Estate Planning in a Low Interest Rate Environment

Transcription

1 Estate Planning in a Low Interest Rate Environment

2

3 the next generation with minimal gift tax consequences. These techniques include the following: Estate Planning in a Low Interest Rate Environment to loans family members installment sales to family members self-canceling installment notes (SCINs) Many factors grantor retained must annuity be trusts considered (GRATs) when establishing an estate plan and choosing the to sales intentionally defective grantor optimal strategies. Certainly individual goals and family dynamics come into play. But trusts (IDGT) rounded to the nearest two-tenths of one percent. the impact charitable of lead market annuity trusts forces (CLATs) and the economic environment is also crucial. The current low interest rate environment affords a number of effective techniques for transferring Key Factors to Consider significant wealth to the next generation with minimal gift tax consequences. It is important to note that these techniques are only successful when the investment performance achieved exceeds certain interest rate assumptions These embedded techniques in include: the Internal Revenue Code. The two most important rates to focus Loans to family members on for estate planning purposes are the Installment sales to family members 7520 rate and the Applicable Federal Self-canceling Rate (AFR) under installment 1274(d). notes Each of (SCINs) these rates is determined monthly. If the Grantor investment retained return annuity realized trusts by employing (GRATs) one of the techniques listed above is greater than either the 7520 or AFR, Sales to intentionally defective grantor depending on which is applicable, the trusts (IDGT) excess return can be passed on to the Charitable next generation lead annuity free of trusts transfer (CLATs) tax. Key Factors to Consider The AFR applies to loans and sales to intentionally defective grantor trusts. It is important Using the to AFR note for a that loan these avoids the techniques imputed are interest only successful rules. 1274(d) when establishes three types of term loans: the investment performance achieved short term, mid term and long term. exceeds certain interest rate assumptions embedded in the Internal Revenue Code. The two most important rates to focus on for estate planning purposes are the Applicable Federal Rate (AFR) under 1274(d) and the 7520 rate. Each of these rates is determined monthly. If the investment return realized by employing one of the techniques listed above is greater than either the AFR or 7520 rate, depending on which is applicable, the excess return can be passed on to the next generation free of transfer tax. The AFR applies to loans to family members, installment sales to family members, self-canceling installment notes and sales to intentionally defective grantor trusts. As stated previously, the key to success is for the investment return earned through these techniques to Short-term loans are loans with a term of three years or less. Mid-term loans are loans with terms of over three years but no greater than nine years. Long-term loans have terms in excess of nine years. The 7520 rate applies in the case of annuities, unitrusts, life estates, remainder interests, term of years and reversions. The Internal Revenue Code assumes that annuities, life estates, remainder interests, term of years and reversions will earn an amount equal to the 7520 rate, which is calculated at 120% of the mid-term AFR, compounded annually, Low interest rates provide an opportunity for individuals to pass on wealth to others free of transfer tax by taking advantage of the interest rates established for valuing annuities and remainder interests under Likewise, a low AFR affords the chance for taxpayers to loan money to others at low rates, funds which then can be reinvested for higher returns. As stated previously, the key to success is for the investment return earned through these vehicles to exceed a pre-determined interest rate. For loans to family members, installment exceed sales to family a pre-determined members, self-canceling interest rate. installment In this notes case, and the sales rate to to intentionally beat is the AFR. These defective vehicles grantor are trusts, extremely the interest advantageous rate to beat is the when AFR. that These interest vehicles rate are hurdle extremely is low. advantageous By way of when illustration, that interest consider rate hurdle the is AFR low. for By way November of illustration 2011 consider (Exhibit the A). AFR for December 2009 (Exhibit A). Exhibit A Exhibit A Applicable Federal Rate for November 2011*, based on annual compounding Applicable Federal Rate for November 2011, based on annual compounding Short term: 3 yr or less Mid term: over 3 yr but < 9 yr Long term: over 9 yr rate to beat is the 7520 rate. The 7520 rate for December, 2009 was 3.2%. Using the AFR for loans avoids the imputed interest rules. 1274(d) establishes three types of term loans: short term, mid term and long term. Short-term loans are loans with a term of three years or less. Mid-term loans are loans with terms of over three years but no greater than nine years. Long-term loans have terms in excess of nine years. The 7520 rate applies in the case of annuities, unitrusts, life estates, remainder interests, term of years, reversions, grantor retained annuity trusts (GRATs) and charitable lead annuity trusts. The Internal Revenue Code assumes these vehicles will earn an amount equal to the 7520 rate, which is calculated at 120% of the mid-term AFR, compounded annually, rounded to the nearest two-tenths of one percent. The 7520 rate for November 2011 is 1.4%. Low interest rates provide an opportunity for individuals to pass on wealth to others free of transfer tax by taking advantage of the interest rates established under Likewise, a low AFR affords the chance for taxpayers to loan money to others at low rates, with those funds then reinvested for higher returns. Annual Semi-annual Quarterly Monthly *Rev. Rul For grantor retained annuity trusts (GRATs) and charitable lead annuity trusts, the interest 1 1

