Tax Planning Update

Law Office of Virginia A. McArthur

Sales to Irrevocable Grantor Trusts Formula Transfer to Mitigate Gift Tax Risks Approved by US Tax Court
by Richard S. Franklin

Selling assets, particularly business interests, to irrevocable grantor trusts have become a mainstream estate planning technique. Yet the IRS has become increasingly aggressive in attacking the valuations applicable to intra-family sales of interests in closely held entities. The bone of contention is usually the level of valuation discounts used by the taxpayer for lack of control as to a minority interest and lack of marketability for the interest being closely held, for which there is no ready market. If the IRS could sustain a higher value for the sold interests, it would argue that the seller (usually the parent or grandparent) has made a deemed gift of the additional value and owes gift taxes. Recently, in the context of an intra-family sale of assets, a taxpayer prevailed in mitigating the risk of owing gift taxes by using a so called formula allocation clause. In Est. of Petter v. Commr, T.C. Memo 2009-280 (Dec. 7, 2009), a mother transferred 8,459 units in a family LLC (funded with UPS stock) under a two part formula. First, she sold to an irrevocable trust for her descendants the number of the 8,459 units that would be equal in value to $4,085,190 based on final gift tax values. The trust paid her by issuing the mother a 20-year promissory note in the equal amount of $4,085,190. The mother had the 8,459 units appraised at the time of the transfer and thought they were worth $4,085,190. But she couldnt be sure the IRS would agree with the valuation. Therefore, the second part of the formula provided that if the units were finally determined to be worth more than $4,085,190, the trust would receive a smaller number of units (i.e., equal to $4,085,190 at the higher per unit value) and the balance of the units (the excess value) would be given automatically to charity (several donor advised funds at community foundations). With the excess value passing to charity, and thereby qualifying for the gift tax charitable deduction, the mother hoped to eliminate her risk of owing gift taxes if the IRS fussed over the valuation. Importantly, in all events, the mother transferred the entire block of 8,459 units in the LLC. The

What is a Sale to an Irrevocable Grantor Trust? In a sale transaction, a parent will sell an asset to a grantor trust created by the parent for the benefit of a spouse and descendants. The parent will usually take back an interestonly promissory note for the purchase price. Selling the asset to the trust freezes the value of the asset for estate tax purposes. No gift tax is applicable because the transaction is a sale, not a gift. If the asset appreciates faster than the interest rate under the promissory note, the excess appreciation belongs to the trust and thereby escapes estate taxation in the parents estate. The sale to the grantor trust can be made without income tax consequences. The grantor continues to pay the income taxes on the income generated by the asset sold to the trust, even though he or she does not receive income from the trust and is not entitled to reimbursement for the tax expenses. The grantors payment of the income tax is the equivalent to making a legally permissible gift tax-free transfer to the trust. The interest on the promissory note is also ignored for income tax purposes. The trust assets and any future appreciation can also usually be exempted from the generation-skipping transfer tax. In short, a sale permits a parent to sell a discounted asset to a trust for the benefit of a child, with the trust paying interest only at less than 3% for up to nine years, with no recognition of gain to the parent at the time of sale, and with the parent paying all of the income taxes on the trust assets, allowing the trust to build up its equity free of income tax.

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formula allocation clause served the function of determining the split between the trust and charity based on how the final gift tax values would shake out. The IRS audited the mothers gift tax return on which she had reported her gifts and the sale transaction.1 The IRS determined that the units were substantially more valuable than $4,085,190. The parties eventually agreed on $6,052,318 as the true value for the units.2 The IRS then argued that the mother had made a deemed gift of the excess value of $1,967,128 and owed substantial gift taxes.

What is a Sale to an Irrevocable Grantor Trust? Cont. This is an opportune time to consider a sale to an irrevocable grantor trust for the following reasons: (i) The sale will freeze the value of the sold asset at its current value, plus interest on the purchase money note, for purposes of determining estate taxes in the sellers estate; (ii) The current recessionary pressures have reduced the values of most companies (therefore, the value of the sold asset may be at a near low point for the foreseeable future, resulting in a relatively low purchase price); (iii) The costs to finance the purchase by the irrevocable grantor trust are particularly low because the applicable federal rates (AFR) are at near historic lows; and

The formula allocation clause giving the excess value to charity should be ignored, according to (iv) Congress may act this year to limit discounts for the IRS, because it violated public policy and minority interests in closely held businesses, which frustrated the enforcement of the gift tax, as it would result in higher valuations and sales prices in removed any incentive for the IRS to audit the gift the future. tax return to ensure accurate valuation. The Tax Court held that the formula allocation clause did not violate public policy. It allowed a gift tax charitable deduction in the year of the original transfer for the excess value that ultimately passed to the charity based on the final gift tax value. The court approved of the formula clause because it did not change what the mother had transferred, but rather determined a final allocation between the units sold to the trust and given to charity. The mother did not use the less favored approach of attempting to recapture the excess units to prevent a taxable gift. The court also reasoned that public policy encourages gifts to charity and that the charity, as a recipient of the excess value, will act like a third party dealing at arms length. The charity is obligated to ensure the proper valuation of the interests being transferred and therefore its involvement helps to ensure the integrity of the gift tax system. While in Petter the excess value was given to a charity and thereby qualified for the charitable gift tax deduction, an alternative for the less charitably inclined is to give the excess value to an inter vivos QTIP marital trust (QTIP) and thereby qualify for the gift tax marital deduction. The main rationale used by the Tax Court in Petter should be applicable when the excess value is given to a QTIP for the sellers spouse. Like the charity in Petter, the trustees of the QTIP would have a fiduciary duty to ensure the proper valuation of the interests being transferred. Another alternative is to give a charity, such as a donor advised fund at a community foundation,3 a portion of the
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Why report the sale on the gift tax return? after all, its not a gift: Reporting the sale achieves the goal of putting the IRS on notice and starting the statute of limitations on the valuation of the units. While reporting a non-gift transaction is not required, the tax regulations specifically provide the mechanism for doing so. The value determined by the mothers appraiser reflected an aggregate 53.2% valuation discount off the net asset value of the UPS stock owned by the LLC. The increased value on audit reflected an approximately 35% discount. The donor advised fund would need to review the transaction and be comfortable with its structure, as well as the tax implications to the fund, including but not limited to the application of the excess business holdings rule and unrelated business taxable income rule.

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excess value, and the balance to a QTIP. For example, 20% of the excess value could be given to a donor advised fund and 80% to a QTIP. The Petter case provides a useful roadmap in mitigating gift tax risks.4 If you have any questions, please contact one of our lawyers. VIRGINIA A. McARTHUR [email protected] RICHARD S. FRANKLIN [email protected] KATE M.H. KILBERG [email protected] LUCY P. WEAVER [email protected]

U.S. TREASURY DEPARTMENT CIRCULAR 230 DISCLOSURE: Any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (a) avoiding penalties that may be imposed by the Internal Revenue Service or by any other taxing authority; or (b) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter addressed herein.

The Petter case follows two other taxpayer favorable cases using similar formula provisions: Est. of Christiansen v. Commr, 130 T.C. 1 (2008), affd, 586 F.3d 1061 (8th Cir. 2009); McCord v. Commr, 461 F.3d 614 (5th Cir. 2006), revg, 120 T.C. 358 (2003).

Copyright 2010 Law Office of Virginia A. McArthur. All Rights Reserved.

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