The use of an income tax defective trust as a tax planning strategy is getting increased attention from estate planners, particularly as a wealth shifting device. When combined with the benefits trusts generally offer, a well designed defective dynastic trust should, for many families be the centerpiece of the family estate plan for years to come. In the following interview, Richard A. Oshins of the Law Offices of Oshins & Associates, Las Vegas, Nevada, discusses some of the benefits and planning opportunities that defective trusts offer. Mr. Oshins comments on the installment note sale to a defective trust and compares it to similar extremely effective estate planning techniques such as the GRAT. Mr. Oshins also comments on techniques which enhance defective trust planning, such as opportunity shifting and beneficiary defective trusts both of which may enable the estate planner to avoid the transfer tax system with substantially more wealth than the traditional note sale by a grantor to a defective trust.
CCH: Describe the defective trust concept and the benefits of that planning technique.
Mr. Oshins: The defective trust is an irrevocable trust in which, for transfer tax purposes, the trust property is owned by the trust and not includible in the transferor's estate, but for income tax purposes, the trust is a grantor trust and income is taxed to the grantor as if the trust did not exist. A variation of that arrangement is a trust where the beneficiary is treated as the owner of the trust for income tax purposes under Code §678. Generally, grantor trust status is obtained by intentionally violating one or more of the grantor trust rules under Subchapter J of the Code.
The defective trust offers many planning benefits and opportunities. First, since the grantor, rather than the trust, will be taxed on the income earned by the trust, the grantor will be making, in essence, the functional equivalent of a tax-free addition to the trust without incurring any gift or GST tax. Second, by paying the tax, the grantor is reducing his or her own taxable estate by the tax paid and any future earnings which it would otherwise have generated. Any potential growth on the "tax" money will inure to the benefit of the trust rather than the grantor. Third, the IRS has ruled in Rev. Rul. 85-13 that transactions between the trust and its "owner" are ignored for income tax purposes. This enables the grantor to engage in various value shifting techniques with the trust, income tax-free.
CCH: What are some of the estate tax planning techniques available using the defective trust?
Mr. Oshins: In my experience, the three most productive wealth shifting techniques, particularly for passing on interests in closely-held business entities, are opportunity shifting, installment note sales to defective trusts and GRATs. These last two techniques closely resemble each other, but in my opinion, in most instances, the note sale offers superior results. In each case, in the typical transaction in which our firm is involved in, the estate owner transfers a non-controlling interest in the entity in exchange for either a note, in the case of the sale, or an annuity interest, in the case of the GRAT. Opportunity shifting is somewhat different from the other two techniques, so I'll address that technique after I compare the other two.
The use of an installment sale to a defective trust in exchange for the trust's promissory note has become an increasingly popular and extremely effective wealth shifting strategy. Generally, this technique is used to sell non-controlling interests in closely-held entities, options, lettered stock or other assets which have large appreciation potential. The note typically is structured as interest only for a period of time, with a balloon payment at the end of the note term and a right of prepayment. The interest is determined with reference to the rate under Code §1274. To the extent that the trust assets produce a return in excess of the relatively low Code §1274 rate, value will be shifted from the estate owner to the trust. Often the sale is made of a non-controlling interest in an entity which was part of a controlling interest in the hands of the seller, thus converting the interest sold to one which is entitled to a valuation discount. The ability to achieve the requisite interest rate where an interest in a closely-held business entity is being transferred is usually easy, since the interest rate is applied against the value of the interest sold after applying the appropriate valuation discounts, while the available cash flow to the trust is based upon a percentage of gross distributable cash flow which is not affected by the valuation discount and which is nearly always controlled by the seller. Thus, for example, an entity which has a cash flow of 10 percent of its value will yield a 16.67 percent cash flow on a transfer which received a valuation reduction of 40 percent.
CCH: Would you compare the installment note sale with the GRAT?
Mr. Oshins: I believe the installment note sale is superior to the GRAT in most respects.
