In a bull market, one of the best ways to transfer wealth is by a sale to a grantor trust. Little wonder that it's been so popular for the past 20 years.

But a net gift coupled with a loan for the gift tax can transfer more wealth and at a faster rate than a traditional sale to a grantor trust for a promissory note. Even when one figures in the settlor's losing the use of the funds that pay the gift tax, the net gift approach still can leave beneficiaries more total wealth. And the longer the donor lives after the gift is made, the greater the net gift's benefit.

Moreover, a traditional sale for a note only transfers wealth when investment returns are positive. If anything became clear in the 2008 financial crisis, it's that America's go-go days are over for a while and that too much leverage can be dangerous. If a trust is highly leveraged and asset values decline, the assets previously held by the trust will be needed to pay back the note, resulting in a wealth transfer back to the senior generation and possibly even bankrupting the trust. Indeed, a traditional sale to a grantor trust in a bear market can leave the estate plan in a worse position than it started.

A net gift coupled with a loan involves much less leverage, and therefore less risk.

Sale to a Grantor Trust

A “sale to grantor trust” has served many well. It's an asset-transfer strategy that, done properly, can provide valuable gift, income and estate tax benefits. The grantor creates and funds an irrevocable trust. He then sells assets (for example, stock and partnership interests) to the grantor trust that are expected to outperform the interest rate on the promissory note evidencing the trust's debt. So long as the promissory note bears interest at the appropriate applicable federal rate (AFR), the value of the note for gift tax purposes will be its face amount and no gift will occur when the assets are sold. Also, the grantor doesn't recognize any gain or loss on the sale of the assets or interest income on account of the note, because the sale and loan evidenced by the note is treated as being between the grantor and himself for income tax purposes.

Consider this example: Gary had created a grantor trust that now holds $1 million. He sells $9 million worth of securities to the trust for a nine-year promissory note paying the mid-term AFR, which is 5 percent. The note is structured so that interest is payable annually, with a balloon payment of the principal due at maturity. Because the trust is a grantor trust, the sale is ignored for income tax purposes, and Gary does not recognize gain on his sale of securities to the trust.

At this point, Gary owns a non-appreciating, fixed-income instrument (the promissory note). The note pays him $450,000 of interest ($9 million purchase price, multiplied by 5 percent, equals $450,000) each year for nine years. Because the trust is a grantor trust, Gary is not subject to tax on his receipt of interest payments under the note. If the trust realizes a 10 percent rate of return, at the end of nine years the trust will have $8,468,712 (after repaying the debt). Of this, $2,357,948 is attributable to the growth of the $1 million initially held in the trust. Thus, the benefit of the sale is $6,110,765.

A sale to a grantor trust has at least four major benefits:

  • No gain recognition — The Internal Revenue Service held in Revenue Ruling 85-13 and several private letter rulings that transactions between a grantor trust and its grantor have no income tax consequences because the grantor trust's property is treated as the grantor's for income tax purposes. As a result, the grantor won't recognize gain or loss upon the sale and won't be taxed on the interest paid by the trust honoring the promissory note.

  • Tax-free transfers — 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 tax. In addition, like 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.1

  • Cash flow — The grantor trust can use the income received in respect of its investments to make interest and principal payments to the grantor under the promissory note. As a result, the grantor's cash flow can be maintained while the note is outstanding, and he may use the interest payments to fund his income tax liability attributable to income and capital gains realized by the grantor trust.

  • Non-appreciating asset — The promissory note will not appreciate in the grantor's estate; thus the growth of the grantor's estate is limited to the interest on the note.

