Sales Strategy Sale to a Grantor Trust (SAGT)

Estate planners have been using the Irrevocable Life Insurance Trust (ILIT) for many years, to increase wealth and liquidity outside the taxable estate. 1 However, transfers to ILITs One effective technique that are often subject to gift estate planners are using taxes, and trusts then pay currently to help minimize income income taxes at higher and gift taxes and to transfer rates than individuals do. 2 more to heirs is a variation of the A Sale to a Grantor Trust standard ILIT in which a grantor (SAGT) can help take sells assets to the trust in advantage of the exchange for a note, after making grantor trust rules 3 to an initial contribution. provide the grantor, the creator of the trust, greater flexibility with wealth transfer and tax planning. Typically, mom and/or dad, as grantors of this type of trust, sell income-producing assets that may appreciate in value, such as a family business interest, to the trust in exchange for an installment note paying the lowest rate of interest possible. The principal of the note is often repaid as a balloon payment at the end of the trust term. The minimum interest rate that is required for the note to be a bona fide note is based on the applicable federal rate (AFR) in the month the note is established, and varies according to the term of the note. TRANSFER TAX SAVINGS The reason for maximizing the gap between the income and/or return on the transferred assets and the interest rate charged on the note is that this excess represents a tax-free transfer to heirs. This taxsaving mechanism is very simple the value leaving the estate exceeds the value coming back into the Sales Strategy Sale to a Grantor Trust (SAGT) LEVERAGING THE GRANTOR TRUST RULES TO HELP INCREASE WEALTH TRANSFER estate from loan interest and principal repayments. With interest rates at historical lows, the benefits of this technique are more attractive even if the asset does not grow in value. The income generated from the assets in the trust can be used to purchase a life insurance policy for wealth transfer purposes. Accordingly, when interest payments are low, there are more funds available to pay the premiums. SAGT BASICS One of the distinctive features of a grantor trust is that it is an irrevocable trust that treats the grantor as the owner of the trust assets only for income tax purposes while the trust assets continue to remain outside the taxable estate. The trust is drafted so that the grantor (or grantor and spouse) 4 possesses certain powers over the trust that cause the grantor to be the owner only for income tax purposes. GRANTOR TRUST RULES The powers that make a trust a grantor trust are described in certain tax code provisions known as the grantor trust rules. 5 If these rules apply to a trust, then the income generated from the trust assets as well as deductions and credits are included on the grantor s income tax return and income taxes are paid at the grantor s tax bracket. The payment of the income taxes is, in effect, an additional tax-free gift the grantor makes to the trust. The trust, therefore, will have more assets and income 6 that can be leveraged with life insurance to potentially increase the amount transferring to heirs. Furthermore, the sale of an asset to the trust can be accomplished without adverse income tax consequences. 7 Advanced Markets Sales Strategy Sale to a Grant Trust (SAGT) John Hancock Life Insurance Company (U.S.A.) (John Hancock) John Hancock Life Insurance Company of New York (John Hancock) 1

BENEFITS OF USING A SAGT The grantor-seller pays the trust income taxes, preserving more of the trust assets for wealth transfer purposes. Payment of the trust s income tax by the grantor-seller is, in effect, an additional tax-free transfer from the grantor to the trust. No gain is recognized by the seller on the sale and the interest payments received on the note are not income taxable to the seller. More assets can be transferred without gift tax consequences since a sale of an asset is not considered a gift. The value of the asset sold to the trust may be discounted allowing grantor to transfer more. Trust income can be used to fund a needed life insurance policy and to potentially transfer more to heirs. Assets in the trust will appreciate outside the taxable estate. The three-year lookback rule does not apply to a sale of assets. 