4 Estate Planning in a Low Interest Rate Environment Loans to Family Members In today s low interest rate environment, taxpayers have the opportunity to make a low interest rate loan to another person who can invest that money and earn a greater amount than the interest he or she is required to pay on the loan. A loan is not a gift if the lender receives in return a promissory note that bears interest at least equal to the appropriate AFR ( 7872; 1274(d)). This presents an ideal opportunity for a taxpayer to lend money to another person, a child for example, who can receive a higher return on the money than the interest rate due on the note. For example, assume a parent lends a child $1 million for three years at 0.19%, the November 2011 short-term AFR. Interest on the note is payable annually with a balloon payment at the end of the term of the loan. The child invests the money and earns 5% tax free. At the end of the year, the child has earned $50,000 and is obligated to pay $1,900 of interest on the loan. The net transfer at the end of the year is $48,100 ($50,000 interest income less $1,900 interest expense). The child has reaped $48,100 of wealth accumulation by receiving a low interest loan from the parents. The child may be able to deduct the interest expense if the debt was incurred to acquire a residence or a taxable-income producing investment. The downside for the parents is that they must pay income tax on the interest earned on the note. The downside for the child is that if the investment of the loan proceeds yields less than the applicable AFR, the child will be required to repay part of the loan with his or her own funds. The parent can make loans to a child for any duration as long as the loan bears interest at the AFR. In other words, a short-term loan made when the AFR is 0.19% must bear interest at a rate of at least 0.19%. The greater the investment return on the borrowed funds, the greater the amount of net transfer of wealth to the child. As interest rates decline, an issue that arises is whether a loan that has previously been made to a child at a rate that exceeds the current AFR can be renegotiated to a lower rate. It appears that as long as the AFR is charged for the loan, no gift is imputed to the parents. Practitioners believe that refinancing the loan rate should have no different tax consequences from one in which the child completely pays off the loan and the parent makes a new loan to the child at the then existing AFR. A conservative approach may be to have the child, as a borrower, provide consideration for the rate reduction (e.g., pay down some principal of the existing loan or make the term of the note shorter in exchange for a lower rate). Installment Sales to Family Members A variation of a loan to a family member is an installment sale to a family member. This involves the taxpayer selling an asset with appreciation potential to a family member in exchange for a promissory note bearing interest at the AFR. In most cases the note requires only that the interest be paid annually with a balloon payment at the end of the term of the note. Once the asset is sold to the family member, any appreciation in the value of the asset subsequent to the sale inures to the benefit of the family member. Subsequent to the sale, the taxpayer (the seller) owns a fixed income investment, (i.e., the note). If the taxpayer dies before the note is repaid in full, any balance due on the note, plus any accrued interest, is included in his or her estate, but not any appreciation of the asset subject to the sale. Because the transaction is a sale, for tax purposes no gift has been made. The estate tax value of the taxpayer s transferred property has been frozen at the balance due on the promissory note. Appreciation in excess of the AFR is removed from the taxpayer s estate. For income tax purposes, the taxpayer receives the installment payments, reports the interest on the note as ordinary income and the balance as part gain, part return of basis under the installment sales rules. 2

5 The taxpayer may elect to forgive some installment payments as they come due by using his or her available gift tax exclusion as long as there is no pre-existing plan to do so. A pre-existing plan of forgiving the installments is viewed as a gift of the property from the seller to the buyer rather than as a valid sale. Rev. Rul , C.B There should not be a commitment to forgive the debt at the inception of the transaction, nor should there be a regular, predictable pattern of annual debt forgiveness. The taxpayer should also keep in mind that forgiveness of the promissory note may trigger recognition of a gain by the seller under the installment sales rules. In addition, if the buyer is a related party (as defined in 318 and 267 of the Internal Revenue Code), the buyer should not sell the property within two years of its purchase as the amount realized by the related party on the second sale is treated as a payment received at that time by the original seller thereby accelerating the gain to the original seller. Thus, a loan in the amount of the fair market value of the property sold is deemed to be full and adequate consideration unless a pre-existing plan to forgive the loan exists. Self-Canceling Installment Notes (SCINs) A logical extension of the installment sale to a family member is a selfcanceling installment note. This concept is the same as an installment sale to a family member except that the promissory note provides that the note payments terminate upon the death of the seller (i.e., the taxpayer). Since the seller s death terminates the seller s right to receive payments, there is nothing of value to include in the seller s/decedent s estate and the seller s estate escapes estate taxes on the value of the note. In structuring a SCIN, the term of the note should not extend beyond the seller s life expectancy. Otherwise, the sale appears to be a transfer with a retained interest which would cause the note to be includible in the seller s estate for estate tax purposes. A SCIN would be worth less to the seller than a conventional installment note, which would be required to be paid off in full. This difference in value, if not compensated for, results in a gift. In other words, a gift will result if the value of the note with the cancellation provision is less than the value of the property transferred. To avoid the gift tax issue, a premium should be paid on the price of the property sold or the interest rate should be above the market rate. Such a premium reflects the value of the self-canceling feature as part of the bargained-for consideration for the sale. For income tax purposes, the balance of the gain on the sale must be reported in the year of the seller s death on the fiduciary income tax return of the seller s estate as income in respect of a decedent. Frane v. Commissioner, 998 F2d 567 (8th Cir., 1993). Thus, a SCIN excludes the value of the note in the seller s estate and avoids gift tax, if a premium is placed on the price paid for the property or the note bears an above-market interest rate. However, the balance of the gain is included on the seller s fiduciary income tax return in the year of death as income in respect of a decedent. A SCIN works best if the seller does not survive the term of the promissory note. The sooner the seller dies after the property is transferred, the less the buyer must pay and the greater the estate tax benefit. Thus, most SCINs are used for sellers whose actual life expectancy is less than their actuarial life expectancy. 3

6 Estate Planning in a Low Interest Rate Environment Grantor Retained Annuity Trusts (GRATs) A GRAT is a wealth shifting vehicle specifically allowed by statute that accomplishes two important objectives. It provides the grantor an annuity payment for a predetermined, limited time period. Also, any appreciation in the trust assets in excess of the 7520 rate is passed on to others (e.g., children) at the end of the term of the trust. The purpose of a GRAT is to make a gift without incurring a gift tax. Generally, the idea is to invest for growth. If the investment return exceeds the 7520 hurdle rate, the GRAT will be successful in passing wealth to the remainder beneficiaries. Generally, a grantor transfers property to a GRAT, which is an irrevocable trust. The grantor retains the right to receive a fixed annuity payable annually for a certain limited term of years. The transfer of the property to the GRAT is a gift for gift tax purposes but the value of the gift is reduced by the present value of the grantor s retained annuity interest. The larger the value of the retained interest, the smaller the taxable gift. When the term of the trust ends, the amount remaining in the trust passes to the remainder beneficiaries with no additional transfer tax. However, for the GRAT to be successful in transferring wealth, the grantor must survive the term of the GRAT. If the grantor dies before the GRAT term ends, the GRAT assets are included in the grantor s estate for Federal estate tax purposes. The interest retained by the grantor is valued by assuming that the retained interest will earn a rate equal to the 7520 rate for the month the GRAT is funded. If the trust actually earns more than the 7520 rate, the excess will pass to the remainder beneficiaries free of transfer tax. Typically, the annuity amount is defined by a formula to protect against an increase in the value of the assets on audit by the IRS. If the value is increased on audit, the formula is designed to increase the amount of the annuity retained by the grantor thereby avoiding an increase in the value of the remainder interest. The formula should define the retained annuity as a percent of the property transferred to the GRAT as finally determined for Federal gift tax purposes. Requirements of the annuity The annuity retained by the grantor must be a qualified annuity interest. The requirements of a qualified annuity interest, as set forth in regulation (b), are as follows: 1. No distributions can be made to anyone other than the grantor. The GRAT document must prohibit distribution to anyone other than the grantor during the term of the GRAT. 2. The annuity retained by the grantor must be paid for a fixed term. 3. The GRAT document must state that prepayment of the annuity amount is prohibited. 4. The annuity must be a fixed amount. It may be a specific dollar amount or a specific fraction or percentage of the initial fair market value of the property transferred to the trust, as finally determined for Federal tax purposes. The annuity amount can increase or decrease from year to year as long as the amount payable in one year does not exceed 120% of the amount payable in the preceding year. 5. The annuity amount must be payable to the grantor annually. If the payment is based on the anniversary date of the GRAT, the annuity may be paid no later than 105 days after the anniversary date. If the payment is based on the taxable year of the trust, the annuity may be paid no later than the date for filing the trust s income tax return (without considering extensions). In addition, the GRAT document must provide that the annuity cannot be paid directly or indirectly by promissory note or similar financial instrument. 4

