Installment sales to intentionally defective (grantor) irrevocable trusts (IDITs) have long been a popular estate-planning tool.1 In a typical IDIT sale, the seller establishes, funds and then sells an asset to an irrevocable trust designed to be treated as owned for income tax purposes (a grantor trust), but not estate tax purposes, by the seller/settlor. The seller is usually neither a beneficiary nor a trustee. A promissory note comprises a large majority of the purchase price. Transactions between the seller/settlor and the IDIT are disregarded for income tax purposes.2 The net effect is, in a rough sense, equivalent to what may be achieved by using a grantor retained annuity trust (GRAT), but an IDIT sale offers a few advantages over a GRAT that some clients find appealing.3
IDIT sales aren’t popular with the government, to say the least. They’ve been challenged in at least three cases in recent memory (Karmazin,4 Woelbing5 and Davidson6), and the President’s Greenbook contains a proposal that, if enacted, would effectively shut down IDIT sales.7 Yet, as things stand now, the IDIT sale strategy seems alive and well. The settlements reached in Karmazin and Davidson are regarded as taxpayer successes,8 and the Greenbook proposal seems headed nowhere.
In this context, some clients and their estate-planning professionals may wish to consider a variation on the traditional IDIT sale theme. With an installment sale to a beneficiary defective inheritor’s trust (BDIT), an individual (not the seller) establishes and funds an irrevocable trust that’s designed to be treated as a nongrantor trust for income tax purposes as to the settlor. The settlor retains no beneficial interests or powers whatsoever, but the seller is the beneficiary and, as such, may receive discretionary income and principal distributions for his health, education, maintenance and support. The trust’s governing instrument confers a Crummey9 withdrawal power on the beneficiary. The Crummey power, coupled with other trust provisions (discussed below), causes the trust to be treated as owned for income tax purposes (a grantor trust) by the beneficiary. The beneficiary sells an asset to the BDIT, and a large component of the consideration flowing from the BDIT consists of a note. Transactions between the seller/beneficiary and the BDIT are ignored for income tax purposes,10 and, assuming the beneficiary doesn’t die until after the Crummey power has lapsed, the beneficial interests and powers held by the beneficiary are insufficient to cause inclusion of the value of any of the trust property in his gross estate.
While not precedent,11 a couple of private letter rulings suggest how to structure a BDIT.
In PLR 201216034 (April 20, 2012), a trust was established for a beneficiary, who was also the sole trustee. The settlor could make contributions to the trust at any time, but the trust was a nongrantor trust with respect to the settlor. Whenever a contribution was made, the beneficiary had a cumulative power to withdraw the entire contribution. However, each year the beneficiary’s power lapsed to the extent of the greater of $5,000 or 5 percent of the value of the trust’s principal. In addition, the beneficiary, as trustee, could make distributions to himself of income or principal in accordance with an ascertainable standard but was prohibited from distributing to any beneficiary whom he was legally obligated to support. The beneficiary also had a nonfiduciary power to acquire trust property by substituting assets of an equivalent value, such value to be determined by an independent appraiser.
The settlor intended to transfer S corporation shares to the trust. The trustee sought rulings from the Internal Revenue Service regarding whether: (1) the trust would be treated as “owned” for income tax purposes by the beneficiary; (2) the trust would be regarded as an eligible shareholder of stock in an S corporation; and (3) the value of the trust assets would be includible in the beneficiary’s gross estate on his death.
With respect to whether the trust would be treated as owned by the beneficiary for income tax purposes, the IRS concluded, first, that the trust would be so treated with regard to the portion of the trust with respect to which the beneficiary had a presently exercisable right of withdrawal. Because the trust wasn’t a grantor trust with respect to the settlor, Internal Revenue Code Section 678(a)(1) applied. IRC Section 678(a)(1) provides, essentially, that a trust will be treated as owned, for income tax purposes, by a person other than the settlor if such person holds a power of withdrawal exercisable solely by such person. The beneficiary’s power of withdrawal, therefore, triggered grantor trust status with respect to the beneficiary for so long as and to the extent such power of withdrawal was exercisable.
