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By Deborah M. Beers, Esq.
Buchanan Ingersoll & Rooney, Washington, DC
By reason of Internal Revenue Code §2642(e) and §2642(f), it is difficult to allocate GST exemption either to a charitable lead annuity trust (CLAT) or a grantor retained annuity trust (GRAT) effectively at the inception of those trusts.
In the case of a CLAT, §2642(e) states that the percentage of a CLAT that will be subject to the GST (the "inclusion ration") is equal to a fraction, the numerator of which is the amount of the GST exemption allocated to the trust, plus the assumed appreciation under §7520, (currently 1.8%) in the value of that exemption over the trust term, and the denominator of which is the actual value of the trust assets at the end of the term. As a result, if the assets in the CLAT appreciate at a rate significantly in excess of the §7520 rate (which is the objective of almost all CLATs) that appreciation will be subject to GST tax on the termination of the trust.
Similarly, under §2642(f), GST exemption may not be allocated to a GRAT1 until the end of the estate tax inclusion period – or ETIP. Any allocation made at that time must be at the values in effect at the close of the ETIP, again negating any attempt to leverage the GST exemption.
Practitioners have suggested various "fixes" for the above problem, some of which may be summarized as follows:
The problem with the second option, above, is that the IRS has indicated,4 in a situation in which the remainder interest was given away to a dynasty trust, rather than sold, that it will not respect the form of the transaction and will deem that the original transferor, under §2652, to the CLAT (in that case) will not be changed, except to the extent of the sales price of the interest, which, as noted above, is likely to be negligible. Many practitioners believe that the IRS's position is wrong,5 but the cost to the taxpayer of guessing wrong would be a GST tax due – payable by the trustee from the trust assets - on termination of (or upon a distribution to skip persons from) the CLAT or GRAT.
It is clear, however, from the description of the facts and findings of PLR 201436007, that some taxpayers may be moving forward with the remainder interest sale technique.
In PLR 201436007, Grantor created TRUST 1 as a wholly owned grantor trust on an unspecified date. Although it is not stated in the ruling, it is likely that TRUST 1 was an intentionally-defective grantor trust, and also likely that TRUST 1 was exempt, by reason of an allocation of the Grantor's GST exemption, from the generation-skipping transfer tax.
Grantor proposed to create TRUST 2, which also will be a wholly-owned grantor trust. Grantor proposed to fund TRUST 2 with a contribution of S corporation stock to TRUST 2 and sell the TRUST 2 remainder interest to TRUST 1. TRUST 2 will elect to be an electing small business trust (ESBT) under 1361(e) upon creation. Again, although it is not stated in the ruling, the fact that the remainder will be sold to TRUST 1 probably indicates that TRUST 2 is a GRAT. Since both trusts are grantor trusts, there would be no gain on the sale.
Grantor requested and got two rulings regarding the effect of the sale on TRUST 2's ESBT status:
1. The sale of the TRUST 2 remainder interest to TRUST 1 will not disqualify TRUST 2 from being an ESBT under §1361(e) during the period when TRUST 1 is a grantor trust as to X because the sale of the remainder interest is not a "purchase" within the meaning of §1361(e). [Note that §1361(e)(1)(A)(ii) states that no interest in an ESBT may be acquired by purchase.] The sale is not a purchase because a purported sale from one grantor trust to another is ignored for federal income tax purposes. (Rev. Rul. 85-13, 1985-1 C.B. 184), and because the basis of property acquired by gift is a carryover basis under §1015(a), and is not governed by §1012(a); and
2. TRUST 2 will not cease to be or fail to qualify as an ESBT after the termination of TRUST 1's grantor trust status because TRUST 1's acquisition of the remainder is not a purchase within the meaning of §1361(e).
The PLR does not discuss (and probably was not asked to rule on) the potential GST implications of the ruling, as described above. However, the PLR notes, in the customary caveat section, that:* * * Specifically, we express no opinion regarding the identity of the transferor of the remainder interest in the S corporation stock to TRUST 2 for purposes of §§2511 and 2652 or the tax consequences of that transfer. In addition, we express no opinion on whether the S corporation stock will be includible in the gross estate of any transferor under §2036 or any other provision of the Code.
This indicates that the IRS was at least aware of the probably purpose of, and the potential for avoidance of the GST tax on termination of TRUST 2 through, the use of the remainder interest sale.
PLR 201436007 does not answer the question of whether the remainder interest sale technique works to avoid the consequences of Section 2642(e) and (f). It does, however, indicate that taxpayers are using this technique in a situation that it would appear to make sense to do so despite the IRS's clear reluctance to bless it. Because of the risks involved, however, practitioners and their clients who are inclined to assume them would be well advised to take a few precautions.
To avoid any step transaction assertions, or attempt to collapse the transaction and treat the grantor of the GRAT as the transferor of the entire value of the assets in the GRAT, the purchasing trust (the GST-exempt grantor trust) ideally should be in existence well in advance of any sale to it by the GRAT. Second, the remainder interest should be transferred by sale, as opposed to gift, for whatever protection may be achieved via the "bona fide sale" exception in § 2036 and also to avert an attempt to conflate the gift to the GRAT and the gift of the remainder interest. The GRAT's spendthrift clause, if any, should not prevent the assignment of an interest in the trust.
However, even if the technique fails, the tax consequences may not be disastrous, since the downside risk is the imposition of a GST tax on the termination of the GRAT (or perhaps on future distributions from the GRAT to skip persons) vs. an almost certain imposition of an estate tax upon the death of the grantor's children if they are the remainder beneficiaries. Depending on (i) the term of the GRAT (or CLAT), (ii) the availability of estate tax exemption to the child's estate, (iv) the applicability, if any of a state estate tax (few states imposed GST taxes), and (iii) the age difference of the grantor and his or her children, and given that there is no longer any difference in the tax rates for the GST and estate taxes, this may be a question of timing more than dollar amounts, so what is really at risk may be the time value of money.
For more information, in the Tax Management Portfolios, see Harrington, 850 T.M., Generation-Skipping Transfer Tax, and in Tax Practice Series, see ¶6340, Generation-Skipping Tax.
Copyright©2015 by The Bureau of National Affairs, Inc.
2 If a child dies during the trust term, the then value of his or her remainder interest (actuarially determined) would be includible in the child's estate, although the tax on the value of that remainder interest could be deferred until the end of the trust term. §6163.
3 A third option might be to make sure that there is always a non-skip person (including, perhaps a charity with a substantial, present, and nondiscretionary right to receive income or corpus from the trust) as a significant beneficiary of the trust.
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