But a sale to a grantor trust also has risks and obstacles:

  • Debt-to-equity ratio — If the debt-to-equity ratio of the grantor trust is too high, the IRS could attempt to re-characterize the sale as a gift to the trust in which the grantor retained an interest (for example, income from the property). Because the trust is undercapitalized (making the note a riskier investment), the IRS could argue that no seller would agree to sell his assets to the trust for a note in an arm's length transaction. If successful, the retained interest would be given zero value under Internal Revenue Code Section 2702 and the grantor would be treated as having made a gift of all of the property transferred, triggering gift tax. Moreover, the property still would be included in the grantor's estate under IRC Section 2036 if he died before the note was paid off. The trust should have at least 10 percent equity (a maximum debt-to-equity ratio of nine-to-one) to reduce the risk of a successful IRS challenge.2

  • Annual cash flow requirements — The trust has annual payments to fund and a large balloon payment upon the note's maturity. The trust must find assets that can generate sufficient cash flow to make these payments or it will need to make payments in kind. If the trust purchased stock in a closely held business, paying in kind would require expensive valuations and be counterproductive to the client's goals.

  • Investment performance risk — Poor investment performance can seriously damage, even destroy the sale's benefits. If the property sold declines in value or fails to appreciate at a rate greater than the note's interest rate, the trust must dip into its other assets to pay the note — a “reverse” asset transfer. The higher the amount of leverage, the more the investment risk.

Net Gifts to the Rescue

Although its upside isn't always as great as a sale to a grantor trust and it triggers a gift tax, the net gift is almost always a less risky way to transfer assets, from both an investment and a tax standpoint. If a gift is made on the condition that the donee will pay the resulting gift tax, it is a net gift. The gift tax is assessed on the amount of property transferred less the donee's gift tax liability.

Revenue Ruling 75-523 states, “Gift tax paid by the donee may be deducted from the value of transferred property where it is expressly shown or implied that payment of tax by the donee or from the property itself is a condition of the transfer.” Thus, the donee can't merely agree to pay the donor's gift tax liability after the gift is made; such agreement must be a condition of the transfer, either prior to, or contemporaneously with the gift. In that ruling, the IRS provided an algebraic formula for determining the amount of gift tax for a net gift: Divide (the tentative tax) by (the rate of tax plus one) to find the amount of gift tax. This gift tax then is deducted from the value of the transferred property to determine the amount of the net gift.

Let's look at an example of a net gift: Tom makes a $1 million gift to a trust for his children. Tom and the trustee of that trust sign an agreement at the time the gift is made that obligates the trustee to pay the gift tax attributable to the gift. Thus, the transfer is a net gift. Assuming Tom has used his entire $1 million gift tax exemption and is in a 45 percent gift tax bracket, the gift tax equals $310,344.

Thus, the net gift is $689,655 ($1 million less $310,344 gift tax). Put differently, a 45 percent gift tax imposed on a net gift of $689,655 would be $310,344.

Rather than selling assets to a grantor trust for a note, one could instead make a net gift to the trust, and when the gift tax is due the following April, lend the trust the funds with which to pay the tax.

Going back to our first example, rather than selling $9 million of assets to a grantor trust for a note, Gary makes a net gift of $9 million of securities to the trust. About 31 percent of this amount will be needed to pay gift tax and therefore is not subject to gift tax, leaving a taxable gift of $6,206,897. The trust would owe gift tax of $2,793,103 (at a 45 percent rate), which it will pay next April using funds Gary lends to the trust at that time. The note issued by the trust in exchange for the loan to pay the gift tax will bear interest at the prevailing AFR (assumed to be 5 percent).

If the trust realizes a 10 percent rate of return, at the end of nine years the trust will have $16,531,982 (after repaying the debt) — compared to the benefit of $6,110,765 from the traditional sale for a note. The trust's annualized rate of return on its $2.7 million investment (that is to say, gift tax) is 21.84 percent!

Advantages

A financed net gift offers at least seven distinct benefits and three disadvantages. On the upside:

  • It subjects property to a reduced transfer tax rate — Estate tax is assessed on the entire estate, including the portion ultimately used to pay the tax, but gift tax is assessed only on the net amount received by the donee. As a result, the effective rate of the gift tax is 31 percent as compared to a 45 percent estate tax.