8 CONSIDERATIONS The note must be structured properly and qualify as bona fide debt. If the seller is viewed as having retained an interest in the transferred property, taxation under IRC Sections 2036(a), 2701 and 2702 will apply. The amount the trust is funded with prior to the sale is generally referred to as seed money or equity. To qualify as bona fide debt, it is important that the trust s amount of debt is not too high. Unfortunately, there is little guidance from the IRS or from the courts as to what ratio of debt to assets either considers too high. The sale of an asset on an installment basis should be limited to a term that does not exceed life expectancy. HOW IT WORKS Grantor Sale of Asset In Exchange for Note (A Gift of a portion of asset can also be made) Trust Income Taxes Interest Payments/Balloon Payment Premiums Grantor Trust John Hancock Return on asset funds premium & interest payments Death Benefit To effectively establish and fund a SAGT, consider the steps involved in the transaction: Step 1. The grantor establishes an Irrevocable Grantor Trust in which life insurance can be included. The trust assets remain outside of the taxable estate but certain powers allow the grantor to pay the trust s income taxes. These powers may include the following: 1) the power of a non-fiduciary person to reacquire the trust assets by substituting property of an equivalent value; 9 2) the power to make loans without adequate interest or security, which will reduce the taxable estate to the grantor or the grantor s spouse; 10 or 3) the power to use trust income to pay premiums on insurance on the life of the grantor or the grantor s spouse. 11 To avoid estate tax inclusion, the grantor or grantor s spouse should not be named as trustee of the SAGT. 2

Step 2. The grantor makes an initial gift of assets to the trust. If the gift is within the annual exclusion or applicable exclusion amount, no gift tax will be due. 12 To leverage the generation-skipping transfer tax exemption, a gift tax return should be filed and the generation-skipping transfer tax exemption should be allocated to the trust to cover the amount of the gift. 13 The grantor may consider making a gift of cash or marketable securities to the SAGT initially to avoid having to check the box on the gift tax return for a valuation discount. 14 Step 3. After making the gift to the trust, the grantor enters into an installment sale agreement with the SAGT trustee in which the trustee agrees to purchase assets from the grantor. Ideally, the trust should buy income-producing assets, such as limited partnership interests or S-corporation stock. 15 Valuation discounts on these assets can be taken by appraisers for a variety of reasons, including lack of marketability or minority interests. The initial gift grantor contribute to the trust should total at least 10% of the value of the assets being sold to the trust. 16 The promissory note for the installment sale is generally structured as an interest-only note for a term of years, with the principal balance due at the end of the term. Typically, the interest rate on the note is the AFR at the time of the sale. 17 Step 4. The assets transferred to the SAGT accumulate inside the trust free of gift and transfer taxes. The grantor will pay the tax due on the trust s annual income at his or her income tax rate. After the trust pays the interest due on the note, a portion of the remaining trust income can be used by the trustee to fund a life insurance policy. Excess funds that accumulate in the trust can be used to fund the balloon repayment at the end of the trust term. It is also possible to coordinate the use of other estate planning vehicles with the SAGT transaction to contemplate the repayment of loan principal at some time in the future. The interest payment made to the grantor will not be taxable income since both the grantor and the trust are considered to be the same taxpayer. In addition, a sale transaction or exchange of assets with the trust will not have adverse tax consequences for the grantor. HOW A SAGT DIFFERS FROM A GRAT If the grantor outlives the term of the note, maximum leverage can be achieved by using this note sale technique. Unlike a Grantor Retained Annuity Trust (GRAT), when a note sale is used, the grantor does not have to outlive the term of the note to obtain significant estate tax benefits. Once the sale is complete, the transferred assets will remain outside the taxable estate since the three year lookback rule does not apply to the sale. 18 Although the unpaid balance of the note may be included in the taxable estate of the grantor if he or she does not outlive the term of the note, the future income and appreciation of the assets will continue to grow outside the estate. If appropriate, the grantor may even make additional installment sales to the trust in future years. THE DIFFERENCE A YEAR OR TWO OR THREE CAN MAKE To illustrate just how powerful low interest rates can be when planning for the transfer of family wealth through a note sale to a grantor trust, the following example assumes no growth on the asset nor the trust side fund and isolates the interest and premium costs of the note sale alone. Assume that Mom and Dad have a Family Limited Partnership valued at $10,000,000. Mom and Dad, as grantors of the trust, transfer $750,000 to the trust as a seed gift. Afterwards, they sell the FLP interests at a discount of 25% to the trust in exchange for $7,500,000 under a 9-year note. They use the December 2010 AFR for mid-term notes of 1.53%. The total income generated by the trust is $600,000 annually. Take a look at how much more death benefit could have been purchased annually as interest rates dropped between December 2007 through December 2010: 3

