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Sophisticated Planning Techniques
 
Grantor Retained Annuity Trust (“GRAT”)
Sale to Income Defective Grantor Trust (“Freeze”)
Qualified Personal Residence Trust (“QPRT”)
Self Canceling Installment Note (“SCIN”)
Private Annuity

Grantor Retained Annuity Trust (“GRAT”)
A grantor retained annuity trust (“GRAT”) is a technique that allows the future appreciation in an asset to be transferred at little or no tax cost. With a GRAT, the grantor transfers property to an irrevocable trust and retains the right to a fixed annuity payment for a specific term of years. At the end of the trust term, the property passes to the grantor’s children or other beneficiaries, either outright or in trust. Accordingly, this an effective vehicle for a client who wants or needs to retain all or most of the income from high yielding and rapidly appreciating property.

All income and appreciation in excess of the amount required to pay the annuity passes to the remainder beneficiaries free of transfer tax. The gift tax value of the transferred assets is determined at the time the trust is established. The amount of the gift is the amount equal to the difference between the value of the property transferred (taking into account applicable discounts) and the value of the retained annuity, which assumes that the payments will cease at the earlier of the annuity term or the grantor’s death.

The interest rate used for valuing the gift is established under section 7520 of the Internal Revenue Code as 120% of the Applicable Federal Annual Mid-term Rate as published in the month the property is transferred to the GRAT. In order for the GRAT technique to be effective, the combined income and appreciation of the property transferred to the GRAT must exceed this 7520 rate.

For income tax purposes, the GRAT is treated as owned by the grantor. Accordingly, the grantor is taxed on income and gain recognized by the GRAT even if those amounts are larger than the annuity payments. This improves the wealth transfer effectiveness of the GRAT since the grantor is in effect making additional gifts to the remainder beneficiaries of the income taxes that are really attributable to assets that belong to the remainder beneficiaries of the GRAT.

The risk of the GRAT is that for estate planning benefits to be realized, the grantor must outlive the term of the trust. If the grantor dies during the term, the property will be included in his or her estate for estate tax purposes. This risk can be minimized and possible avoided in several different ways, including purchasing life insurance, creating multiple GRATs with varying terms and the sale of the remainder interest of the GRAT.

Some commentators have suggested that Florida statutes dealing with asset protection may apply to GRATs so that GRATs may provide not only estate tax benefits, but asset protection benefits as well.

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Sale to Income Defective Grantor Trust (“Freeze”)
This technique is very effective for a grantor to transfer high yielding and rapidly appreciating assets to a trust established for the benefit of the grantor’s family members, and “freeze” the value of such assets for estate tax purposes.

A grantor trust, also referred to as a defective income trust or a wholly grantor trust, is a trust that is structured in a way that all income and principal of the trust is deemed to be owned by the grantor of the trust for federal income tax purposes. This means that the grantor must report all of the income, deductions and credits of the trust on his or her individual income tax return.

Since the trust is ignored for federal income tax purposes, a sale or other transaction between the grantor and the trust will not be treated as a taxable event. In a normal sale transaction, there would be taxable income to the grantor to the extent that the purchase price exceeded his or her tax basis in the asset sold to the trust. However, since the trust is a grantor trust it is treated as if it was not a separate taxpayer from the grantor for income tax purposes. Thus the sale of the asset is not treated as a sale for income tax purposes and no gain or loss is recognized. It is important to note that this exception applies for income tax purposes only. The grantor trust is treated as a separate entity for estate and gift tax purposes. Thus, while no income tax consequences result from the sale, the sold asset is not includible in the grantor’s taxable estate for estate and gift tax purposes.

This technique is often compared to a grantor retained annuity trust (“GRAT”), however the major advantage of the sale is that the transferred property will be excluded from the grantor’s estate regardless of the time of death (although the balance due on the promissory note given to the grantor in the installment sale transaction will be included in the grantor’s estate). This is different than a GRAT, where the death of the grantor prior to the expiration of the term causes the assets to be included in the grantor’s estate. Another advantage of the installment sale over the GRAT is that interest payable to the grantor is required to be calculated at the applicable federal rate as opposed to 120% of the mid-term rate. Since the grantor receives a lower rate of return, assets with a greater value are ultimately passed to the beneficiaries. The sale is also a better vehicle for transfers to grandchildren since the generation skipping transfer (“GST”) tax exemption cannot be allocated to a GRAT until the expiration of its term.

The disadvantages of the installment sale when compared to the GRAT are the increased gift tax exposure resulting from an incorrect valuation of the transferred property. With a GRAT, the annuity is expressed in terms of a percentage so that an incorrect valuation will automatically be adjusted.

Another disadvantage is that the grantor trust must be funded with assets that can support the promissory note obligation. This generally requires the grantor to make a gift to the trust of about 10 to 15% of the value of the property sold.