  • It requires less cash flow — The amount borrowed by the trust to pay the gift tax will be about two-thirds less than it would be in the case of a sale. Less cash flow is required to service the note, allowing the note to be serviceable in the first place and paid off much faster.

  • It's got a built-in debt-to-equity limit — Because the note will be about 31 percent of the value transferred to the trust, the trust will always have sufficient equity to support the note's bona fides. Therefore, there is no debt-to-equity limit on the amount of property that can be transferred via a financed net gift.

  • It's less likely to trigger IRC Sections 2702 and 2036 — In a net gift, the donor receives nothing back from the trust (other than the promise to pay the gift tax the next year). Any loan made to pay the gift tax would not be made until several months — possibly more than a year — later. Therefore, the risk that the IRS could successfully argue that the donor retained an interest in the trust property implicating IRC Sections 2702 and 2036 is greatly reduced.

  • It has less investment risk — Because the net gift requires less leverage than the sale, it also has less risk. In a sale, if the assets purchased for a note decline in value, the trust's other assets (received via gift) may need to be used to repay the note, putting assets back into the seller's hands. In a net gift, a much smaller “financed” portion is at risk.

  • The gift tax portion of a net gift can be discounted — The benefit of a net gift is even greater if the entire net gift consists of assets subject to valuation discounts, such as stock in a closely held company or limited partnership interests. The 31 percent of the assets transferred to cover the gift tax are valued at a discount and not subject to gift tax, although the trust will pay the tax using cash borrowed from the donor. As a result, the trust receives an “extra” amount equal to the discount on that portion of the assets. For example: Assume we're transferring limited partnership units representing $1 million of underlying real estate. After applying a 35 percent minority interest and marketability discount, the units would be valued at $650,000. As a net gift, the taxable gift (net) would be $448,000 and the gift tax would be $202,000. So, 31 percent of the $650,000 transferred is to cover the gift tax and is not subject to gift tax itself. The undiscounted value of 31 percent of the units is $310,000. So the trust receives an extra $108,000 of value that is not subject to gift tax. The discount reduces the effective tax rate to 20.2 percent ($202,000 tax divided by $1 million undiscounted value).

  • It has a smaller revaluation risk — If the IRS successfully argues that the assets transferred were worth more than reported, the additional value would be a gift, triggering a gift tax. But, because the trust will assume this additional, potential liability, the additional value is a net gift, resulting in a smaller gift tax (31 percent of the additional value). Of course, the trust must pay the tax, reducing the wealth transfer. In a traditional sale to grantor trust, the gift tax would be 45 percent of the increased value.

Disadvantages

Of course, financed net gifts do have disadvantages.

  • The gift tax must be paid in cash — And of course that means the donor is reducing the family's current assets as well as losing those assets' potential future growth.

  • It can trigger capital gain — Unless the net gift is made to a grantor trust, the donor will recognize capital gain on the amount by which the gift tax liability exceeds the donor's adjusted basis in the property transferred.

  • But perhaps the biggest disadvantage is this: If the donor dies within three years of making the gift, the advantages of the net gift are greatly reduced — The gift tax paid is included in the donor's gross estate and subject to estate tax under IRC Section 2035(b). The gift tax paid plus the estate tax on the gift tax included in the estate under Section 2035 will equal what the estate tax would have been if the property had been subject to estate tax in the first place. But if the property increased in value between the date of the gift and the donor's death, this increase will escape transfer taxation.

Section 2035(b) applies to gift taxes paid by a donee as well.4 The donor of a net gift is deemed to have paid the tax by ordering the donee to pay the tax on his behalf in satisfaction of the gift tax liability. In Estate of Samuel, the Tax Court stated, “Mechanical application of section 2035(c) would completely remove from the transfer tax base all funds used to pay gift tax on such gifts. This interpretation of the statute is wholly inconsistent with Congress' goal of sharply distinguishing deathbed gifts from other gifts and eliminating the disparity of treatment between deathbed gifts and transfers at death.”5 (Section 2035(b) was Section 2035(c) at the time of this case.) Thus, net gifts cannot be used to avoid the three-year rule of Section 2035(b).