December Mid-Term AFR Interest payment would have been Remaining amount available to fund the premium Amount of death benefit that could be purchased Difference in death benefit compared to 2011 2007 4.13% $309,750 $290,250 $13,473,980 $9,066,450 2008 2.85% $213,750 $386,250 $17,937,464 $4,602,966 2009 2.64% $198,000 $402,000 $18,669,753 $3,870,677 2010 1.53% $114,750 $485,250 $22,540,430 This is a supplemental illustration authorized for distribution only when preceded or accompanied by a basic illustration from the issuer. Benefits and values may not be guaranteed: the assumptions on which they are based are subject to change by the insurer. Actual results may be more or less favorable. Refer to the basic illustration for guaranteed elements and other important information. The premiums on a John Hancock Protection SUL, a flexible premium universal policy on Male Age 65 and Female Age 62, both Preferred Non Smokers are assumed to be paid from the income of the trust. Death benefit figures based on 9 annual premiums as indicated. Now, take a look at another case to see how a SAGT works: CASE STUDY: MATTHEW BERMAN Matthew Berman, age 58 has a net worth of $25 million that includes a business interest valued at $10 million. Matthew would like to sell the business to his 2 children who are running the operations. Because the business is in a Family Limited Partnership (FLP), a qualified appraiser applies a 30% discount for transfer purposes. Matthew needs $10 million of life insurance coverage. Matthew will make an initial cash gift to a grantor trust of $700,000. He will then enter into an installment note with the trust to sell the business to his sons who are the beneficiaries of the trust. Since the 2010 Tax Act allows for a $5 million lifetime exemption from gift taxes if the gifts are made by the end of 2012, Matthew decides to make an additional gift of $4.3M of the FLP interests. The remaining balance of the business, considering the 30% discount, is $2.7M and will be the value of the business transferred to the trust in exchange for a 5-year installment note. The trust will pay interest to Matthew at the mid-term AFR of 1.95% (January 2011) on the $2.7 million note annually, and then make a balloon payment of the principal at the beginning of year 6. The balance of the trust income will fund 12 premium payments of $217,993 on a John Hancock Protection UL policy with a face amount of $10 million. The excess income will accumulate in the trust side fund at 6% and will be used to make the balloon payment. Since Matthew will be recognizing the trust income on his individual income tax return, the trust accumulation will be significantly greater than if the trust would have had to pay the income taxes. Year Sale Value of Asset to Grantor Trust Interest @ 1.95% Paid by Trust Cumulative Loan Protection UL Premium Protection UL Death Benefit Income from Trust Assets Trust Side Fund (net of interest & premium payments) @ 6% Net to Heirs (net of loan repayment) 1 $2,700,000 $52,650 $2,700,000 $217,993 $10,000,000 $700,000 $1,158,277 $18,458,277 2 $0 $52,650 $2,700,000 $217,993 $10,000,000 $700,000 $1,644,051 $18,944,051 3 $0 $52,650 $2,700,000 $217,993 $10,000,000 $700,000 $2,158,972 $19,458,972 4 $0 $52,650 $2,700,000 $217,993 $10,000,000 $700,000 $2,704,788 $20,004,788 5 $0 $52,650 $2,700,000 $217,993 $10,000,000 $700,000 $3,283,352 $20,583,352 6 ($2,700,000) $0 $0 $217,993 $10,000,000 $700,000 $1,087,281 $21,087,281 10 $0 $0 $0 $217,993 $10,000,000 $700,000 $3,424,045 $23,424,045 15 $0 $0 $0 $0 $10,000,000 $700,000 $7,961,174 $27,961,174 This is a supplemental illustration authorized for distribution only when preceded or accompanied by a basic illustration from the issuer. Benefits and values may not be guaranteed; the assumptions on which they are based are subject to change by the insurer. Actual results may be more or less favorable. Refer to the basic illustration for guaranteed elements and other important information. The premiums on a John Hancock Protection UL policy for $10M Death Benefit on Male, Age 58 Preferred Non Smoker, Massachusetts resident are assumed to be paid from income. 4

SAGT AS AN EXIT STRATEGY The grantor can sell income-producing closely held business interests, such as corporate or partnership interests to the ILIT, on an installment basis before or when the financing loan is due. The ILIT can then use the income generated by the asset to make interest payments to the client on the note, as well as repay any outstanding loan balance, and/or fund the policy s ongoing premiums. In many cases, a SAGT can provide a possible exit strategy for an existing financing arrangement in which the loan must be repaid at some point in the future. 