Formula Transfers for Estate Planning Insights

Formula Transfers for Estate Planning STEVEN B. GORIN, CPA, JD, CGMA THOMPSON COBURN LLP sgorin@thompsoncoburn.com 314-552-6151 9909261

Review of Materials Slides Technical materials: 2,500+ page PDF, only part of which supports the slides Look to cross-references from slides to PDF 2

Overview Why sales to irrevocable grantor trusts work well for pass-through entities and how their risks compare to transfers to grantor retained annuity trusts (GRATs) When taxpayers have succeeded when an excess gift goes to charity (whether by formula gift or disclaimer) or the formula limits the transfer 2020 Tax Court case disallowing a deduction for a formula gift to charity 2020 Tax Court case disapproving of using dollar amounts for transfers 3

Overview How to design a formula purchase price designed to run the gift tax statute of limitations How to design the recipient trust to use a disclaimer How to design the recipient trust to run the gift tax statute of limitations 4

Irrevocable Grantor Trust (III.B.2.) Irrevocable outside of estate tax system Grantor trust income taxed to grantor The grantor reports all of the trust s taxable items on the grantor s income tax return In other words, the trust grows free from income (including capital gain) tax, and the grantor s taxable estate decreases because the grantor is paying taxes on the trust s income 5

Irrevocable Grantor Trust (III.B.2.d.i.(c)) Reg. 1.671-4 Can use grantor s social security number Trust can have its own tax ID (required if QSST taxed to beneficiary as deemed owner) and files an annual Form 1041 with a grantor information statement 6

Irrevocable Grantor Trust (III.B.2.) The grantor may enter into transactions with the trust that are ignored for income tax purposes but respected for gift tax purposes Most powerful when the grantor sells an interest in an entity taxed as a partnership or as an S corporation in exchange for a note 7

Irrevocable Grantor Trust (III.B.2.) Entity makes distributions to its owners to pay their income tax on their distributive share of the entity s income ( tax distributions ) Because the trust does not pay income tax, it uses its tax distributions to repay the note 8

Irrevocable Grantor Trust (III.B.2.) Grantor has to pay tax on the K-1 issued to the trust Grantor uses the note payments to pay income taxes Rather than restoring the grantor s estate for the value of the sold business interest, the note payments go straight to the taxing authorities, making the note essentially be a disappearing asset 9

Irrevocable Grantor Trust (III.B.2.) Example Give $1 million gift to trust, using lifetime gift tax exemption Sell $9 million business interest to trust in exchange for note Interest-only for 9 years with balloon at end, but prepay ASAP 10

Irrevocable Grantor Trust (III.B.2.) Example Note is fully repaid with tax distributions Grantor then turns off grantor trust powers (or keeps on to deplete estate) More details on grantor trusts in CPA Academy Webinar How to Shift Income to Beneficiaries (last slide) 11

Polling Question 1 What is an irrevocable grantor trust? A trust taxed to the grantor for income but not estate/gift tax purposes Doesn t every trust have a grantor? A trust that beneficiaries take for granted A defective trust

GRAT A Safe Type of Sale (III.B.2.b.) Can eliminate uncertainty in initial gift tax results by using grantor retained annuity trust (GRAT), because annuity automatically adjusts, but GRAT has other uncertainty: Foot fault may have explosive gift tax effects Generally can t turn off grantor trust powers 13

GRAT A Safe Type of Sale (III.B.2.b.) Other GRAT issues: Paying annuity in kind but may be able to avoid paying in kind with graduated GRAT Dying during GRAT term (but can be better under Code 6166 than dying with substantial note) Moving remainder into GST exempt trust (III.B.3.a.ii.) 14

Formula Describes How Much Is Transferred (III.B.3.a.i) Wandry (III.B.3.a.viii) approved a gift of LLC interests defined by a fixed dollar amount, without any excess going to a charity or other IRS officially said that it disagreed with the case (but did not appeal) Some question whether a tax case can really determine what was transferred 15

Required Language (III.B.3.a.v.) Something along the lines of finally determined for federal gift tax purposes Nelson (2020) - If a formula transfers a business interest equal in value to that determined by an appraiser, the business interest is whatever the appraiser determined, rather than that finally determined for federal gift tax purposes 16

Polling Question 2 What language is required for a formula transfer? 1. Finally determined for federal gift tax purposes 2. Determined by an appraiser 3. Similac, Enfamil, or Gerber 4. E=mc2

Formula Describes How Much Is Transferred (III.B.3.a.i) Gift of excess over finally determined value might go to charity, spouse outright or in marital deduction trust, GRAT, or incomplete gift trust Only cases have been gift over to charity described further below If to marital deduction trust, better to be general power of appointment marital deduction trust 18

