The Goals

The owners of interests in closely-held businesses have long sought out ways by which they can remove the future appreciation of such interests from their gross estates for estate tax purposes, but without incurring gifts taxes and income taxes.

One popular method to achieve these goals has been the sale of the closely-held interest to a grantor trust. A grantor trust is an irrevocable trust of which the seller is treated as the owner for income tax purposes. Thus, for income tax purposes, a grantor trust is taxed as if the deemed owner owned the trust assets directly, and the deemed owner and the trust are treated as the same person. This results in transactions between the trust and the deemed owner being ignored for income tax purposes; specifically, no capital gain is recognized when an appreciated interest in a closely held business is sold by the deemed owner to the trust.

For transfer tax purposes, however, the trust and the deemed owner are treated as separate persons and, under certain circumstances, the trust is not included in the deemed owner’s gross estate for estate tax purposes at the death of the deemed owner. In this way, the post-sale appreciation has been removed from the deemed owner’s estate for estate tax purposes. The greater the post-sale appreciation, the greater the transfer tax benefit achieved.

The IRS Doesn’t Like It

Sales to grantor trusts use the disconnect between the income tax and transfer tax rules – specifically, the ability to sell a property for gift tax purposes, but to still own it for income tax purposes – in order to transfer wealth while minimizing the gift and income tax cost of such transfers. If this wasn’t bad enough for the IRS, future capital gains taxes can also be avoided by the grantor’s “repurchase,” at fair market value, of the appreciated asset from the grantor trust and the subsequent inclusion of that asset in the grantor’s gross estate at death. Under current law, the basis in that asset is then adjusted (“stepped-up”) to its fair market value at the time of the grantor’s death, often at an estate tax cost that has been significantly reduced or entirely eliminated by the grantor’s lifetime exclusion from estate tax.

Consequently, the IRS will often challenge a taxpayer’s sale to a grantor trust. The results have been mixed, depending upon how carefully the subject transaction was structured, as illustrated by one case earlier this month.

A Recent Example

The Decedent was employed by and held the majority of the voting and nonvoting shares of Company, a closely-held manufacturing business.

In 1999, the Trust was executed by Decedent and his Spouse as donors, and their two sons as trustees. The Trust purchased three life insurance policies on the joint lives of Decedent and Spouse.

The Trust and Company entered into a Split-Dollar Insurance Agreement that covered the three life insurance policies owned by the Trust. Pursuant to this agreement, Company was obligated to pay a portion of the annual premiums equal to the total premiums less the annual Value of the Economic Benefit (VEB) amounts. Decedent was required to pay the annual VEB amounts. Upon the death of the survivor of Decedent and Spouse, the Trust was required to reimburse Company for its prior premium payments.

In 2006, Decedent sold all of his nonvoting stock of Company to the Trust in exchange for a promissory note in the amount of $59 million, and bearing interest based upon the applicable federal rate. The purchase price was determined by an appraisal of the stock’s fair market value by an independent appraiser.

The sale of the nonvoting stock was made pursuant to an Installment Sale Agreement, which provided that the Decedent sold stock to the Trust worth $59 million. The agreement further provided that both the number of shares of stock sold and the purchase price of $59 million were determined one month before the sale, but that Decedent and the Trust acknowledge that the exact number of shares of stock purchased by the Trust depended on the fair market value of each share of stock. The sale agreement further provided that, based on a recent appraisal of the stock, this resulted in one million shares of stock being purchased, but that in the event that the value of a share of stock was determined to be higher or lower than that set forth in the appraisal, whether by the IRS or a court, then the purchase price would remain the same but the number of shares of stock purchased would automatically adjust so that the fair market value of the stock purchased equaled $59 million.

At the time of the 2006 stock sale, and subsequently, the Trust had significant financial capability to repay the promissory note without using the acquired nonvoting stock of Company or its proceeds.