First, if the grantor dies during the term of his retained interest, it is the IRS's position that all of the trust property will be included in his estate, including post-transfer appreciation. With the installment sale, survivorship is not essential in order to result in a tax benefit. The instant the sale is made, the asset owned by the seller is converted into a long-term installment note with a face amount reflecting the value of a non-controlling interest in a closely held entity with a lower than market interest rate. The low interest rate, long term, and possibly questionable ability to pay would entitle the estate to obtain a valuation discount on its 706.
In many instances, the relative tax risk by using a GRAT rather than a note sale is even greater where the interest transferred would be part of a control interest in the hands of the estate owner. For gift tax purposes, the transfer to the GRAT will reflect a valuation discount. However, if the interest is includible in the estate, it will often be converted from a non-controlling interest into one which is valued as part of a control block in the hands of the estate owner, resulting in significantly larger transfer taxes. By selecting the sale option, the estate owner is assured of obtaining a valuation discount to reflect a non-controlling interest.
A second major drawback of a GRAT as compared to a sale is that GST tax exemption cannot be allocated until the grantor's retained interest has ceased because of the ETIP rules. Code §2642(f) provides that GST tax exemption may not be allocated during any period in which the trust would be included in the grantor's estate, other than by reason of the three-year rule of §2035. At that time, the leverage feature of the retained interest is lost and the exemption would have to be allocated against the full value of the property, which is generally regarded as wasteful. In contrast, the sale technique does not include a retained interest which would subject the seller to estate tax inclusion, and consequently the ETIP problem is finessed.
For those, like me, who believe that virtually all gifts and bequests should be made in trusts in order to enhance what the beneficiaries receive, in particular the insulation of the transferred property from creditors and transfer taxes, the inability to use dynastic planning with a GRAT is a particularly meaningful detriment.
Third, the payout in the GRAT is inferior to the note sale alternative in at least three ways: (1) the interest rate for a note sale is determined under §1274, which is generally less than the interest rate for a GRAT which under §7520 is 120 percent of the federal midterm rate under §1274. The difference in interest rates will cause more to be passed out of the estate by using the sale alternative; (2) In a GRAT, the annuity payments are fixed by the trust document and are thus inflexible; (3) Moreover, the payment schedule cannot exceed 120 percent of the preceding year's payments. Because the GRAT payments will include principal and thus, will be larger, earnings from the principal will inure to the benefit of the grantor. That result is contrasted with the fact that the principal is retained by the trust in an interest only installment sale until the balloon payment, which enables the trust to derive the benefit of the earnings and growth of the unpaid deferred principal, income tax free.
Fourth, it is the position of the Service that in a GRAT the gift tax cannot be zeroed out. Although most practitioners believe that the IRS's position is incorrect, the risk of gift tax is a negative factor which must be considered. Conversely, the sale will be made for fair market value and, therefore, there is no gift.
Fifth, the Treasury Regulations prohibit anyone other than the owner of the retained interest from participating in the trust until the end of the retained term. Conversely, there is no such prohibition for a trust which acquires an installment note. Therefore, the trust beneficiaries can enjoy the trust property immediately with the sale technique, but must wait until the end of the term of the GRAT to obtain any benefits.
The GRAT, on the other hand, has two features superior to the installment sale. First, if the valuation of the interest transferred is incorrect, using the note alternative there is a much greater gift tax exposure. Moreover, because the sale is treated as having no gift tax element, no GST tax exemption would have been allocated. Although there are several methods which can be used to mitigate the risk, none of them offers the risk avoidance that is inherent in a GRAT drafted in which the annuity interest is expressed as a percentage of the initial value of the asset transferred. With a GRAT, as a condition of qualification, the Regulations require a revaluation provision whereby any shortfall or overpayment must be repaid with interest. This requirement negates the gift tax exposure.
The second benefit that the GRAT offers is that there is specific statutory authority under §2702 and other administrative guidance. The sale alternative, on the other hand, is not specifically authorized under the Code and the structuring of the arrangement is based upon the judgment of the practitioner rather than by following published judicial and administrative guidance.
CCH: In addition to the note sale and GRAT, you mentioned the concept of opportunity shifting as a mechanism for funding the defective trust. Would you please explain that technique?