2010 TAX ACT PLANNING OPPORTUNITY The 2010 Tax Act provides a two-year window of opportunity for families with substantial assets. The amount that can now be transferred without gift taxes (also referred to as the lifetime exemption amount) is $5 million per person. However, this exemption is available in 2011 and 2012 only. That is, beginning on January 1, 2013, this tax-free amount returns to its previous level of only $1 million. By combining the installment note technique with the increase in this gift tax exemption, significantly more assets can be transferred outside of the taxable estate during lifetime. SUMMARY A Sale to a Grantor Trust is a sophisticated planning technique that may allow a family to achieve significant tax benefits while funding an irrevocable trust during lifetime. This type of trust can be particularly useful when Mom and/or Dad are looking to transfer large amounts of limited partnership interests, S-corporation stock, or other incomeproducing assets without incurring gift tax. A SAGT can also be used if a grantor s applicable gift tax exclusion amount has already been used. Essentially, a SAGT allows a family to transfer assets outside the taxable estate at a discounted value and then use the trust income to fund a needed life insurance policy. The difference between the interest payable on the note sale annually and the income generated by the asset, as well as its growth, can be used to fund a needed life insurance policy outside the taxable estate at minimal to no gift tax cost. 5

1. Trusts should be drafted by an attorney familiar with such matters in order to take into account income and estate tax laws (including the generation-skipping transfer tax). Failure to do so could result in adverse tax treatment of trust proceeds. 2. In 2011, trusts pay income at the highest income tax rate (35%) after $11,350 of income. Individual income taxpayers generally do not reach the 35% income tax bracket until their income is over $379,150 (for married taxpayers filing jointly or single taxpayers). Note that one of a number of ways a grantor trust can cease to exist is when the grantor dies. Therefore, if a survivorship life insurance policy is owned by a grantor trust and the grantor-insured is the first to die, the trust ceases to be a grantor trust in which the insured is responsible for the payment of trust income taxes. Therefore the trust then becomes responsible for its own income taxes. Clients should consult their own legal and tax advisors to examine whether or not a surviving spouse could be considered a grantor in their particular situation. 3. See IRC Sections 671-678. The grantor will be treated as the owner of the trust if Sections 671-677 apply. A person other than the grantor may be treated as the owner of the trust if Section 678 applies. 4. IRC Section 672(e). The grantor will be treated as the owner of the trust if the grantor s spouse holds certain interests or powers over the trust assets. 5. See IRC Sections 671-677. The defective trust takes advantage of the differences between the estate tax rules of IRC Sections 2036-2042 and the grantor trust income tax rules in IRC Sections 671-678. 6. Revenue Ruling 2004-64 has clearly stated that an irrevocable trust which protects assets from estate tax can also have the income tax benefits of a grantor trust. In this Ruling, the IRS determined that a grantor can pay income tax on trust income and it will not be considered a gift to the trust. If the grantor is reimbursed by the trust for the income tax payment, as long as the reimbursement is discretionary, rather than mandatory for the trustee, the trust will remain outside of the taxable estate of the grantor. 7. Revenue Ruling 85-13. The IRS ruled that a grantor trust is disregarded for income tax purposes and that transactions between the grantor and the trust have no income tax consequences. See Revenue Ruling 2004-64 regarding income tax payments and gift taxes. See also Revenue Ruling 2007.13 on transfers of a life insurance policy to a defective grantor trust. 8. Lookback refers to the inclusion of assets removed from the estate in a 3-year period. Please contact your financial advisor for more information. 9. IRC Section 675(4). See also Jordahl v. Commissioner, 65 TC 92 (1975). 10. IRC Section 675(2). 11. IRC Section 677(a)(3). 12. A SAGT will ordinarily be structured as a Crummey trust, giving the trust beneficiaries an opportunity to withdraw contributions to the trust, allowing the contributions to qualify for the gift tax annual exclusion as present interest gifts. The annual exclusion is $13,000 in 2010, and will be indexed annually for inflation in increments of $1,000. The applicable exclusion amount for gift tax is $1,000,000 in 2010 and is not expected to change. The gift tax rate, however, in 2010 is 35% with a change to 55% in 2011 and thereafter if legislation to change this does not pass. 13. In December of 2010, Congress passed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Act ), providing for a reduction in transfer tax rates for 2011 and 2012, with a return to 2001 transfer tax rates in the year 2013. In addition to reducing the tax rates, the 2010 Tax Act increased