7 6. If the annuity is defined as a fraction or percentage of the fair market value of the property transferred to the GRAT, the GRAT document must require that the annuity be adjusted to reflect the overvaluation or undervaluation of the transferred property. The grantor must be required to reimburse the GRAT for any amount paid to the grantor as a result of an overvaluation and the GRAT must pay to the grantor any amount due the grantor as a result of an undervaluation. 7. If the GRAT year is a short year and the payment is based on the anniversary date, the annuity amount must be pro-rated. If the payment is based on the taxable year, on the other hand, pro-ration is required for the first taxable year. 8. Once funded, no additional contributions are permitted. Zeroed-out GRAT The larger the value of the grantor s retained interest, the smaller the value of the taxable gift. The objective is to maximize the value of the annuity and minimize the value of the remainder interest. Doing so results in little or no gift. This can be accomplished by using a so-called Walton GRAT, which provides for the contingency that if the grantor dies during the term of the GRAT the balance of the annuity payments are made to the grantor s estate. Walton v. Commissioner, 115 T.C. 589 (2000). Prior to the Walton case the IRS took the position that the value of the retained annuity interest had to take into consideration the fact the grantor could die prior to the term of the GRAT and, hence, the grantor would not receive the annuity for the entire term of the GRAT. In other words, the value of the qualified annuity interest was determined as if the right to the annuity was retained for the shorter of the GRAT term or until the grantor s death. In the view of the IRS, the right to receive an annuity for the shorter of the GRAT term or the grantor s life was considered to be worth less than the right to receive the annuity for the entire GRAT term. The IRS maintained that any interest that would pass to the grantor s estate if he died during the GRAT term would not be included in the value of the retained annuity. Thus, the amount of the annuity was reduced by the probability that the grantor would die before the end of the GRAT term and that value was considered a remainder interest taxable as a gift to the remaindermen. The Walton case changed that. As a result of the Walton case the value of the annuity payable to the grantor and to the grantor s estate if he dies during the GRAT term is not reduced by the value of the probability that the grantor will die during the GRAT term. In the Walton case the GRAT was payable to the grantor and, if the grantor died during the term of the GRAT, the remaining annuity payments were payable to his estate. Thus, either the grantor or his estate would receive the annuity payments for the entire term of the GRAT. As a result, the GRAT was designed to return to the grantor and his estate the entire amount of the initial gift plus interest at the 7520 rate. The Walton case held that the value of the annuity payable to the grantor plus the value of the annuity payable to the grantor s estate if he died during the term constituted a qualified annuity interest. This resulted in the remainder interest having no value. These types of GRATs are known as zeroed-out GRATs. The tax treatment for this type of GRAT was upheld in Walton v. Commissioner, 115 T.C. 589 (2000) and the IRS has acquiesced. IRS Notice , I.R.B The regulations under 2702 have been amended to recognize such GRATs. Reg (e), Example 5. Generally, a zeroed-out GRAT provides an annuity for a long enough term at a high enough payout rate that the value of the remainder interest is zero or close to zero. In other words, the value of the annuity is equal to the value of the property transferred to the trust plus interest at the 7520 rate in effect on the date of funding. The result is that little or no lifetime gift tax exemption is used or gift tax paid in transferring any appreciation to the remaindermen. This concept is illustrated in the following example (Exhibit B). 5

8 Estate Planning in a Low Interest Rate Environment Exhibit B Zeroed-out GRAT Assume a grantor, age 60, transfers $5 million to a 10-year GRAT. The grantor retains an % annuity for the shorter of his life or 10 years. The 7520 rate for the month of transfer is 1.4%. The GRAT earns 2% income and 15% appreciation (17% total return). The value of the % annuity for 10 years, assuming the assets earn 1.4% (the 7520 rate), is $4,999, The value of the remainder interest (and hence the value of the gift) is $5,000,000 less the value of the retained annuity of $4,999, or $1.19. The grantor receives $575, ($5,000,000 x %) for 10 years. When the GRAT term ends in 10 years, if the grantor is still alive, the assets in the GRAT are excluded from the grantor s gross estate for Federal estate tax purposes. Assuming a 17% rate of return, the balance left in the trust after 10 years and after paying out $575, to the grantor for 10 years is $11,353,028. To achieve a remainder interest of $11,353,028 this example assumes a 17% rate of return. To further explore the same set of facts in this Exhibit, the table below reflects the amount of money that would be left in the trust at the end of the 10-year term using various other rate of return assumptions: Return Amount to Remaindermen 7% $1,906,418 9% $3,134,504 11% $4,640,972 13% $6,474,478 15% $8,690,672 17% $11,353,028 Clearly, a successful zeroed-out GRAT can pass significant wealth to the remainder beneficiaries. In addition to the rate of return, two other key factors that drive the success of the zeroed-out GRAT in this Exhibit are the term of the GRAT and the 7520 rate. The table below illustrates the retained annuity percent at various 7520 rates needed to zero-out the GRAT rate 2-Year GRAT 5-Year GRAT 10-Year GRAT 2% 52.06% 21.83% 11.88% 3% 52.82% 22.46% 12.49% 4% 53.58% 23.11% 13.12% 5% 54.35% 23.75% 13.77% 6% 55.12% 24.41% 14.43% 7% 55.89% 25.07% 15.10% 8% 56.67% 25.73% 15.79% 9% 57.45% 26.41% 16.49% 10% 58.22% 27.10% 17.20% 6

