How to Slash Gift, Estate, and Generation-Skipping Transfer Taxes: Part II
Good to Know
This blog is the second of a three-part series that includes:
- Part I: Reducing the IRS valuation (but not the real value) of Client Assets,
- Part II: Creative Use of Installment Sales and Specialized Trusts, and
- Part III: Using Annuities, Charitable Trusts, and Other Techniques.
Background—Eliminate Transfer Taxes
This blog combines the valuation discounts we discussed in our last blog with a sophisticated version of the installment note to potentially eliminate transfer taxes. As a reminder from Part I of this series, your client Sue owns 100% of the shares of ViralVeil, Inc., a privately held corporation valued at $100 million (MM). There were 100 shares of voting common stock issued and outstanding. There were no other classes of stock. Sue wanted to gift 90 shares of the corporation to her children; the value of the gift of 90 voting common shares would have been $90MM for gift tax purposes.
She could have used valuation discounting techniques to reduce the gift tax value of the 90 shares from $90MM to $54MM. This tactic alone would have saved over $14MM in gift taxes. Yet, she would still have to pay over $17MM in gift taxes. This blog will illustrate how to eliminate all gift taxes when Sue transfers the 90 shares to her children. We will begin with the creative use of installment sales techniques as an alternative to making an outright gift.
Self-Cancelling Installment Note (SCIN)
This strategy assumes that the 90 shares of non-voting stock are sold using a variation of the standard installment note. A SCIN has a self-cancelling provision, which cancels the note upon the death of the seller. The debt is literally cancelled at the seller's death. Such arrangements are typically useful when a parent or grandparent desires to transfer assets to another generation with minimal transfer tax consequences.
Self-Cancelling Installment Note Requirements
A compliant SCIN must include a risk premium to the seller, and the buyer must demonstrate “economic substance.”
Risk Premium
The self-cancellation provision in the installment note must be carefully crafted if the note is to avoid any adverse gift or estate tax consequences. One tactic is for the buyer (typically a child or a grandchild) to pay a risk premium to the seller (Sue in this case) for the self-cancelling feature in the form of a higher interest rate. The IRS requires that Sue (the seller) receive a risk premium to compensate her for the risk that the note will be cancelled before it is fully paid off. Furthermore, the note must be structured based on the actuarial chance the seller will die – essentially eliminating any “sham” transactions where the death of the seller is imminent. The IRS may take a close look at intra-family transfers, so care must be taken to structure it as an arm’s length transaction, or the IRS may deem the transfer a gift.
Economic Substance
Sue would be selling 90 shares of non-voting stock to her children for $54MM. The IRS perspective is that a loan of $54MM would generally require a downpayment or other evidence of creditworthiness. While the IRS may not specify what “economic substance” looks like, SCINs have been structured in practice with a 10% downpayment from the buyer. What does that mean for Sue’s children? They must come up with a $5.4MM downpayment from their own resources, or Sue can gift the $5.4MM to them! The 5.4MM gift to the children would not incur gift tax, assuming Sue has at least that much remaining in her Basic Exclusion Amount.
Zero Estate Tax Plan
Sue likes these strategies and puts them into action. She sells the 90 non-voting shares to the children for $54MM. The children use $5.4MM in cash to pay Sue the 10% downpayment, and they finance the remainder of the purchase price with a SCIN. The sale is not considered a gift if properly structured. At Sue’s death, the value of the SCIN is zero in her gross estate because it is cancelled. Voila! Sue has a zero estate plan. As an added bonus, Sue retains control of the corporation while she is alive. Remember that she owns the voting shares (refer to Part I in our blog series).
Sue can potentially avoid all gift and estate taxes using this strategy, but what about income taxes? It turns out that Sue must pay income taxes on the capital gains and interest income as part of the installment sales transaction. A specialized type of trust, the Intentionally Defective Grantor Trust, can address the income tax issue.
Intentionally Defective Grantor Trust (IDGT)
An IDGT is a grantor trust. A grantor trust is considered a taxpayer’s alter ego for income tax purposes. If the grantor (Sue) sells the 90 shares to an IDGT for which she is the grantor, the IRS tells us that Sue is selling to herself. Based on that premise, the IRS further informs us that you cannot be taxed when you sell your property to yourself (i.e., your alter ego). The beneficiaries of the trust should be Sue’s children so that her children receive the shares when the trust terminates. The trust can terminate for many reasons, including the death of the grantor (Sue). Dividends paid to the trust from Sue’s corporation can be used to make principal and interest payments to Sue. Sue may be taxed on a portion of the dividend income because an IDGT is a grantor trust. Interestingly enough, the income taxes Sue pays are not considered a gift to the children (trust beneficiaries).
Coming Attractions
Our next blog in this series will illustrate how different strategies such as Annuities, Charitable Trusts, and other techniques can be used to reduce or avoid gift and estate taxes.
Disclaimer
The information presented herein is provided purely for educational purposes and to raise awareness of these issues; it is not meant to provide and should not be used to provide gift, estate, generation-skipping, or financial planning advice of any kind. An experienced estate planning attorney should advise clients in these transfer tax issues. There are variations, alternatives, and exceptions to this material that could not be covered within the scope of this blog.