The rationale summarized in the preceding paragraph didn’t apply, however, from and after the point when the beneficiary’s power of withdrawal lapsed. The IRS stated, however, that the beneficiary could potentially be considered the owner of the trust for income tax purposes under Section 678(a)(2) after his power of withdrawal lapsed if, thereafter, he held another power that would result in grantor trust status under IRC Sections 671 to 677. The other power in this case was the beneficiary’s right to acquire trust property by substituting assets of an equivalent value.12 The IRS noted that whether Section 678(a)(2) applied would be based on whether the power of substitution met the requirement under IRC Section 675(4)(C) that the power be exercisable in a nonfiduciary capacity. The IRS stated that this is a factual determination, and so it wouldn’t render a definitive ruling on whether the interplay between Section 678(a)(2) and Section 675(4)(C) conferred grantor status on the beneficiary.
Addressing the second ruling request, the IRS, assuming that the entire trust was properly treated as owned by the beneficiary for income tax purposes, ruled that the trust would be considered an eligible shareholder of stock in an S corporation under IRC Section 1361(c)(2)(A)(i).
As to the third ruling request, the IRS concluded that the trust property subject to the beneficiary’s power of withdrawal at his death would be considered property subject to a general power of appointment (POA), causing the value of such property to be
includible in his gross estate for estate tax purposes.13
In PLR 200949012 (Aug. 17, 2009), a trust was established for a beneficiary. Whenever a contribution was made to the trust, the beneficiary held a cumulative power to withdraw the entire contribution. However, each year the beneficiary’s power lapsed to the extent of the greater of $5,000 or 5 percent of the value of the trust’s principal. In addition, the beneficiary could direct the making of distributions to himself of income or principal for his health, education, maintenance and support. This power of direction didn’t lapse. Also, the beneficiary held a testamentary power to appoint the remaining trust property to or for anyone other than himself, his estate or the creditors of either.
Neither the settlor nor the settlor’s spouse had any current or potential beneficial interest in the trust, and neither of them was or could become a trustee. There were myriad savings provisions in the trust instrument designed to ensure that the settlor couldn’t be considered the owner of the trust for income tax purposes.
The IRS first ruled that the settlor wasn’t an owner of the trust under Section 671 and that neither the settlor nor anyone else was the owner of any portion of the trust under IRC Sections 673, 674, 676, 677 or 679. As usual, the IRS refused to rule on whether Section 675 applied, stating that was a question of fact to be determined when federal income tax returns are filed.
The IRS next ruled that the beneficiary would be treated as the owner of the trust for income tax purposes under Sections 671 and 678 both before and after the lapse of his power of withdrawal.
Although the IRS didn’t so state in either of the PLRs summarized above, it appears the IRS treated the lapse of the beneficiary’s power of withdrawal in each case as a release and further treated such lapse as a partial release within the meaning of Section 678(a)(2).
As with all sophisticated estate-planning techniques, close attention to the details in the design and implementation is critical, but, for those thinking about an IDIT sale, a BDIT sale could be a superior option in at least a few respects. The seller in a BDIT sale may obtain better asset protection because the seller doesn’t convey any property to the trust without having received “reasonably equivalent value” in exchange, and so whether the seller made a fraudulent transfer shouldn’t be an issue.14 Additionally, to ensure that, even if the BDIT sale were considered in part gratuitous, the transaction wouldn’t be treated as a completed gift, the seller in a BDIT sale may hold a non-general POA (as in PLR 200949012). Finally, the seller in a BDIT sale should be able to possess significant and easily definable powers and beneficial interests in the trust and still have the value of the trust property excluded from his eventual gross estate for estate tax purposes (unless he dies during that brief time after the trust is initially funded during which the power of withdrawal is exercisable). This is because the seller in a BDIT sale never makes a gratuitous transfer to the trust15 but, rather, only a “sale for an adequate and full consideration in money’s worth.”16 Accordingly, the “string” provisions of the estate tax law (IRC Sections 2036 and 2038) shouldn’t apply. Potential inclusion in the BDIT seller’s gross estate for estate tax purposes should be governed solely by IRC Section 2041, and Section 2041 shouldn’t apply to a properly structured BDIT sale because the seller wouldn’t have any ability to direct principal distributions: (1) to or for himself other than for his health, education, maintenance or support; or (2) to or for his estate, his creditors or his estate’s creditors.17
There are important caveats. First, BDITs, like IDITs, seem not to be favored by the government. In Section 4.01(39) of Revenue Procedure 2015-3,18 the IRS identifies BDIT sales as among the transactions as to which rulings or determination letters won’t ordinarily be issued. This publicly enunciated position could be interpreted as a message to taxpayers that: (1) the IRS views BDIT sales with disdain; and (2) taxpayers undertake them at their peril. Second, it might be questioned whether the person representing himself as the settlor of a BDIT is the true transferor of the property funding the trust on its creation or whether the seller/beneficiary, presumably having arranged for such person to create and fund the trust, is in substance the transferor.19 If the seller/beneficiary were determined to be the real settlor of the BDIT, the asset protection advantage referenced in the preceding paragraph could be forfeited or diminished, and Section 2036 could cause inclusion of the value of all or part of the BDIT property in the seller/beneficiary’s gross estate for estate tax purposes.20 Third, as with an IDIT sale, a BDIT sale that’s structured too aggressively (for example, initial funding too small in relation to the magnitude of the subsequent sale; no or insufficient beneficiary guarantees of note repayment) could be viewed as lacking in economic substance and, therefore, not a true sale but a transfer with a retained beneficial interest within the meaning of Section 2036(a)(1). Fourth, as between the BDIT designs outlined in PLR 201216034 and PLR 200949012, the PLR 200949012 approach may be preferable because its success doesn’t depend on whether the IRS later determines the IRC Section 675(4)(C) power of substitution is exercisable in a nonfiduciary capacity.21