the available exemptions against the estate and gift taxes and it made changes to the calculation of estate taxes. Under the current law, which is based on the 2010 Tax Act, the maximum estate tax rate is 35% with a $5,000,000 exemption for each individual. For 2012, this $5,000,000 will be indexed for inflation, taking into account inflation that occurred from January 1, 2010, through December 31, 2011. The $5,000,000 exemption amount can be used either during lifetime, as a gift tax exemption amount, or at death as an estate tax exemption. In addition, each individual has a $5,000,000 exemption to the generation-skipping transfer (GST) tax; this $5,000,000 can be used during life or at death. If an individual passes away with an unused amount of exemption remaining, that individual s surviving spouse can use the unused portion of the decedent s $5,000,000 exemption, to shelter a transfer from either gift or estate taxes. The 2010 Tax Act will sunset at the end of 2012, returning us to the estate tax rate and exemption that existed in 2001. Due to the temporary nature of the new provisions and the uncertainty they create, the sample assumes a current law scenario through all years, which is not guaranteed to happen. Therefore, clients should consult with their own professional tax and legal advisors to determine the scenario that most adequately addresses their concerns. Under the current law scenario, the calculations assume a unified Gift and Estate Tax Exemption of $5,000,000 and a maximum transfer tax rate of 35% for the years 2011 and 2012. Although the exemption amount may be indexed for inflation in 2012, to keep the illustration as simplified as possible, the software does not take the indexing into account. In 2013, the current law scenario will assume a unified Gift and Estate Tax Exemption of $1,000,000 and a maximum transfer tax rate of 55% to coincide with what is scheduled under the 2010 Tax Act. Important Note: The 2010 Tax Act as presently written does not provide clear guidance as to the effect prior use of lifetime gifting exemptions will have upon estate tax calculations. Therefore, you may have to recognize a portion of the lifetime gift you made (over and above the annual exclusion amount) on your estate tax return at death. Clients should consult with their own professional and legal advisors to address these potential issues. 14. The current IRS Form 709 has a check the box item requiring the disclosure of whether any discounts were applied in the valuation of the interest that is the subject of a gift. This new requirement goes a step further and requires the disclosure of any discounts applied in valuing any assets owned by such entity. For example, if a parent gifted a share of a family limited partnership to her son and declared a gift value of $20,000 after the application of a 20% discount for lack of marketability, this discount would also have to be disclosed with the gift tax Form 709. 15. A defective grantor trust can also be funded with growth assets, rather than income producing assets. When an insurance premium is due, the grantor can purchase assets from the trust in exchange for cash. The purchase will not incur any capital gains tax. Revenue Ruling 85-13. Grantor trusts can be shareholders of S corporations. IRC Section 1361 and PLRs 9543049 and 9444033. 16. IRC Section 2036(a)(1). The 10% rule helps avoid the perception that the sale is a transfer with a retained interest by the grantor. See PRL9515039. 17. IRC Section 1274(d). The IRS publishes the AFR on a monthly basis. 18. IRC Section 2035(d)(2). Gifts of life insurance are included in the donor s estate if the gift is made within three years of the insured s death. This provision does not apply to sales of assets. 6

This material does not constitute tax, legal or accounting advice and neither John Hancock nor any of its agents, employees or registered representatives are in the business of offering such advice. It was not intended or written for use and cannot be used by any taxpayer for the purpose of avoiding any IRS penalty. It was written to support the marketing of the transactions or topics it addresses. Comments on taxation are based on John Hancock s understanding of current tax law, which is subject to change. Anyone interested in these transactions or topics should seek advice based on his or her particular circumstances from independent professional advisors. Insurance policies and/or associated riders and features may not be available in all states. Insurance products are issued by John Hancock Life Insurance Company (U.S.A.), Boston, MA 02116 (not licensed in New York) and John Hancock Life Insurance Company of New York, Valhalla, NY 10595. 2011 John Hancock. All rights reserved. IM1423 05/11 MLINY04121114696 Availability for distribution subject to State approval. INSURANCE PRODUCTS: Policy Form Series: 11PROUL Policy Form Series: 11PROSUL Not FDIC Insured Not Bank Guaranteed May Lose Value Not a Deposit Not Insured by Any Government Agency