Gift Over to Charity (III.B.3.a.iii.) Give a meaningful gift whether or not IRS audits A record demonstrating due diligence by the charity (described in materials) makes the gift much more likely to be respected Moore (2020) denied charitable deduction because charity gets nothing unless IRS audits (III.B.3.a.vi.) 19

Gift Over to Charity (III.B.3.a.iii.) Graev - Charitable deduction denied because chance that charity would have to return the gift was not so remote as to be negligible (III.B.3.a.vii) Christiansen Approved formula disclaimer that resulted in charitable gift (III.B.3.a.x) Petter Approved a transfer to charity in a sale/gift transfer, based on values as finally determined for federal gift tax purposes (III.B.3.a.xi) 20

Gift Over to Charity (III.B.3.a.iii.) McCord(III.B.3.a.xii) Courts respected agreement under which fixed dollar amounts worth of business interests determined what portion went to the family and what portion went to charity After the transfer, the family and charity obtained appraisals that they used to agree among themselves who got what portion of business interests 21

Polling Question 3 A formula gift of excess to charity often needs: 1. A chicken dinner 2. A substantial current component 3. Involvement of the Attorney General 4. A receipt confirming goods and services

Disclaimer (III.B.3.a.i) Formula disclaimers have long been recognized If a transfer to a trust, should expressly authorize the trustee to disclaim Instrument of transfer or trust agreement might clarify what happens in the event of disclaimer 23

Achieving Finality Adequate Disclosure on Gift Tax Returns (III.B.4.) Build requirement to file in formula transfer documents Incomplete gift might not run statute of limitations, so consider making some part of any excess be a completed gift Sale from One Trust to Another (includes GST statute of limitations) (III.B.3.a.ii.) 24

Defined Consideration Clause (III.B.3.a.iv.) Sell the property for the formula purchase price, with a blank in the face amount of the promissory note Obtain appraisal Allonge to note provides the estimated purchase price Expiration of statute of limitations finalizes the purchase price 25

Defined Consideration Clause (III.B.3.a.iv.) Sample clauses in sale agreement: In consideration of a sum equal to the Fair Market Value (defined below) of the Transferred Property (the Sale Price ), concurrently with its execution of this Agreement on the Effective Date, Seller is irrevocably granting, selling, transferring and conveying the Transferred Property to Buyer on the terms set forth herein. The Fair Market Value of the Transferred Property shall be such value as finally determined for federal gift tax purposes on the transfer of the Transferred Property by Seller as of the Effective Date, in accordance with the valuation principles set forth in United States Treasury Regulation section 25.2512-1. Seller agrees to file a gift tax return reporting this transaction so as to cause the gift tax statute of limitations to run. 26

Defined Consideration Clause (III.B.3.a.iv.) A promissory note might refer to the Sale Price in the sale agreement and then provide: Promptly after the initial determination of the Sale Price and again upon the final determination for federal gift tax purposes of the Sale Price under the Sale Agreement, Holder shall be entitled to attach to this Note a statement fixing the amount of principal due under this Note in a manner appropriate to make this Note a negotiable instrument within the meaning of Section 3-104 of the Uniform Commercial Code as in effect in the State of ____. 27

Defined Consideration Clause (III.B.3.a.iv.) An Allonge (supplement to promissory note) might then estimate the purchase price once the appraisal is finalized: Promptly after the initial determination of the Sale Price and again upon the final determination for federal gift tax purposes of the Sale Price under the Sale Agreement, Holder shall be entitled to attach to this Note a statement fixing the amount of principal due under this Note in a manner appropriate to make this Note a negotiable instrument within the meaning of Section 3-104 of the Uniform Commercial Code as in effect in the State of ____. 28

Defined Consideration Clause (III.B.3.a.iv.) Prior slides say that the value is the finally determined value whatever that may be and we re just estimating until we know that value Never say value is X, but if IRS adjusts on audit then we change to Y The latter loses under Procter(III.B.3.a.xiii) 29

Polling Question 4 What is the appraiser s role in a formula transfer? 1. To determine value 2. To make our fees look reasonable 3. To estimate value until finally determined 4. To use a value our client likes

Defined Consideration Clause (III.B.3.a.iv.) My favorite tool because adding a year or two to the note s repayment period is usually not a big deal if IRS finds higher value No gift over to require later transfers Supported by King (10th Cir.), which did not use as taxpayer-favorable language as mine 31

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Conclusion Free Resources Gorin s Business Succession Solutions (quarterly updates to 2,700+ page materials plus chance to subscribe to other publications) CPA Academy instructor page, including: Fiduciary Income Tax Refresher and Latest Update How to Shift Income to Beneficiaries Pass-through Entities Held By Trusts Formula Transfers for Estate Planning Beneficiary Deemed-Owned Trusts 34

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