If you have any questions regarding the installment sale to grantor trust transaction or would like to know whether it may be an appropriate estate planning tool for you, please contact us.

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Qualified Personal Residence Trust (“QPRT”)
The qualified personal residence trust "QPRT" is an effective technique to reduce transfer taxes with respect to a primary and vacation residence.

The "QPRT" would be designed, for example, as follows:

  1. The Settlor of the QPRT would transfer the residence to the QPRT and retain the right to reside in and use the residence for a period of years (term); and

  2. At the end of such term, the retained interests would expire and the residence would be distributed to the remainder beneficiaries (children).

After the expiration of the QPRT, the settlor could lease the residence from the remainder beneficiaries (children) for fair rental value. This would permit the Settlor to continue to live in the residence without interruption. Upon the expiration of such term, if the Settlor survives such term, the residence at its appreciated value is removed from the Settlor's gross estate for transfer tax purposes.

For example, assuming a taxpayer age 60, creates a QPRT for the benefit of his or her children in a month when the §7520 rate is 7.0%. Also assume the residence is valued at $1,000,000 and the QPRT is established for 15 years. The transfer of the residence to the QPRT will generate a gift of $256,140 (75% transfer tax savings).

The "down-side" risks associated with the "QPRT's" is that if the Settlor dies prior to the expiration of the term, the fair market value of such residence is includible in the Settlor's gross estate for federal estate tax purposes. This risk can be minimized and possibly avoided in several different ways, including purchasing life insurance, creating multiple QPRTs with varying terms and the sale of the remainder interest of the QPRT.

If you are interested in using a QPRT for your primary or vacation residence or have any questions or comments on how this technique would more particularly apply to your situation, please contact us.

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Self Canceling Installment Note (“SCIN”)
An installment note is a promissory note issued in conjunction with the sale of property where at least one payment is to be received by the seller after the close of the taxable year in which the sale occurs. A self-canceling installment note (“SCIN”) is an installment note which contains a provision under which the buyer's obligation to pay automatically terminates in the event the seller dies before the end of the term of the note.

SCINs are useful when one family member, typically a parent or grandparent, wishes to transfer property to another family member, typically a child or grandchild, with minimal gift and estate tax consequences.

In general, the fair market value of any unpaid installment obligation on the date of death is included in the estate of the seller. However, if the note is a SCIN, the buyer is under no obligation to make any further payments after the seller's death, which leaves no unpaid balance to be included in the seller's estate. The SCIN can be an effective means of transferring property to family members without estate or gift tax consequences in the event of the death of the seller predeceases the term of the note.

If the transaction is to be recognized as an arm’s length sale rather than a part sale/part gift, the seller must be compensated for the risk of not receiving the entire purchase price. Therefore, either the principal balance of the note or the interest rate payable under the note will be greater than it would be in an ordinary promissory note sale. This increased amount is referred to as risk premium.

The choice of whether to reflect the risk premium as an increase in the sales price or as an increase in the interest rate depends on the relative tax situations of the buyer and seller.

If the Seller outlives his or her life expectancy, determined at the time of the sale, the buyer will effectively overpay for the assets, thereby increasing Seller’s taxable estate.

If you have any questions regarding the SCIN or would like to know whether it may be an appropriate estate planning tool for you, please contact us.

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Private Annuity

An alternative to a self canceling installment note (“SCIN”) is a private annuity. The key difference between the two transactions is that is that a SCIN has a fixed maturity date, whereas the private annuity continues until death. As such, the private annuity is a useful tool if the seller is expected to predecease his or her life expectancy. A private annuity does not require the risk premium applicable in a SCIN transaction.

The private annuity is a useful tool for an individual who wants to spread gain from a highly appreciated asset over his or her life expectancy. It is also a very effective estate tax saving tool since payments end when the transferor dies and the entire value of the asset sold is immediately removed from the transferor's gross estate.

For income tax purposes, the seller recovers his or her tax basis over the expected annuity payments, so that each payment received upon a sale of appreciated property is in part a return of basis, capital gain and ordinary income. Once the seller has reached his or her life expectancy and recovered basis in full, excess payments are taxable as ordinary income. Sellers who die prior to their life expectancy may deduct the unrecovered basis on their final tax returns.

In both a private annuity and a SCIN, the buyer risks paying more for the property than he or she would pay using cash or an installment note. The major advantage of the private annuity is that there is no income included in the seller’s estate at death. If the seller dies prior to life expectancy, the buyer would receive property at below fair market value, and there would be no estate or income tax inclusion by the seller. In addition, the buyer is not entitled to an interest deduction in a private annuity even though a portion of each payment is included in the seller’s income. The interest payments made on a SCIN transaction are deductible.

If you have any questions regarding the private annuity or would like to know whether it may be an appropriate estate planning tool for you, please contact us.

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