not lose any gift tax exemption nor pay any gift tax. If the company is sold for $40 million before the first annuity payment is due, Bob will have transferred about $29.061 million to his children, free of gift tax.2 This is a good result, but shy of what Bob could have achieved through an outright gift.
There is a third alternative that could allow Bob, up to 21 1/2 months after the date of his original gift, to decide how large his taxable gift will be and whether he'll make any taxable gift whatsoever. This alternative takes advantage of two provisions of the Internal Revenue Code that allow a taxpayer to do something with retroactive effect: the qualified disclaimer provisions of IRC Section 2518 and the qualified terminable interest property (QTIP) election under Section 2523.
The technique would work as follows: Bob would create a disclaimer QTIP trust with these provisions:
- Sue and a disinterested third party act as trustees.
- All income is payable to Sue for life.
- The principal is payable to Sue in the disinterested trustee's absolute discretion.
- Upon Sue's death, the remaining balance of the trust would be payable in equal shares to Bob and Sue's children. • If Sue disclaims her interest in the trust, the assets of the trust would pass directly to Bob and Sue's children.
- Bob retains a power to reacquire the trust assets by substituting other assets of equivalent value, such that the trust would be taxable as a “grantor trust.”3
On Jan. 1, 2008, Bob would transfer his Family Fortune stock to the trust. Because the stock has been appraised at $10 million, Bob potentially would be making a taxable gift of $10 million, but he will have two opportunities before Oct. 15, 2009, to adjust or even nullify the taxability of this gift.
Under IRC Section 2518, if a person makes a “qualified disclaimer” with respect to any interest in property, it will be treated as if it had never been transferred to the person. “Qualified disclaimer” means “an irrevocable and unqualified refusal by a disclaimant to accept an interest in property” — but only if the refusal is in writing, the writing is received by the holder of legal title not later than nine months after the day on which the transfer was made, the disclaimant has not accepted the interest or any of its benefits and the interest passes without direction by the disclaimant to the transferor's spouse or to a person other than the disclaimant.4
In Private Letter Ruling 200442027, the Internal Revenue Service ruled that a series of “cascading” disclaimers, including disclaimers from a QTIP trust to a discretionary trust for the donor's spouse and issue, were qualified disclaimers. The taxpayer who requested that ruling had created five trusts under a single trust agreement. Under Trust 1, the taxpayer's spouse was entitled to all income, principal in the discretion of the trustee and all principal at the expiration of a nine-month term. The taxpayer's spouse had a “qualifying income interest for life” in Trusts 2 and 3. Thus, those trusts were eligible for the QTIP election. Trusts 4 and 5 were discretionary trusts for the benefit of the taxpayer's spouse and children. Under the terms of the trust agreement, property disclaimed by the taxpayer's spouse from Trust 1 was to be added to Trust 2; property disclaimed from Trust 2 was to be added to Trust 3; property disclaimed from Trust 3 was to be added to Trust 4; and property disclaimed from Trust 4 was to be added to Trust 5. The taxpayer requested a ruling that a series of pecuniary disclaimers of differing amounts from Trusts 1, 2, 3 and 4 would be qualified disclaimers under IRC Section 2518. The IRS granted the ruling.
The disclaimer QTIP trust contemplates a disclaimer from a potential QTIP trust to Bob's children. This is similar to the disclaimer from Trust 3 to Trust 4 in the ruling. Trust 3 was a potential QTIP trust. Although Trust 4 included the donor's spouse as a beneficiary, it was primarily intended to benefit the donor's children. Because the IRS ruled that the disclaimer from Trust 3 to Trust 4 was qualified, it should reach the same conclusion as to a disclaimer of Sue's interest in the disclaimer QTIP trust.
If, before Oct. 1, 2008, Bob's investment banker finds a person willing to buy Bob's stock for $40 million, Sue can make a qualified disclaimer of her interest in the trust. Under the terms of the trust, the Family Fortune stock will pass to Bob's children and Bob will have made a taxable gift of $10 million. Bob will have succeeded in transferring $40 million in assets to his children at a cost of: (a) using up his and Sue's combined $2 million exemption from gift tax; and (b) the payment of $3.6 million in gift tax.