1. See, e.g., Michael D. Mulligan, “Fifteen Years of Sales to IDITs—Where Are We Now?” 35 ACTEC Journal 227 (2009).
2. See Revenue Ruling 85-13, 1985-1 C.B. 184.
3. For example, interest payments on a note (computed under Internal Revenue Code Section 1274) are almost always smaller than grantor retained annuity trust (GRAT) payments (computed under IRC Section 7520) in a comparably sized transaction, facilitating easier cash flow; GST exemption can be allocated to the transfer by which an intentionally defective (grantor) irrevocable trust is initially funded (IRC Section 2631(a)) but can’t be allocated to a GRAT because of the estate tax inclusion period rules (IRC Section 2642(f)); an interest-only note enables better leverage because the GRAT annuity for a given year can’t exceed 120 percent of the preceding year’s annuity amount (Treasury Regulations Section 25.2702-3(b)(1)(ii)).
4. Karmazin v. Commissioner, Tax Court Docket No. 2127-03.
5. Estate of Woelbing v. Comm’r, Tax Court Docket No. 30261-13.
6. Estate of Davidson v. Comm’r, Tax Court Docket No. 13748-13 (stipulated decision July 6, 2015).
7. “General Explanation of the Administration’s Fiscal Year 2016 Revenue Proposals,” Department of the Treasury (Feb. 2, 2015).
8. See, e.g., “IRS Caves on Billionaire’s Estate Taxes, Agrees to Lower Widow’s Gift Tax Liability,” 129 DTR K-4 (July 7, 2015).
9. Crummey v. Comm’r, 397 F.2d 82 (9th Cir. 1968).
10. See supra note 2.
11. IRC Section 6110(k)(3).
12. See IRC Section 675(4)(C).
13. Treas. Regs. Section 20.2041-3(d)(3).
14. See Uniform Fraudulent Transfer Act Sections 3 and 4.
15. Note that the lapse of the seller/beneficiary’s Crummey power isn’t a “transfer” to the beneficiary defective inheritor’s trust (BDIT) so long as the value of the property with respect to which the Crummey power could have been exercised just before the lapse didn’t exceed the greater of $5,000 or 5 percent of the value of the BDIT property. See IRC Section 2514(e).
16. Better to secure this result in a case in which the value of the asset being sold can’t be determined by market quotations the sale contract should contain a defined value clause. See Petter v. Comm’r, T.C. Memo. 2009-290, aff’d 643 F.3d 1012 (9th Cir. 2011). Incorporating a defined value clause into the sale contract also guards against the sale’s being re-characterized as partly a gift for gift tax purposes and/or a transfer for asset protection purposes.
17. See Treas. Regs. Section 20.2041-1(c)(1).
18. Rev. Proc. 2015-3, 2015-1 I.R.B. 129.
19. See Securities and Exchange Commission v. Wyly, 2014 U.S. Dist. LEXIS 135671 (S.D.N.Y.) (Sept. 25, 2014).
20. In a self-settled trust state, Jennings v. Smith, 161 F.2d 74 (2d Cir. 1947), could prevent the Section 2036 inclusion problem unless the BDIT instrument confers a non-general power of appointment (POA) on the seller/beneficiary.
21. Note, however, that a non-general POA, such as that described in Private Letter Ruling 200949012 (Aug. 17, 2009), could be problematic if the seller/beneficiary were found to be the real settlor. See supra notes 18 and 19.