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Installment Sale to Grantor Trust (“ISGT”) Planning

What is an ISGT?

An ISGT is a technique to transfer wealth in a tax-efficient way by allowing future appreciation to pass to the next generation without triggering a current capital gain tax on the sale.

In a typical transaction, the grantor sells an asset with appreciation potential to a so-called “grantor trust” in return for a 9 year note. The trust must have some equity at the time of the sale, which is typically obtained by a gift from the grantor.  During the 9 years the note is outstanding, interest must be paid to the grantor, but principal may either be amortized over the term of the note or paid in a balloon payment at maturity. The interest rate on the note is based on rates prescribed by the IRS. Any assets left in the trust after the note payment would continue to be held in trust for the benefit of the grantor’s descendants.

Why Use an ISGT?

If the asset that is sold appreciates in value over time, the appreciation is removed from the seller's gross estate for federal estate tax purposes.  While the federal estate tax has been repealed for decedents dying in 2010, it comes back in 2011 and future years. Stock in a privately held company can be a good asset to transfer through an installment sale, particularly if the seller anticipates that there may be considerable appreciation in value. To establish the purchase price, the grantor would use a qualified business appraiser to establish a fair market value of the interest being sold based on a valuation discount due to lack of voting control and lack of marketability.  Another good candidate for an ISGT would be an LLC formed to hold a portfolio of marketable securities.  In addition to removing the appreciation from the grantor’s estate, estate and gift taxes may be reduced by valuation discounts for the LLC interests sold to the trust and any retained by the grantor.

Income and Capital Gain Taxes

Where a grantor makes an installment sale of property to a grantor-type trust, no capital gain is realized on the sale, and no income is realized when the trust receives interest on the installment obligation. The grantor is taxed on all of the income earned in the trust.  The trust may use earnings from the property to make the installment payments back to the grantor, all without current capital gains or income tax consequences.

Gift and Estate Taxes

The initial gift to the trust to provide equity for the sale will be a taxable gift by the grantor eligible for the grantor’s federal gift tax exemption amount (currently $1,000,000).  If properly drafted and implemented, the assets in the trust should be excluded from the grantor’s estate for estate tax purposes at the grantor’s death.  A sale to a grantor trust should result in estate and gift tax savings if the property sold to the grantor trust produces an after-payment return exceeding the interest rate on the note.¹

Example

Assume a grantor sells interest in an entity that owns property with an underlying value of $2,000,000 which may be valued by a qualified appraiser at a 30% discount valuation for a sale price of $1,400,000 to a grantor trust.  The purchase price consists of $140,000 in cash and the balance in a 9 year note with an interest rate of 1.73%² with a balloon payment of principal at the end of the term.  To fund the trust, the grantor makes a cash gift of $150,000 to the trust on which no gift tax is payable (assuming the grantor has not previously used up his or her lifetime gift tax exemption). ²

The potential benefits of making this installment sale are illustrated below. The calculation amounts are approximate and are based on hypothetical appreciation rates of 5% -12% per year for the 9 year period.³

Appendix A sets out this example in further detail.

Risks and Additional Issues

An ISGT transaction may involve more tax and valuation risks than a Grantor Retained Annuity Trust (“GRAT”), which is explicitly permitted by federal tax law statute.   Although the ISGT is a common technique, it is important to keep the following points in mind:

• In order to avoid adverse gift tax consequences to the grantor, the promissory note must require that the grantor receive interest at the minimum rate required under current tax law. This rate is the hurdle rate above which the property sold to the grantor trust must appreciate in order for the technique to be successful.

• Before the sale the trust should have assets having a value equal to at least 10% of the amount of the installment note, a minimum amount which has been accepted by the IRS.  The purpose of the 10% minimum is to counter an argument based on economic substance that the transferor has retained an interest in the assets sold to the trust that would cause the assets to be included in the transferor's gross estate for federal estate tax purposes under the so-called “retained interest” estate tax inclusion rules.  It is preferable that there be a decent interval of time – perhaps a month or more – between the creation and initial funding of the trust and the sale of the assets to the trust.