At the time of the sale, the Trust owned three life insurance policies on Decedent’s and Spouse’s lives with an aggregate cash surrender value of over $12 million. Decedent’s estate claimed that all of this cash value could be pledged to a financial institution as collateral for a loan that could be used to make payments on the promissory note to Decedent. A portion of the cash value could also be accessed via policy loan or via the surrender of paid-up additions to the insurance policies that could be used to make payments on the note. Moreover, since Company was required to continue making payments during Decedent’s and Spouse’s lifetimes under the Split-Dollar Insurance Agreement, the amount of cash surrender value available for this purpose would continue to grow.

In addition, the beneficiaries of the Trust executed personal guarantees in the amount of ten percent of the purchase price of the stock.

Decedent passed away in 2009, and his estate tax return was filed in 2010. After examining the return, the IRS timely issued a Notice of Deficiency in 2013. Decedent’s estate filed a petition with the Tax Court .

The IRS’s Challenge

The Notice of Deficiency asserted a deficiency in gift taxes for 2006 (the year of the stock sale) in excess of $31 million. Specifically, the IRS determined that the promissory note that Decedent received in the exchange should be disregarded, and the entire fair market value of the nonvoting shares of Company stock that Decedent sold to the Trust in 2006 – which the IRS determined was over $116 million (almost double the value of the taxpayer’s appraisal) – should be treated as a taxable gift. (You should always count on the IRS to challenge the reported fair market value of a closely-held company.)

In the alternative, the IRS determined that the Decedent made a taxable gift equal to the difference between the fair market value of the Company shares sold to the Trust in 2006 and the principal of the promissory note received in exchange.

The IRS also determined that the entire value of the stock acquired by the Trust in 2006 should have been included in Decedent’s gross estate for purposes of the estate tax (again ignoring the promissory note), claiming that Decedent had retained, for his life, the possession or enjoyment of, or the right to the income from, the Company stock Decedent sold to the Trust in 2006. (By the date of Decedent’s death, the value of the stock had increased another $46 million, according to the IRS.)

Finally, the IRS asserted that the 2006 stock sale was not a bona fide sale for adequate and full consideration, and that the promissory was not the personal and enforceable obligation of Decedent.

Oh, Shucks

After being scheduled for trial, the Decedent’s estate and the IRS reached a settlement, and the Tax Court signed a stipulated decision in which both parties agreed that there were no gift tax or estate tax deficiencies.

“Why, Lou, are you disappointed?” you may ask. “Didn’t the taxpayer emerge victorious?”

True, but think about it. The Decedent’s sale to the Trust was not especially remarkable, at least on its face. The Trust was funded with sufficient assets to support the note, and the beneficiaries personally guaranteed the note. A contemporaneous value for the shares was obtained from an independent appraiser. The note bore adequate interest, at the applicable federal rate. The transaction was properly documented. Why would the IRS have challenged such a transaction?

That being said, there were some elements of the transaction, the Court’s resolution of which could have had implications for future planning. For example, the use of insurance on the life of the Decedent to support the Trust’s note. Also, did Decedent and the Trust use separate counsel? What about the beneficiaries who guaranteed the debt? Did they have independent wealth to support their guarantees?

What’s Next?

As we said last week, so much will depend upon the outcome of the November elections.  A Democratic victory could see the introduction of proposals to eliminate the disconnect between the income tax and transfer tax rules.

Under one such proposal (that has appeared in the current Administration’s budgets for several years and that would likely be reintroduced under the right circumstances), if a person who is the deemed owner of a trust under the grantor trust rule engages in a transaction with that trust that constitutes a sale or exchange that is disregarded for income tax purposes by reason of the person’s treatment as the deemed owner of the trust, then the portion of the trust attributable to the property received by the trust in that transaction (i) would be subject to estate tax as part of the gross estate of the deemed owner, (ii) would be subject to gift tax at any time during the deemed owner’s life when his or her treatment as a deemed owner of the trust is terminated, and (iii) would be treated as a gift by the deemed owner to the extent any distribution is made to another person during the life of the deemed owner.

Until then, however, taxpayers and their advisers should monitor the IRS’s efforts in the courts to restrict sales to grantor trusts, and they should be careful in how they structure such transactions.