If Section 2035 is triggered and the donor leaves his entire estate to his surviving spouse, the estate tax paid by the estate under Section 2035 would decrease the marital deduction, resulting in more tax. The trust could assume the Section 2035 liability too as part of the net gift, which would reduce the taxable gift even more, under McCord v. Commissioner.6 But the trust's payment of the tax will reduce the benefits. One should consider having the trust assume the Section 2035 tax only in the event the donor's spouse predeceases the donor.

Alternatives

Another way to analyze the financed net gift is by comparing it to two alternatives: life insurance and bequests of discounted assets.

A net gift is comparable to life insurance because they both have an out of pocket cost: gift tax and insurance premiums. But life insurance has a number of disadvantages when compared to the net gift:

  • Cost — Whether life insurance is cost-effective depends on the client's age and health, while the gift tax cost is not dependent on such factors. Some clients aren't insurable.

  • Gift tax issues — If the insurance premiums exceed the gift tax exclusions and exemptions, gift tax will be paid on the excess. Loans could be made to the trust instead of taxable gifts, but the debt will reduce the net proceeds to the trust.

  • Declining return — The longer the client lives, the lower the rate of return from the investment in life insurance. The return from the net gift depends on the asset performance and could increase over time.

  • Delayed benefit — Insurance will not provide benefits now. The intended beneficiaries will receive funds only after the insured dies or the policy is surrendered for its cash value or sold to a third party.

A net gift is comparable to a bequest of discounted assets because both are subject to an effective tax rate less than the estate tax rate and in both cases the recipient bears the tax (gift or estate). But a net gift of non-discounted assets will provide the recipient with more after-tax wealth than a bequest of assets subject to a 30 percent valuation discount.

In our example, Gary made a net gift of $9 million of marketable securities to a trust, from which the trust would pay gift tax of $2,793,103, leaving it with a net $6,206,897. Instead, Gary could have transferred the securities to a family limited partnership (FLP) and bequeathed limited partnership (LP) units representing $9 million of underlying assets. Assuming a valuation discount of 30 percent, the LP units would be valued at $6.3 million for estate-tax purposes. At a 45 percent estate tax rate, $2,835,000 of estate tax would be due. That is $41,897 more tax than with a net gift — and $41,897 less for the recipient who eventually will net $6,165,000 if and when the FLP is liquidated.

Note that the assets transferred by gift don't receive a full basis step-up like the inherited assets do; rather, the basis is stepped-up by the amount of gift tax paid (although LP units only are stepped-up to their discounted value). Also, the tax is due sooner with a net gift than a bequest.

But there are serious advantages to a net gift over the inherited LP units. A net gift:

  • Gives instant gratification — The net gift transfers wealth to the recipient now for his present use and enjoyment, rather than at the donor's death in the future (and after the estate is administered).

  • Leaves less for the estate tax — The assets received in a net gift continue to grow outside of the donor's estate, while the LP units' value grows inside the estate and will be subject to future estate tax.

  • Requires fewer professional fees — The net gift of marketable securities does not require a partnership (and the legal and accounting fees to set it up and maintain it) or an appraisal.

  • Isn't as risky — The net gift also does not have the audit risk associated with a bequest of LP units.

Income Tax

Because liability for gift taxes falls on the donor under IRC Section 2502(d), when a donee agrees to pay such tax in consideration for the gift, the donor who is relieved of the tax liability realizes an immediate economic benefit. The U.S. Supreme Court stated in Diedrich v. Comm'r, “The gain thus derived by the donor is the amount of the gift tax liability less the donor's adjusted basis in the entire property. Accordingly, income is realized to the extent that the gift tax exceeds the donor's adjusted basis in the property.”7

Thus, the transfer is treated as if the donor sells the property to the donee for less than its fair market value. The “sale” price is the gift tax liability assumed by the donee; the balance of the value of the transferred property is treated as a gift.

