THE INTENTIONAL GRANTOR TRUST

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1 The following articles on intentionally defective grantor trusts and charitable remainder trusts were prepared by Matthew J. Howard and Brian D. Smith of Moore Ingram Johnson & Steele, LLP. The intentionally defective grantor trust and the charitable remainder trust are just two of the numerous estate planning vehicles that are available to practitioners. THE INTENTIONAL GRANTOR TRUST The grantor trust is a trust which is treated as owned by the grantor and all of the income and deductions of which are therefore attributed to the grantor under Internal Revenue Code Sections Prior to 1993, grantor trust status was to be avoided for all irrevocable trusts which were intended to be completed gifts for gift tax purposes and not part of the grantor's estate. However, beginning in 1987 and effective as of 1993, Trusts became subject to the top income tax bracket at $8,100 of income (1997 rates), by comparison with $271,050 for individual taxpayers (income tax rates schedules for 1997). Now, therefore, the grantor is likely to be paying a lower tax on the trust income than would the trust if it accumulated the income. Thus, the benefit of the gift tax free gift, which has always been available through the grantor trust, is not off-set by any income tax costs for the family as a whole. The intentional grantor trust has become one of the most popular vehicles for "leveraged" gifts. The leverage occurs by reason of the fact that the trust assets grow income tax free (like a qualified retirement plan or a charitable remainder trust), and distributions to a beneficiary are likewise income tax free to the beneficiary, while the grantor's conferring this additional benefit through repayment of the tax on the income in question is not a taxable gift because the grantor (and not the trust of the beneficiary) is liable for the tax under the Internal Revenue Code. As used in this article, the term "intentional grantor trust" means a trust which is a "grantor trust" for income tax purposes, a completed gift for gift tax purposes, and a transfer which will not be included to any extent in the grantor's estate for estate tax purposes. Thus, by definition the grantor is not a beneficiary of such a trust and can not control who will take under the trust (except subject to an ascertainable standard). Grantor trust status is extremely useful if it is contemplated that there will be transactions between the grantor and the trust, and one wishes these transactions to be income tax free. The IRS has consistently taken the position that income and deductions of a grantor trust will be treated as realized by the grantor directly; thus a transaction between the grantor and a grantor trust

2 cannot give rise to any taxable income because it is a transaction between the grantor and himself. Rev. Rul , C.B.184; PLR , , , Contra: Rothstein v. U.S., 735 F.2d 704 (2d Cir.1984). For example grantor/taxpayer owns stock in a closely held business, ABC Inc. ABC Inc. stock continues to appreciate rapidly. However, ABC Inc. is an S-Corp and grantor does not want to forego the "S" distribution earnings. Therefore, grantor decides to sell off a portion of ABC Inc.'s stock to the intentional grantor trust in exchange for a promissory note. The promissory note will provide for interest only payments with a balloon payment at the end of 15 years. The note must carry interest at the Applicable Federal Rate as published by the federal government. The interest payments will be paid with S corp earnings. In the meantime, the S corp stock owned by the grantor trust will appreciate outside of the grantor's estate. At death, the balance of the note will be included in the grantor's estate which will be far less than the value of the appreciated stock of ABC Inc. The key to this planning is to achieve grantor's trust status without causing the trust either to be an incomplete gift or to be included in the grantor's estate. The fact that this is possible in the first instance attests to the disparity between the "retained strings" that will cause inclusion in the grantor's estate and the retained strings that will cause inclusion in the grantor's income tax base. The trick therefore is how to expose a taxpayer who wants to make a trust taxable to the grantor in a safe and easy way without encountering unwanted wealth transfer tax consequences. In this respect, the secret is to think in terms of flunking various exceptions to grantor trust liability provisions, with an eye on the estate, gift, and generation-skipping transfer tax consequences of a particular interest or power. By far the most popular defect is the one that the government loves to hate and, because it is easy and safe, upon which the government no longer will rule: The Section 675(4)C power to swap assets. This provision authorizes any person not acting in a fiduciary capacity and without the consent of a fiduciary to exchange trust assets for full and adequate consideration with entire trust portion rule consequences and no wealth transfer tax exposure to the power holder. However, other viable alternatives also should be considered, given the governments antipathy for this approach. The relatively unconventional method of creating grantor trust liability, in this case without the help of a spouse or other third party, is for the grantor to borrow the corpus of the trust for less than