There is no reason why Sue's disclaimer could not be a “qualified disclaimer” under IRC Section 2518. She would not have to accept any benefits from the trust before Oct. 1, 2008. Income is only required to be paid annually. Thus, the first income payment could have been delayed until Jan. 1, 2009. Her disclaimed interest also would pass without direction on her part, because the trust agreement contains a specific clause on its devolution.
If, on Oct. 1, 2008, there still is uncertainty about whether a buyer can be found for the Family Fortune stock or if there's a change in business conditions such that the company is no longer saleable, Sue could decline to make any disclaimer. Bob still would have transferred $10 million, but his transfer potentially would be non-taxable because the disclaimer QTIP trust would remain eligible for QTIP treatment.
For Bob, the due date of his gift tax return on which he must report his transfer to the disclaimer QTIP trust is April 15, 2009. He can extend this due date to Oct. 15, 2009, by filing an application for an automatic extension. This will also extend the due date for making the QTIP election.
Before Oct. 15, 2009, Bob will have a second opportunity to decide whether to make his gift taxable and in what amount.
If the stock has been sold for $40 million or a sale is pending, he can decline to make the QTIP election and file a gift tax return reporting a taxable gift of $10 million. The stock or the proceeds of the stock's sale will not pass to Bob's children immediately, because Sue will not have disclaimed her interest in the trust. Instead, the assets will be held in trust for Sue for life. Because Bob's objective is to transfer wealth to his children and not to enlarge Sue's estate, the trust assets can be invested for capital appreciation rather than income. This will minimize the income that must be paid to Sue as the mandatory income beneficiary and maximize the amount that will pass to their children when she dies.
If the stock has been sold for $40 million, but Bob nevertheless wants to avoid paying gift tax, he can make a QTIP election with respect to only 80 percent of the disclaimer QTIP trust. He will be treated as making a taxable gift of $2 million (20 percent of the original transfer of $10 million.) No gift tax will be due if Sue consents to split the gift, and if both Bob and Sue allocate their full $1 million exemption from gift tax to the gift. Bob will have succeeded in transferring $8 million in proceeds to his children free of gift tax. The remaining $32 million will be held in a QTIP trust for Sue's benefit for the rest of her life and will be included in her gross estate for federal estate tax purposes.
If no buyer has been found by Oct. 15, 2009 or if changes in the business climate have made the company unsaleable, Bob can make a QTIP election with respect to the entire trust. He thereby will avoid making a taxable gift and wasting any part of his lifetime exemption from gift tax. Under the trust's terms, the disinterested trustee will have the power to distribute any part of the principal to Sue at his absolute discretion. If the parties don't wish to continue administering the QTIP trust because it isn't serving any tax purpose, the trustee could terminate it through the exercise of this power.
If, in the next year, the company recovers its financial position and a sale again looks possible, Sue could take the stock distributed to her and transfer it to a similar trust for Bob's benefit. The process would start all over again and the parties would have up to 21 1/2 months to decide whether Sue's transfer would constitute a taxable gift, in whole or part.
How does the disclaimer QTIP trust technique compare with an outright gift or a transfer to a short-term zeroed-out GRAT?
In almost every conceivable case, it should be superior to an outright gift. Reduced to its elements, the disclaimer QTIP trust is nothing more than an outright gift with the added feature of a 9 1/2 month-to- 21 1/2 month period of mutability. It creates additional options for the donor without imposing any new restrictions. The only occasions when a donor might decline these additional options is when he doesn't want to pay the transaction costs of establishing the trust or when he's missing the right cast of characters to play the roles of disclaimant and disinterested trustee.