If gain is recognized, the basis of the property received by the trust will be increased by the amount of such gain. In addition, the basis of such property also is increased by the amount of gift tax paid that is attributable to the property's pre-gift appreciation.8

If the net gift is made to a grantor trust, the deemed sale of a portion of the assets transferred to the trust under Diedrich should not be a taxable event under Rev. Rul. 85-13. Moreover, the trust's actual payment of the gift tax liability should not constitute taxable income to the grantor, because at the time of payment it was no longer the grantor's liability; the trust already assumed such liability at the time of the gift. This is the case even though Treasury Regulations Section 1.662(a)-4 provides that any amount distributed pursuant to the terms of a will or trust instrument in discharge or satisfaction of any person's legal obligation is included in the gross income of that person under IRC Section 662(a) as if it were distributed directly to that person as a beneficiary.

ESBTs

Additional considerations need to be taken into account if the net gift is made to an electing small business trust (ESBT). One requirement of an ESBT is that no interest in the trust can have been acquired by purchase.9 If any portion of a beneficiary's basis in the beneficiary's interest is determined under IRC Section 1012, the beneficiary's interest was acquired by purchase. The regulations clarify that the prohibition on purchases applies to purchases of a beneficiary's interest in the trust, not to purchases of property by the trust. According to the summary of the final ESBT regulations,10 a net gift of a beneficial interest in a trust, when the beneficiary pays the gift tax, would be treated as a purchase of a beneficial interest under these rules, while a net gift to the trust itself, when the trustee of the trust pays the gift tax, would not be so treated.

Selling Clients on the Idea

Financed net gifts can transfer more wealth with less risk than a traditional sale to grantor trust. Many clients will balk at the payment of gift tax, however, so this strategy is a likely candidate for older, unmarried clients (who are presumably closer in time to paying estate tax). Its appeal may rest on how it is presented to the client: You give away your stock and your kids have to pay the tax — just like at death, but at a lower tax rate and your kids don't have to wait for you to die. The children should be happy too: They get $9 million of stock and have to pay the IRS $2,793,103, rather than having to pay their parents $9 million.

The Wealth Management Group at Bernstein Global Wealth Management analyzed the financed net gift and traditional sale to grantor trust in Monte Carlo simulations. (See “What's the Bottom Line?” p. 28.) The analysis illustrates the reduced investment risk of the financed net gift (to say nothing of the tax risks) and the probability of a greater overall wealth transfer.

Endnotes

  1. See Revenue Ruling 2004-64 (July 6, 2004).

  2. The minimum 10 percent has no basis in the Internal Revenue Code or precedent, but merely derives from the requirement in IRC Section 2701(a)(4) that the junior equity interests in a corporation or partnership be valued at no less than 10 percent of the sum of the total value of all equity interests plus the total amount of all indebtedness of such entity.

  3. 1975-1 CB 310 (Jan. 1, 1975).

  4. See Estate of Sachs v. Commissioner, 88 T.C. 769 (1987), aff'd. in part and rev'd. in part, 856 F.2d 1158 (8th Cir. 1988).

  5. Estate of Samuel, TC, CCH Dec. 43,823 (Apr. 6, 1987).

  6. McCord v. Comm'r, 461 F.3d 614 (5th Cir. 2006), rev'g 120 TC 358 (2003).

  7. Diedrich v. Comm'r, 112 S. Ct. 2414 (1982).

  8. Treasury Regulations Section 1015(d)(6).

  9. Treas. Regs. Section 1.1361-1(m)(1)(iii).

  10. T.D. 8994 I.R.B. 2002-23 (June 10, 2002).


David A. Handler is a partner in the Chicago office of Kirkland & Ellis LLP