Mr. Oshins: I believe that the best and most underused estate planning strategy available is "opportunity shifting," which can be defined as the shifting of the opportunity to earn income or generate wealth. In its simplest form, a person, generally a parent, will refer business to another person, or give advice to the other person about a favorable business opportunity. In the preferred, more complex version, the opportunity shifter will refer the business or give advice to a defective trust or an entity, such as an LLC or limited partnership in which interest are owned by a defective trust. Because the referring party or advisor never owns the property, there is no transfer which would be subject to the transfer tax system. Thus, when a new business is formed, a product is being developed, or a favorable investment opportunity is available, a new entity should be formed, some or all of which should be owned by a defective trust.
One variation of this concept, and a planning technique often not considered, is for the individual who has the opportunity to find a third person, such as a parent, who will set up a trust for the primary benefit of the one who has the opportunity, and gift the seed money for the new venture to the trust. I often refer to this approach as "getting an advance on your inheritance." In many instances, a small gift to a dynastic trust which is placed in a favorable business venture or investment opportunity, can mature into a significant fund which, because it is in a trust set up and funded by a third person, will not be subject to the opportunity shifter's transfer tax and will be protected from his or her creditors. Moreover, under this scenario, the person who has the favorable opportunity can be the trustee and the primary beneficiary of the trust. However, in some egregious situations, courts have ignored the trust's spendthrift provisions and have allowed creditors to access trust funds.
CCH: You mentioned a variation of the defective trust arrangement where the beneficiary is treated as the owner. How does that work?
Mr. Oshins: Where all transfers to a trust are subject to a power of withdrawal by the beneficiary, and the trust is not defective as to the grantor, the powerholder is treated as the owner of the trust under Code §678(a)(1) for income tax purposes. The income tax treatment of lapsed powers of withdrawal is not certain. However, the IRS has consistently ruled that the former powerholder remains the taxpayer after the lapse under Code §678(a)(2). Thus, a trust defective as to the beneficiary can be created by giving the beneficiary the power to withdraw contributions to the trust.
In many respects, the Beneficiary Defective Trust is superior to a trust under which the grantor is taxed. All benefits of the traditional defective trust are also available to the beneficiary of the Beneficiary Defective Trust. In addition, because the trust is set up by a third person, the beneficiary can be the trustee of the trust as well as its primary beneficiary without exposing the trust assets to the transfer tax system. Since the trust, rather than the beneficiary, owns the property, the assets receive protection from creditors, including a spouse in a divorce. These benefits, control and enjoyment of the trust property, could not be obtained by a grantor because of Code Secs. 2036 and 2038. Another right that can be given to a beneficiary and not retained by a grantor is the power to control the subsequent disposition of the trust assets.
CCH: Would you give us an illustration of how the Beneficiary Defective Trust would work?
Mr. Oshins: Assume a client has a new business opportunity which requires a $100,000 investment. Instead of the client shifting the opportunity, a third party, typically a parent, would set up a trust for the primary benefit of the client and, secondly, for the client's descendants. The client can be selected as the trustee and can be given a broad special power of appointment over the trust assets (we call this a "Beneficiary Controlled Trust"). The client would also be given a power of withdrawal over the $100,000 which lapses as to the greater of 5% or $5,000 each year.
As a result of the power of withdrawal, the client will be treated as the owner of the trust for income tax purposes, and, therefore, can sell assets to the trust tax-free. This will enable the client to access the cash flow of the business for his own personal enjoyment. The client will also be able to shift assets from his taxable estate to the trust. Because he is both the trustee and primary beneficiary, he could continue to use, control and enjoy the transferred assets without them being subject to inclusion in his estate. Code Sec. 2036 would not apply because the assets would be transferred for equal value. The estate tax exposure would be limited to the amount the client could have withdrawn at death, an amount which would be reduced annually by the lapse. If the business opportunity proved to be successful, the value of the trust would grow rapidly, resulting in the amount subject to withdrawal lapsing quickly.
The concept of a Beneficiary Controlled/Beneficiary Defective Trust, combined with opportunity shifting concepts, can significantly erode the transfer tax system, particularly for families that own closely-held businesses.