3 adequate interest or security, triggering Section 675(3). Alternatively, if the trustee is the grantor's spouse or any other related or subordinate party, a loan to the grantor or to the grantor's spouse for adequate interest and security will still trigger Section 675(3) entire trust portion treatment. In summation, the intentional grantor trust is a tax planning device which benefits all concerned. Even though the grantor remains liable for the income tax due on the trust earnings, this additional income tax paid is most affordable by the grantor and is not an additional gift by the grantor. Therefore the grantor can use his or her annual exclusion for other transfers of property. As with any tax planning, careful consideration should be given to the various gift, estate, and generation-skipping transfer tax consequences surrounding this planning. Charitable Remainder Trusts The charitable remainder trust is a highly effective estate planning tool. For a trust to qualify as a charitable remainder trust, it must meet the requirements for either a charitable remainder annuity trust under 664(d)(1) of the Internal Revenue Code (the "Code") or a charitable remainder unitrust under 664(d)(2). Very simply, the charitable remainder trust allows the donor to transfer property to a trust retaining an income interest in the trust property for life or for multiple lives, with the remainder then passing to a charity at the death of the last noncharitable beneficiary. Such a trust arrangement produces multiple charitable deductions- income, gift and estate. A simple testamentary transfer to a charity, on the other hand, only produces an estate tax charitable deduction. The most common form of charitable remainder trust is the charitable remainder unitrust established under section 664(d)(2) of the Code. The charitable remainder unitrust provisions of the Code require the trust to pay the noncharitable beneficiary an amount called the "unitrust amount" not less often than annually. The "unitrust amount" must then be one of the following three amounts: A fixed percentage of the net fair market value of the trust's assets, valued annually; The lesser of a fixed percentage of the net fair market value of the trust's assets, valued annually or the net income for the trust; or The lesser of a fixed percentage of the net fair market value of the trust's assets, valued annually or the net income for the trust plus any amount of the net income from the trust which is in excess of the fixed percentage amount to the

4 extent that the aggregate of the amounts paid in prior years was less than the aggregate of such required amounts. Many people quickly dismiss the validity of the charitable remainder unitrust as a part of their estate plan simply because they would rather their assets go to their descendants than to a charity. One thing to keep in mind, however, is that in some cases a significant portion of the estate is going to the IRS. In these estates, the donor needs to consider whether they want the IRS to receive the bulk of their estate, or a charity. While these clients may be unable to pass all of their wealth on to future generations, they can at least direct a portion of their estate to a worthwhile cause. Typically, after looking at charitable planning in this way, the donor sees the charitable remainder unitrust in a completely different light. The Taxpayer Relief Act passed by Congress in 1997 made several changes to the charitable remainder trust rules that all practitioners in the estate planning area should be aware of. One such change is the new 10% charitable remainder requirement found in new Code sections 664(d)(1)(D) and 664(d)(2)(D). This provision essentially says that upon funding the charitable remainder trust, the actuarially determined value of the remainder interest that will eventually pass to charity must equal at least 10% of the fair market value of the trust assets. This new requirement adds some complexity to charitable planning that all estate planners must understand. For example, assume Taxpayer A, a 47 year old individual, contributes $100, to the Taxpayer A Charitable Remainder Unitrust on April 15, Under the trust agreement, Taxpayer will receive a unitrust amount of 10% of the net fair market value of the trust's assets as determined on the first day of the tax year. Using Taxpayer A's age, the 6.8% applicable federal rate for April, 1998 and the actuarial tables found in IRS Publication 1458, the present value of the remainder interest that will eventually pass to charity is $10, This remainder value just barely passes the new 10% requirement. Alternatively, assume all of the same facts except that Taxpayer A is now 46 years old. Under the same facts, the Taxpayer A Charitable Remainder Unitrust no longer qualifies because of the new 10% requirement. In order to bring the trust within the 10% remainder requirement, the fixed percentage that is used as the unitrust amount must be changed to 9.67%. With a unitrust amount of 9.67%, the present value of the remainder interest that will pass to charity is $10, As you can see from this example, the younger the donor, the more careful you must be with the unitrust fixed percentage.

5 There are numerous other charitable remainder trust issues that the practitioner should be aware of, however, this article is somewhat limited in space and cannot hold them all. It is important to keep in mind that charitable remainder trust planning is not a field to enter into lightly. If carefully pursued, however, it is an area that can effectively fulfill many of a client's estate planning needs.