Sophisticated estate-planning structures are by no means “set it and forget it” vehicles. The most brilliantly structured transaction will only succeed if the various technical requirements are followed in the ongoing administration of the vehicle, and lack of proper administration can result in unexpected tax and even non-tax consequences. It’s, therefore, a good idea to set expectations before the closing of the initial transaction as to who will have the responsibility for the ongoing maintenance of these administrative requirements.
Let’s look at a select few (but by no means all) of the issues that practitioners and clients should keep in mind when administering common planning techniques after a vehicle is created and funded.
Grantor retained annuity trusts (GRATs) are very popular estate-planning vehicles blessed by Internal Revenue Code Section 2702. While a GRAT is often referred to as a “safer” or “more conservative” vehicle because it’s statutory, the violation of certain technical requirements associated with a GRAT may potentially result in a much harsher consequence than other techniques.
For instance, the GRAT regulations provide that the GRAT will violate IRC Section 2702 if: a trustee fails to pay the required annuity to the grantor within the 105 day grace period;1 additional contributions are made after a GRAT is created;2 a GRAT’s annuity payment increases by more than 120 percent of the prior year’s annuity;3 or the GRAT issues a promissory note to the grantor in satisfaction of its annuity payment.4
While it seems easy enough to avoid these traps, it’s possible to violate one or more of them inadvertently. For example, if the grantor exercises a swap power contributing cash to the GRAT in exchange for existing hard-to-value assets, and those assets are later determined to have a lower value than the value used in making the swap, arguably the swap could constitute an additional contribution.
While not entirely clear, the consequence of such a technical violation has potential to cause the grantor’s gift to the GRAT to be entirely subject to gift tax as of the date of creation, with the grantor’s retained annuity being valued at zero from inception. That is, what would have been intended to be a gift tax-free contribution into a “zeroed-out GRAT” might instead be fully subject to gift tax at creation.
Sales to IDGTs
Sales to intentionally defective grantor trusts (IDGTs) have become popular over the past several years as an alternative to GRATs. There are some pressure point issues that should be considered when administering an IDGT transaction.
When a grantor sells assets to an IDGT in exchange for a valid promissory note that reflects full and adequate consideration, technically no taxable gift should result. For such arrangement to succeed, however, the note has to be recognized as a valid debt, and the sale must be for fair market value. The most important factors as to the validity of the debt are whether the parties intended from inception to recognize it as a true debt obligation, and the subsequent actions of the parties demonstrate the intention that the debt is a true debt. Were the terms of the note reasonable, and was adequate interest imposed? Did the trust make payments to the grantor as required under the note? Were interest payments properly reported?
Arguments the Internal Revenue Service has made in the past are also worth noting. For example, if there’s a poor record of the parties complying with the note’s payment terms, the IRS could argue that under traditional gift tax principles, the note issued was illusory and the transaction was made for no consideration, thus resulting in a gift. Alternatively, if a grantor sold interests in a family limited partnership (FLP) or limited liability company (LLC) to an IDGT, the IRS could argue that the note that the grantor received from the trust wasn’t a valid debt, but rather was a form of disguised preferred equity in the entity giving rise to deemed gift arguments under IRC Section 2701 or that the sale for the note constituted a transfer with a retained interest that would trigger a deemed gift under Section 2702. All of these arguments involve the IDGT being compromised because the note is recharacterized or deemed invalid due to improper administration.
FLPs and LLCs
In the FLP arena, too, there are certain factors that can make or break the success of the planning. The IRS may argue, for example, assets would still be included in a decedent’s estate under IRC Section 2036(a)(1), despite the fact that the parent may have transferred partnership interests out of his estate during his lifetime. Strict adherence to the formalities of the partnership after it’s formed is therefore essential. The list below, while not comprehensive, presents some practical tips to consider in the post-formation administration of a partnership:
• Make sure that legitimate non-tax reasons existed for the formation of the partnership in the first place, and operate the partnership business consistent with these reasons.
• Make sure that assets contributed into the partnership have been properly re-titled in the name of the partnership.
• Make sure that a partnership account is properly established and funded and that partnership revenues are properly distributed into the account (rather than directly to the individual partners).
• Make sure that partnership distributions are made on a pro rata basis to all partners.
• Don’t allow any partner direct access to partnership assets.
• Don’t allow a partner’s personal assets to be commingled with partnership assets.
• Make sure partnership management actively engages in investment decisions with respect to the deployment of the partnership’s assets.
• Regularly review investment performance, and make investment decisions.
• Memorialize decisions with respect to partnership investments, distributions and other matters.
• Follow the specific formalities required in the partnership agreement. For example, if required under the partnership agreement, management should provide annual reports to partners within the required time frame.
• Prepare a list of the various administrative requirements under the partnership agreement and follow it.
• Comply with any notice or consent provisions with respect to any transfers of partnership interests or partnership meetings.5
—The authors would like to thank Jingchao Liu, a summer associate at Withers Bergman LLP, for her valuable contributions to this article.
1. Treasury Regulations Section 25.2702-3(b)(4).
2. Treas. Regs. Section 25.2702-3(b)(5).
3. Treas. Regs. Section 25.2702-3(b)(1)(ii)(B).
4. Treas. Regs. Section 25.2702-3(d)(6).
5. For a more detailed discussion of the points made in this article, see N. Todd Angkatavanich and Stephanie Loomis-Price, “Set It, But Don’t Forget It—Practical Tips to Avoiding the Devil in the Details After a Transaction Has Closed,” Trusts & Estates (September 2011), at p. 20.