9 Delayed payments A GRAT can achieve a greater return if the annuity payments are delayed. The regulations allow an annuity payment to be delayed for 105 days if the annuity payment is based on the anniversary date of the funding or until the date for filing the GRAT s income tax return (not including extensions) if the annuity payment is based on the GRAT s taxable year. By delaying the payments for this short period of time, the annuity payments remain in the trust for an additional short period of time allowing the additional trust principal to continue to grow. Increasing annuity payments Another way to achieve a greater return in a GRAT is to begin the annuity payments at a lower amount and increase the amount of each subsequent annuity payment by the maximum amount allowed (i.e., up to 20% of the preceding year s annuity payment). Increasing the annuity payment by 20% each year results in smaller payments in the earlier years, allowing the amount left in the trust to continue to grow. In fact, increasing the annuity by 20% annually may be the best way to optimize wealth transfer in a long-term GRAT. Based on the fact pattern in Exhibit B, the table in Exhibit C compares the results at various rates of return of a GRAT funded with $5,000,000 paying an % annuity with a GRAT funded with $5,000,000 paying a % annuity in the first year and increasing the annuity payment by 20% in each of the subsequent nine years. Exhibit C Wealth Transfer Impact of Flat vs. Increasing Annuity Payments Return Amount to Heirs Amount to Heirs ( % Flat Payment) ( % Payment Increasing 20% Annually) 7% $1,906,418 $2,343,432 9% $3,134,504 $3,842,246 11% $4,640,972 $5,659,466 13% $6,474,478 $7,848,531 15% $8,690,672 $10,470,357 17% $11,353,028 $13,594,204 Despite the fact that the balance in a longer term GRAT can be enhanced by either delaying payments or by starting the annuity at a lower rate and increasing the annuity by 20% each year, if the grantor dies during the term of the GRAT, the GRAT assets will be included in the Grantor s estate for Federal estate tax purposes. Thus, a longer term GRAT suffers from a mortality risk (i.e., the risk that the grantor will die prior to the end of the GRAT term resulting in adverse estate tax consequences). This mortality risk can be minimized by using a GRAT with a shorter term, also known as a short-term GRAT. Short-term GRATs A GRAT that lasts for a relatively long term has two disadvantages. First, as mentioned above, there is a greater risk that the grantor will die during the term (mortality risk) causing the GRAT assets to be included in the grantor s gross estate for Federal estate tax purposes. Second, there is the risk that the greatest appreciation in the GRAT will occur in the first couple of years and that appreciation will disappear before the termination of the GRAT as a result of a declining market (volatility risk). As a result, many GRATs are established as short-term GRATs (i.e., GRATs with a term of two or three years). A short-term GRAT is typically established for a term lasting two or three years with the grantor retaining a large enough annuity given the applicable 7520 rate to zero-out the GRAT (i.e., the value of the remainder interest is zero or close to zero). For example, a two-year GRAT established in November, 2011 when the 7520 rate is 1.4% would require a % annuity for 7

10 Estate Planning in a Low Interest Rate Environment two years to zero-out the GRAT. A shortterm GRAT minimizes the risk that the grantor will die during the term of the GRAT. If the GRAT assets appreciate significantly during the first or second year of the GRAT, the risk of the investments declining in value over time (as is possible with a longer term GRAT) is minimized. In addition, the remainder beneficiaries will receive the balance of the GRAT assets sooner with a short-term GRAT. The major problem with a short-term GRAT is that higher payments will be required to be paid to the grantor, leaving the amount returned to the grantor exposed to estate tax in his or her estate. Short-term rolling GRATs One solution to the problem of a grantor receiving higher annuity payments from a short-term GRAT is to establish a series of short-term rolling GRATs. As each annuity payment is received by the grantor, the grantor transfers that payment to a new two-year GRAT, retaining an annuity to zero out the new GRAT. The concept of short-term rolling GRATs is shown in Exhibit D. Exhibit D Short-Term (2-Year) Rolling GRATs GRAT Annuity 2010 Short-term rolling GRATs increase the probability that the GRAT will pass on wealth to the remaindermen and increase the probability that the investment return of the GRAT will be maximized. There is a greater chance that any significant appreciation in GRAT assets will not be lost due to the longer time horizon with longer term GRATs. These GRATs also help to minimize the risk of estate tax exposure if the grantor dies prior to the termination of the GRAT (i.e., decreases the mortality risk). Finally, short-term rolling GRATs reduce the amount of time the remaindermen have to wait to receive GRAT assets on termination of the GRAT. GRAT GRAT Remainder Beneficiaries on Termination Annuity GRAT On the other hand, short-term rolling GRATs are more complicated and difficult to administer. In addition, if the 7520 rate rises, GRATs created in subsequent years will require a higher annuity payout to the grantor and a higher rate of return to provide a benefit to the remainder beneficiaries. Asset allocation Aggressive investment is the key to passing the most wealth to the remaindermen. Reallocation may be necessary during the term of the GRAT to correct underperformance or to lock in gains from overperformance. If the GRAT underperforms the 7520 rate, the GRAT may have to take on more risk to beat the 7520 hurdle. While the added risk may help the GRAT beat the investment hurdle, it could also accelerate the GRAT s failure. Another alternative to help increase investment performance may be to have the grantor substitute more growth oriented assets for the GRAT s current assets. 8

11 It may be wise to protect gains realized in periods of overperformance by reallocating into more conservative investments such as cash or Treasury securities or by diversifying the portfolio. However, the grantor should be aware that gains on any sales in the GRAT will be taxed to him or her, not to the GRAT. Instead of selling assets in the GRAT it may be possible for the grantor to substitute more conservative assets from the grantor s portfolio for GRAT assets. Single-Asset GRATs Many advisors feel that the investment performance of a GRAT can be enhanced if separate assets or asset classes are contributed to separate GRATs. In other words, investment performance may be improved if the GRAT is invested in one asset (e.g., one issue of a particular stock) or asset class (e.g., financials) rather than a diversified portfolio. By isolating different assets to separate GRATs the tax benefits are not diluted if some assets in the GRAT appreciate while others depreciate in value. In other words, if the GRAT is invested solely in one asset or asset class that achieves strong performance, the return would not be diluted by lesser performing investments that are part of the portfolio, enabling greater wealth transfer to heirs. When longer-term GRATs might be best Despite the relative popularity of short-term GRATs, some investors prefer longer-term GRATs. A longer-term GRAT allows the grantor to lock in a current low 7520 rate. Grantors contemplating a long-term GRAT can hedge the mortality risk that the grantor may die during the term of the GRAT by setting up a series of GRATs with increasing terms (e.g., a three-year, fiveyear, seven-year and nine-year GRAT). A series of GRATs with different terms increases the likelihood that the grantor will survive the term of some, or hopefully, all of the GRAT terms. Long-term GRATs make sense when the asset contributed to the GRAT is an interest in a closely-held business. The term of a GRAT holding a closely-held business interest can be set based on the term necessary to bring the annuity payment down to a level that can be funded with cash flow from the business. This prevents transferring a discounted interest in the business back to the grantor which requires annual appraisals and other complications. Gift tax consequences The gift of the remainder interest doesn t qualify for the gift tax annual exclusion because such gift does not qualify as a present interest. In addition, the grantor should avoid gift splitting. If the grantor dies during the GRAT term, the spouse s applicable exclusion amount is not restored. Estate tax consequences If the grantor survives the term of the GRAT, the GRAT assets will escape taxation in the grantor s estate. If the grantor dies during the GRAT term, the GRAT assets will be included in the grantor s gross estate under The amount included in the estate for estate tax purposes is the amount of principal of the GRAT needed to pay the annuity based on the 7520 rate in effect for the month of death. Reg (c) and (e), T.D published on November 7, Generation skipping tax consequences The generation skipping tax exemption can only be allocated at the end of the GRAT term under the estate tax inclusion period (ETIP) rules of 2642(f). Thus, a GRAT is not an effective vehicle to leverage the generation skipping tax exemption. 9