Compared with a short-term zeroed-out GRAT, the disclaimer QTIP trust has both advantages and disadvantages. Chief among its advantages is its revocability. A GRAT is not subject to commutation; nor are adjustments allowed in the annuity amount after its creation.(5) By contrast, in a disclaimer QTIP trust, there is a window of between 9 1/2 and 21 1/2 months during which the donor can adjust his taxable gift to any amount between zero and the full amount of his original transfer.6 The trustee also has discretion to terminate the trust at any time by paying out all the principal to the donor's spouse.
Another advantage of the disclaimer QTIP trust is the donor's ability to allocate generation-skipping transfer tax exemption (GST exemption) at the time of the original transfer. No GST exemption can be allocated during an estate tax inclusion period (ETIP) — that is, any period when the transferred property is includible in the donor's estate — other than under IRC Section 2035.7 If Bob transfers his stock to a zeroed-out two-year GRAT, it will almost certainly be included in his estate under IRC Section 2036 if he dies during the term.8 Accordingly, Bob cannot allocate GST exemption until the end of the GRAT term.9 This puts him at a severe disadvantage. If he could make the allocation at the beginning of the term, $2 million in exempt stock could grow to $8 million in exempt proceeds upon sale of the stock. But instead, he is left with $2 million in exempt proceeds.
Contrast this with a disclaimer QTIP trust when there is no ETIP. Bob can allocate his $2 million GST exemption to the Family Fortune stock at its appraised value of $10 million. If the stock is later sold for $40 million, his allocation will cover $8 million of proceeds. The decision on how much exemption to allocate doesn't have to be made until the extended due date of Bob's gift tax return. Thus, Bob can postpone his allocation by 21 1/2 months and still use values as of the date of transfer.
These advantages notwithstanding, a GRAT still offers gift tax leverage not available in a disclaimer QTIP trust. In Bob's case, if his stock sells for $40 million before the first annuity payment, a two-year zeroed-out GRAT will allow $29.016 million to be transferred to Bob's children without the use of any gift tax exemption or any payment of gift tax. In the best case, a disclaimer QTIP trust would remove $40 million from Bob's estate at the cost of exhausting Bob and Sue's combined $2 million gift tax exemption and the payment of $3.6 million in gift tax. While that can be called an excellent result, it still doesn't approach the leverage of a zeroed-out GRAT.
Another shortcoming of the disclaimer QTIP trust is that it only works with a married donor. Any donor, whether married or not, can make a transfer to a GRAT. For an unmarried donor, it may be possible to construct a disclaimer trust in which any disclaimed interest simply reverts to the donor. This would preserve one element of the disclaimer QTIP trust — the ability to nullify a taxable transfer within nine months. But there is no question of preserving the second component — the ability to nullify a taxable transfer up to 21 1/2 months after it is made through the QTIP election.
Practitioners whose clients own a closely held business or other assets with the potential for explosive growth should include the disclaimer QTIP trust as part of their arsenal and consider using it in the right circumstances.
- This assumes that the Internal Revenue Code Section 7520 rate is 6.2 percent.
- This is computed by taking the $40 million in proceeds from the sale and subtracting the two annuity payments of $5,469,561 each.
- See IRC Section 675(4)(C).
- IRC Section 2518(b).
- Treasury Regulations Section 25.2702-3(d)(5) prohibits commutation.
- If his original transfer is made on January 1 of a given year, he will have a 21 1/2 month window, because the extended due date of the qualified terminable interest property (QTIP) election will be Oct. 15 of the following year. If his original transfer is made on Dec. 31 of a given year, he will only have a 9 1/2 month window. If the transfer occurs sometime between January 1 and December 31, the window will be somewhere between 9 1/2 and 21 1/2 months. Proposed Treas. Regs. Section 20.2036-1(c)(2)(i).
- Treas. Regs. Section 26.2632-1(c)(2)(i).
- That's because the corpus necessary to generate his annuity will likely equal or exceed the value of the grantor-retained annuity trust (GRAT) corpus at his death. If the IRC Section 7520 rate is 6.2 percent and Bob's annuity is $5.47 million, the GRAT corpus would have to exceed $88 million before any assets are excluded from Bob's estate.
- Treas. Regs. Section 26.2632-1(c)(1)(ii).