• The exact level of the principal loan repayments will be calculated based on the discounted valuation of the assets.  If the valuation were to be successfully challenged by the IRS, then the amount in excess of the IRS valuation differential may be deemed to constitute a taxable gift for federal gift tax purposes.  If the grantor is married, this risk may be mitigated by a saving clause marital deduction formula gift under the trust provisions.

• Upon the death of the grantor, the promissory note, to the extent not repaid, becomes part of the decedent’s gross estate. If the grantor dies prior to complete loan repayment, there may be some capital gain (although the income tax rules are not presently settled).  In that event, there might be some risk of estate tax inclusion of the appreciated value of the stock in the grantor’s gross estate. To mitigate risk associated with the death of the grantor during the term of an ISGT, arrangements may be made for prepayment of the note, or, alternatively, for the debt to be assumed by grantor’s spouse, if the grantor is married.

• Because the assets are transferred during the grantor’s lifetime, they will not receive a stepped up basis upon the grantor’s death.⁴  However, the exclusion of the appreciation of the assets from estate tax is typically a greater advantage than receiving the step up in basis.

• The ISGT strategy is in some respects similar to the self-canceling installment note (SCIN). The main advantage of the SCIN is that the unpaid balance of the note is not included in the seller's estate.  The disadvantage of using a SCIN is that the terms of the promissory note must include an interest rate premium to compensate for the cancellation provision.   The use of a SCIN is typically appropriate where the grantor is in ill health and not expected to outlive his or her life expectancy.⁵  A SCIN will be disadvantageous if the grantor lives beyond his or her life expectancy.

October 2010

IRS CIRCULAR 230 DISCLOSURE
To the extent this document constitutes tax advice subject to Circular 230, this tax advice was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.  (The foregoing legend has been affixed pursuant to U.S. Treasury Regulations governing tax practice).

Appendix A

Assumptions:

• Client is sole shareholder of S Corporation in which the principal asset is appreciated real estate valued at $2,000,000.
• Client has previously recapitalized the S Corporation into voting and non-voting stock.
• The shares of non-voting stock have identical economic rights (i.e. the right to receive dividends and share in the proceeds of a liquidation).
• The non-voting shares represent $2,000,000 of the underlying pro rata value of the S Corporation's real estate.

Step One: Form and Fund Trust

• Client creates a trust which is effective to transfer property out of client’s estate for estate tax purposes but which for income tax purposes is treated as a grantor trust.
• Client funds the trust with cash in an amount ($150,000) which is at least sufficient to be used as a down payment for the purchase of the stock and reports the $150,000 as a taxable gift on a federal gift tax return.
• The beneficiaries of the trust are one or more of the client’s descendants as specified under the trust terms.
• Income and principal of the trust may be accumulated or distributed among client’s descendants in the Trustee's discretion.
• Upon termination of the trust, the principal and accumulated income will be distributed among children’s descendants pursuant to the trust terms.

Step Two: Sale of S Corporation Stock to Trust

• Client subsequently sells the S Corporation non-voting stock to the trust for $140,000 cash and a $1,260,000 9-year interest only balloon promissory note.
• Due to the minority interest and/or lack of marketability and/or control, the principal amount of the note should be significantly less than the true value of the real estate. Assuming a 30% discount, the purchase price is $1,400,000.
• Because client is considered owner of the trust for income tax purposes, client will not incur a gain on the sale of stock to the trust.
• If the IRC Section 7872 AFR rate is used for the note and the stock is valued properly, there will not be a taxable gift.

Step Three: Trust Makes Annual Note Payments

Client receives interest payments each year from the trust.

• Because client is considered owner of the trust for income tax purposes, client will not recognize interest income upon receipt of the payments.
• Client will be required to pay all of the trust’s income tax. As a result, client’s descendants receive an additional “gift” in the amount of the income tax payment with no additional gift or estate tax liability. There is flexibility for future years to change this tax treatment as may be appropriate.

*Represents the October 2010 mid-term AFR with annual compounding.