12 Estate Planning in a Low Interest Rate Environment A possible solution to the generation skipping tax problem is for the GRAT to provide that the GRAT distribute only to the grantor s children living at the expiration of the GRAT term or the children of a child of the grantor who died prior to the establishment of the GRAT. Under this approach, no share of the GRAT would be available for the children of a child of the grantor who was living at the inception of the GRAT but who died prior to the expiration of the GRAT. If relying on this alternative, the grantor should consider reviewing his or her estate plan to provide otherwise for the children of a deceased child who are eliminated as the remaindermen of a GRAT. Benefits of a GRAT If the GRAT succeeds, it removes appreciation from the grantor s estate with little or no gift tax if the grantor outlives the term of the GRAT. In addition, the grantor retains cash flow in the form of an annuity. Since the annuity can be defined in terms of a percentage or fraction of the assets transferred to the GRAT, the risk of valuation adjustment as a result of a gift tax audit can be minimized or eliminated. If the valuation of the assets transferred to the GRAT increases, so does the annuity, leaving the value of the remainder interest unchanged. Finally, if the GRAT is unsuccessful, any gift tax exemption used is restored or any gift tax paid will be applied to the grantor s estate tax so the grantor has lost nothing but the transaction costs to establish the GRAT (e.g., attorney, accountant, trustee and appraisal fees). Disadvantages of a GRAT The major disadvantage of a GRAT is the mortality risk (i.e., that the grantor will die during the term of the GRAT and the GRAT assets will be included in the grantor s gross estate). Also, if the GRAT s investment performance fails to beat the 7520 rate, the GRAT will not be successful in passing on wealth. Another disadvantage is the annuity must be paid even if the trustee has to use corpus or borrow funds to make the annuity payment. Also, the generation skipping tax exemption cannot be allocated until the termination of the GRAT. If the GRAT is successful, more of the generation skipping tax exemption will be required to shelter the GRAT from generation skipping tax than would have been needed if the exemption could have been allocated at the inception of the GRAT. If the GRAT is successful, the grantor s basis in the transferred assets will be carried over to the GRAT and its beneficiaries. Summary In general, a GRAT is a potentially valuable estate planning tool for the grantor, allowing a grantor to transfer significant wealth while incurring little or no gift tax. To maximize the value of a GRAT, a grantor should consider establishing a series of short-term, zeroed-out, rolling GRATS with annuity payments increasing 20% per year, which are invested in one growth-oriented asset or asset class as a way to facilitate wealth transfer. Taxpayers should be aware, however, that legislative changes have been proposed that would establish a minimum ten-year GRAT term and a minimum 10% value for remainder interest. This would increase both the mortality risk (i.e., risk that the grantor will die during the GRAT term) and volatility risk (i.e., risk that gains realized early in the GRAT term will be lost by investment decline by the end of the GRAT term). The legislative proposal also would eliminate the ability to use a zeroed-out GRAT. A GRAT is a statutory vehicle. If the statutory requirements are met, there is little risk that an IRS challenge to the GRAT will succeed. 10

13 Sale to Intentionally Defective Grantor Trusts A sale to an intentionally defective grantor trust (IDGT) is a technique used to freeze the value of an asset in the grantor s estate for estate tax purposes. The objective is for the grantor to sell an asset to an irrevocable trust in exchange for a promissory note from the trust. The trust is structured as a grantor trust. The transaction is a sale, not a gift. The transaction allows the grantor to freeze the value of his estate at the value of the promissory note, all without income and gift tax consequences. If the value of the assets in the IDGT appreciate in value over the AFR, the excess is transferred free of transfer tax to the remaindermen. A defective grantor trust is simply an irrevocable trust over which the grantor retains a power that causes the income of the trust to be taxed to the grantor rather than being taxed to the trust. Transactions between the grantor and a grantor trust are ignored for income tax purposes. Rev. Rul , C.B A number of powers under Internal Revenue Code , if retained by the grantor, will cause him to be taxed on the trust s income. Some of these powers will not only cause the income of the trust to be taxed to the grantor but also will cause the assets of the trust to be included in the grantor s gross estate for estate tax purposes. The idea is for the grantor to retain a power that will cause the income of the trust to be taxed to him for income tax purposes but avoid having the trust assets included in his estate for estate tax purposes. Only certain powers will accomplish both goals. The more frequently used powers are: 675(4)(C) power, in a non-fiduciary capacity, to reacquire trust assets by substituting assets of an equivalent value; 675(2) power to borrow without adequate interest or adequate security; and 674(c) selected powers held by an independent trustee. If the trust is established with a power that causes the income to be taxed to the grantor without the assets being included in his estate, the results will be as follows: the trust income will be taxed to the grantor rather than to the trust, allowing the trust to grow free of income tax transactions between the grantor and the trust have no income tax consequences the grantor will not incur a capital gain when he sells assets to the trust interest payments on any promissory note the grantor receives from the trust will not be taxable income to the grantor assets sold to the trust will retain the grantor s basis in those assets (i.e., there will be a carryover basis) the trust assets will not be included in the grantor s estate for Federal estate tax purposes The sale to an IDGT essentially involves a four step process. These steps are detailed further below: 1. The grantor creates and seeds the trust. 2. The grantor sells assets with appreciation potential to the IDGT in exchange for a promissory note for the full fair market value of the property sold to the trust. 3. The IDGT makes payments on the promissory note to the grantor/seller during the term of the promissory note. 4. Ideally, the IDGT pays off the note during the seller s lifetime. 11

14 Estate Planning in a Low Interest Rate Environment Step One: Create and Seed the IDGT After creating an IDGT, the grantor transfers a seed gift to the trust. Although no statutory requirement, regulation or case requires a seed gift to the trust, most practitioners recommend a seed gift in the amount of 10% of the assets ultimately to be transferred to the trust. This is based, in part, on private letter ruling , in which the IRS approved a sale to an IDGT funded with a 10% seed. This initial funding constitutes a gift for gift tax purposes. Thus, the grantor will be required to allocate part or all of his lifetime gift tax exemption to the gift or, if he has already used his gift tax exemption, he will have to pay gift tax on the transfer. At the same time, the grantor will want to allocate a portion of his generation skipping tax exemption to the gift so that any further appreciation in the trust assets will be sheltered from generation skipping tax. The seed gift is made to the trust to give the trust credibility as a lender. Commercially, one does not lend money to someone who has no assets. One reason for making a seed gift is that a person who creates a trust but makes no gratuitous transfers to the trust is not treated as the owner of the trust for grantor trust purposes. Reg (e) (1). However, the real reason for the seed is a legal issue (i.e., the promissory note transferred to the grantor must represent debt rather than equity). If the promissory note represents debt, the AFR can be used as the interest rate on the note. If the promissory note represents equity, the promissory note could be deemed a gift to the trust with a retained interest. Classification as a gift with a retained 12 interest would trigger estate tax inclusion under 2036 and also could trigger the application of 2701 and Some practitioners would prefer to avoid making a taxable gift on seeding the IDGT. As a substitute for a cash seed, some practitioners substitute a personal guarantee by the beneficiary for the cash seed. The personal guarantee seeks to make the loan a bona fide debt instrument, by ensuring repayment of the debt despite the lack of other adequate assets in the trust. Many feel that a personal guarantee alone should suffice to create a bona fide debt instrument, assuming the guarantor has sufficient assets to ensure repayment of the debt. If a personal guarantee is used, the guarantor should be paid a commercially reasonable annual fee for his guarantee. Otherwise, the IRS may treat the value of the personal guarantee as a gift to the trust. If the value of the personal guarantee is treated as gift to the trust, the trust would not be treated as wholly-owned by the original grantor the guarantor would also be treated as a grantor. If more than one grantor is involved, transactions between the grantor and the IDGT would not be completely ignored for income tax purposes. A counter-argument could be made that no gift is in fact made to the trust until the guarantor is called upon to make good on his guarantee. Another way to address the gift tax issue is to transfer the seed gift to the trust with a grantor retaining a special power of appointment over the gift thereby making the gift incomplete for gift tax purposes. Step Two: Grantor Sells Assets to IDGT for a Promissory Note After the grantor has seeded the trust, the next step is for the grantor to sell assets to the IDGT in return for a promissory note. The promissory note may be secured by the assets sold to the IDGT. The promissory note usually is structured as annual payments of interest only, with a balloon payment at the end of the term of the note. The interest rate on the note is the AFR for the month of sale. For example, a November 2011 short-term note requiring annual payments of interest would carry an interest rate of 0.19%, a mid-term loan a rate of 1.20% and a long-term loan a rate of 2.67%. Note that in most cases the AFR for short-term and mid-term loans will generally be lower than the 7520 rate for a GRAT. The promissory note may be prepaid. The note can be secured by the trust assets. The entire corpus of the trust should be liable for repayment of the note, not just the assets sold to the trust in return for the note. Also, the payments on the note should not be based on the performance of the assets sold to the trust. The note should be structured to last for a period of time that is less than the grantor s life expectancy. In addition, the term of the note should not exceed years in order to eliminate the risk that the promissory note is treated as equity rather than debt. The above precautions are necessary to prevent an IRS argument that the note is really a gift with a retained interest includible in the grantor s estate under 2036.

15 Consideration should be given to reporting the sale on a gift tax return to get the gift tax statute of limitations running. The gift tax statute of limitations will commence only if the gift is adequately disclosed. Thus, it is recommended that all the sale documents (sales agreement, transfer documents, promissory note, security agreements, etc.) be attached to the gift tax return. Step Three: IDGT Makes Payments on the Promissory Note After the sale of the assets to the IDGT, the trust makes payments on the promissory note either in cash or in kind. The cash seed, if sufficient, can be used to make the payments. Alternatively, cash flow from an asset sold to the IDGT may be used to make payments on the promissory note. Payments made in kind will not generate any income tax consequences, as transactions between the grantor and the IDGT are ignored for income tax purposes. Rev. Rul , C.B The interest paid by the IDGT to the grantor is not taxable to the grantor for the same reason. Income earned by the trust is taxed to the grantor. The payment by the grantor of the income tax on the income earned by the IDGT is not a taxable gift from the grantor to the trust. Rev. Rul , I.R.B. 7. Thus, the grantor s payment of the trust s income tax is in effect a gift-taxfree transfer from the grantor to the trust. This allows the trust s principal to remain unreduced by income tax on the trust s income. If the AFR declines in subsequent years it may be possible for the trust to renegotiate the rate downward as long as the rate is the AFR for the month of the renegotiation. As is the case with refinancing loans to family members, it may be a good idea to furnish some consideration (e.g., a shorter term or a paydown of some of the principal) in return for the lower interest rate. Step Four: Pay Off the Promissory Note During the Seller s Lifetime Income tax consequences may result if the promissory note has not been paid off by the time of the grantor s death. The issue on this point is unresolved. The IRS may argue that the balance of the gain on the installment sale must be recognized on the seller s death. However, death generally is not an income tax recognition event. To avoid the issue it is generally recommended that the promissory note be paid off during the grantor s life. Alternatively, consider having the grantor/ seller elect out of installment sale reporting at the time of the sale. The gain would be recognized in the first year but, under the theory of Rev. Rul , there is no income recognition. Death in a subsequent year arguably would be a non-event for income tax purposes. However, the IRS may take the position that, since the original sale is a non-event for income tax purposes, the grantor/seller is not able to elect out of installment sale reporting. Consider the following example: A grantor creates and seeds an IDGT with $500,000. He applies $500,000 of his gift tax exemption and $500,000 of his generation skipping tax exemption to the gift. Thus, no gift tax is due on the gift and the trust has a zero inclusion ratio for generation skipping tax purposes. Subsequently, the grantor sells $4.5 million of assets to the IDGT in return for a nine-year promissory note at 1.20% (November, 2011 mid-term AFR). The promissory note is interest-only payable annually with a balloon payment at the end of the 9-year term. The trust assets grow 10% per year. As a result: The grantor has frozen the value of $4.5 million (loan amount) in his estate; The initial $500,000 seed is a gift to which the grantor applied $500,000 of his lifetime gift tax exemption; The sale is not a gift for gift tax purposes; The entire trust is exempt from generation skipping tax as the grantor has applied $500,000 of his generation skipping tax exemption against the $500,000 seed gift; The trust assets are not included in his estate for estate tax purposes; 13

16 Estate Planning in a Low Interest Rate Environment The grantor recognizes no taxable gain on the sale due to Rev. Rul , C.B. 184; The grantor pays no income tax on the interest payments of $54,000/year ($4.5 million x 1.20%) due to Rev. Rul , C.B. 184; The IDGT pays off the $4.5 million promissory note in year nine; The value of the assets in the trust have grown at 10% per year so that after paying off the $4.5 million note, the trust still has $6,556,447 of assets at the end of year 9, which is transferred to the remaindermen; and $6,056,447 ($6,556,447 remaining in the trust at the end of year 9 after paying off the note less the $500,000 initial seed ) is transferred to the remaindermen outside the transfer tax system (i.e., free of estate, gift and generation skipping tax). This transaction is illustrated in Exhibit E. Exhibit E Sale to Intentionally Defective Grantor Trust Grantor Result: Grantor freezes value of his estate Gift Tax Consequences The initial 10% seed is a gift for gift tax purposes. The sale to the IDGT is not a gift, assuming the assets are sold to the trust at their fair market value. Income Tax Consequences The initial sale to the trust does not cause immediate gain recognition because the grantor is treated as the owner of the trust for income tax purposes and transactions between the grantor and the IDGT are ignored for income tax purposes. Rev. Rul , C.B. 184; Reg (c), Ex. 5; Rev. Rul , I.R.B Gift of $500,000 plus sale of $4.5 million assets $4.5 million 9 yr P/N at 1.20% IDGT $6,556,447 Outright or in trust for heirs Interest payments on the promissory note do not create taxable income to the grantor due to the trust s grantor trust status. The grantor is liable for income tax on the income of the trust. However, payment of the trust s income taxes reduces the grantor s estate for Federal estate tax purposes and allows the trust to grow free of income tax. The grantor s payment of the trust s income taxes is not a gift from the grantor to the trust. Rev. Rul , I.R.B. 7. Unresolved are the income tax consequences if the grantor dies before the promissory note is paid off. The IRS position is that the unreported installment gain is triggered at the seller/grantor s death. However, some practitioners believe that the gain should be deferred under 453 and taxed as income in respect of a decedent as payments on the note are made after the grantor/ seller s death. 14

17 Estate Tax Consequences The value of the promissory note rather than the appreciating assets sold to the trust is included in the grantor s gross estate for Federal estate tax purposes. The assets sold to the IGDT are not included in the grantor s gross estate. Generation Skipping Tax Consequences The grantor s generation skipping tax exemption should be allocated to the initial seed to exempt the trust from generation skipping tax. Once the IDGT has been seeded and generation skipping tax exemption has been allocated to cover the initial seed, no further generation skipping tax exemption need be allocated to the IDGT with respect to the sale. The only risk is that if the sale to the IDGT is not respected and the assets are included in the grantor/seller s gross estate under 2036, the generation skipping tax exemption may not be allocated during the estate tax inclusion period (ETIP). The assets could be included under 2036 if the note is determined to be equity as opposed to debt. Thus, it is important that the transaction is structured correctly so that the note is debt as opposed to equity. Tax Benefits The benefits of a sale to an IDGT are as follows: The sale to the IDGT is not a gift; If generation skipping tax exemption is allocated to cover the seed, the trust will be exempt from the generation skipping tax; The IDGT s income is taxed to the grantor rather than to the IDGT resulting in the tax-free growth of assets in the IDGT; Transactions between the grantor and the trust have no income tax consequences. Thus, the sale of the assets to the IDGT can be made without recognition of income and interest payments made by the IDGT on the note to the grantor are not taxable income to the grantor/seller; The trust assets are excluded from the grantor s estate; and Any appreciation of the assets of the IDGT above the AFR hurdle rate inures to the benefit of the remainder beneficiaries of the IDGT free of transfer tax. Practical Benefits The practical benefits of a sale to an IDGT are as follows: The short-term and mid-term AFR used for the promissory note often is slightly lower than the 7520 rate used for a GRAT. Thus, the hurdle rate for a sale to an IDGT is lower than the hurdle rate for a GRAT; The promissory note typically calls for interest only with a balloon payment at the end whereas a GRAT requires larger annuity payments. Thus, more money is left to grow in the IDGT with a sale to an IDGT than in a GRAT; The beneficiaries may receive payments from the IDGT at any time. On the other hand, since a GRAT cannot be commuted, the GRAT beneficiaries must wait until the GRAT terminates to receive distributions; A sale to an IDGT may benefit multiple generations if the generation skipping tax exemption is used whereas a GRAT typically benefits only the next generation as the generation skipping tax exemption cannot be allocated during the GRAT s estate tax exclusion period (ETIP); and It is easier to sell a business interest to an IDGT than to transfer a business interest to a GRAT. The longer term of an IDGT makes it easier for the cash flow from the business to be used to make the payments on the note than it would be to make larger annuity payments over a shorter period of time with a GRAT. 15

18 Estate Planning in a Low Interest Rate Environment Disadvantages of a Sale to an IDGT A sale to an IDGT does have disadvantages, such as: The risk that the promissory note may be treated as equity rather than debt thereby exposing the trust assets to estate tax inclusion under 2036 and 2702; The potential gain recognition if the grantor/seller dies before the promissory note is paid; The risk that the IRS may determine that the assets sold to the IDGT exceed the amount of the promissory note, in which case a gift would result. The use of a defined value clause, which has gained some acceptance under recent cases, but has not to date been approved by the IRS, may minimize this risk. A defined value clause would cause any value exceeding the amount of the promissory note to pass to a spouse, a QTIP trust or a zeroed-out GRAT. However, the best solution to this problem is to get a reliable appraisal for the assets sold to the IDGT; and If the investment return underperforms the applicable AFR, the grantor gets back the assets gifted (seed) to the IDGT, resulting in a waste of the grantor s gift tax and generation skipping transfer tax exemption allocated to the gift. Which is Better: GRAT or Sale to IDGT? Factors in Favor of Sales to IDGTs If the grantor dies before the GRAT term ends, the GRAT assets (limited to the amount needed to pay the annuity based on the 7520 rate in effect at the time of the grantor s death) are included in the grantor s gross estate. On the other hand, no survivorship requirement exists for a sale to an IDGT. The hurdle rate for a GRAT is the 7520 rate whereas the hurdle rate for a sale to an IDGT is the AFR. The AFR for short-term and mid-term loans usually is lower than the 7520 rate, hence the hurdle for success of the sale to an IDGT technique is lower. In addition, the GRAT passes more back to the grantor than a sale to an IDGT. Annuity payments for a GRAT must be made by the anniversary date of the GRAT (or 105 days later) or by the end of the taxable year (or by the due date of the trust s income tax return not including extensions). A sale to an IDGT only has to pay interest. The IDGT can decide to repay the principal on the promissory note at any time before it is due, affording greater flexibility. Annuity payments of a GRAT are larger than the payments on a note under a sale to an IDGT. A sale to an IDGT only has to pay interest. The trust can decide to repay the principal on the promissory note at any time before it is due. It is more difficult to cover GRAT payments with trust cash flow. The GRAT may have to make in-kind distributions to cover the annuity payments. In-kind distributions may be re-grated resulting in additional complexities. A sale to an IDGT is more generation-skipping tax efficient than a GRAT. The generation skipping tax exemption cannot be allocated to a GRAT until the end of the GRAT term (the ETIP). If the GRAT assets appreciate, more generation skipping tax exemption must be allocated to the GRAT to cause the GRAT to have a zero inclusion ratio. If the value of the GRAT assets at the end of the term exceed the generation skipping tax exemption, a zero inclusion ratio is impossible. Thus, less generation skipping tax leverage is achieved with a GRAT. The generation skipping tax exemption need only be allocated to the seed gift in a sale to an IDGT. The sale portion of the transaction is not a gift, so no generation skipping tax exemption need be allocated. Once the generation skipping tax exemption is allocated to the seed gift, the trust will have a zero inclusion ratio. 16

19 Exhibit F Comparison of GRAT to IDGT GRAT IDGT Advantage Trustee Grantor may serve Independent trustee Payments Anniversary date days or taxable year by return due date Annually; can be interest only, balloon at end IDGT Hurdle rate 7520 AFR ( 7872) (usually lower) IDGT Zero-out? Yes Yes but seed is a taxable gift GRAT Need equity floor? No Probably 10% seed recommended GRAT Ability to adjust gift by formula? Yes Difficult may be able to use defined value clause GRAT Must payments be made if value declines? Yes if investments don t beat hurdle, assets returned to Grantor, nothing lost except transaction costs Yes if investments don t beat hurdle, assets returned to Grantor resulting in waste of gift tax exemption to cover seed n/a Able to unwind? No Yes, P/N can be pre-paid IDGT Survival required for transfer tax savings? Yes No IDGT GST leveraging? No GST allocated at the end of term Yes allocate to seed only IDGT Eligible S corporation shareholder? Yes Yes n/a 17

20 Estate Planning in a Low Interest Rate Environment Factors in Favor of GRATs Gift tax can be avoided with a zeroedout GRAT, which is allowed by regulation. Reg (e), Examples 5 and 6 as amended by T.D. 9181, 70 Fed. Reg (2/25/05). The regulations also allow a price adjustment if the value of the gift is increased on audit. Reg (b)(1)(ii). Although a defined value clause may be included in a sale to an IDGT, a defined value clause in such a case has not been approved by the IRS. Thus, if the subject matter consists of difficult to value assets, a GRAT is generally favorable where the grantor s goal is no gift tax. Charitable Lead Annuity Trusts (CLATs) A CLAT is an irrevocable trust (inter vivos or testamentary) which pays a fixed percentage of the initial value of the trust to a charity for a term of years. The balance of the CLAT then is passed to non-charitable beneficiaries at the end of the charitable term. The annuity paid to charity can be set by a formula so that the value of the annuity is almost the entire value of the assets transferred to the CLAT. In effect this causes the value of the remainder interest to be zero or close to zero. Like a GRAT, the estate planning objective of a CLAT is to maximize the value of the annuity and minimize the value of the remainder. The actuarial value of the stream of payments made to charity over the term of the CLAT qualifies for either a gift tax or estate tax charitable deduction. The lead interest payable to charity is valued using the 7520 interest rate in effect for the month the CLAT is funded or the rate in effect for the two months prior to funding. Like a GRAT, if the total return of the assets transferred to the CLAT exceed the 7520 rate during the term of the CLAT, there will be assets remaining in the trust which will pass to the non-charitable remainder beneficiaries free of transfer tax. Investment return in excess of the 7520 rate inures to the benefit of the non-charitable remainder beneficiaries. Alternatively, if the investment return in the CLAT does not exceed the 7520 rate, the annuity payments will exhaust the CLAT, leaving no assets available at the end of the term for the remainder beneficiaries. Consider the following example: A grantor establishes a $1,000,000, 10-year non-grantor testamentary CLAT upon his death in November The CLAT pays an annual annuity of % of the initial value of the trust payable to charities selected by the trustees. The remainder interest is payable to the decedent s children who are living. The November rate is 1.4%. The CLAT experiences an investment return of 10% per year for its entire 10-year term. The actuarial value of the annuity interest is $1,000,000 and the value of the remainder interest is $0 ($1,000,000 less the annuity value of $1,000,000). The decedent s estate is entitled to an estate tax charitable deduction of $1,000,000. The value of the assets remaining in the CLAT at the end of its 10-year term is $874,572. Thus, the estate gets an estate tax charitable deduction of $1,000,000 and, if the children are willing to wait 10 years, they will receive $874,572 free of any transfer tax. Charitable deduction The timing of the income tax charitable deduction depends on the type of CLAT the grantor creates. Generally, there are two types of CLATs: a non-grantor CLAT and a grantor CLAT. A non-grantor CLAT does not contain a grantor trust type power and is generally treated as an irrevocable trust subject to taxation under the normal rules for the taxation of trusts under Subchapter J of the Internal Revenue Code. The grantor of a non-grantor CLAT does not receive an income tax charitable deduction on the funding of the CLAT. The trust is taxed under the normal rules applicable to the taxation of trusts. As a result, a non-grantor trust receives an income tax charitable deduction each year for the annuity amount paid out to the charity under 642(c) of the Internal Revenue Code. The deduction is unlimited in amount. 18