Posted on August 11, 2011

For many years, the GRAT has been a staple of estate planning strategies. It was something that every high net worth client considered as a freezing technique.

With the new estate tax law that became effective last December, a GRAT may not be the best strategy for many clients going forward.

While the GRAT is an excellent method for shifting the future growth of an asset to the children, there are a number of risks associated with this strategy. For example, the trust maker must survive the entire GRAT term for there to be any benefit. In addition, payouts from the GRAT must be done on a regular basis (monthly, quarterly, annually, ect.) and each payment must be basically the same amount (no more than a 20% increase) as the previous payment.

For many client’s, there is a better technique available to accomplish the same goals but without these risks. This technique is an installment sale to a grantor trust (IDGT).

How does the installment sale work? The trust maker sells the property to a grantor trust at its fair market value in exchange for a note. There are two important aspects to this strategy. First, the trust must be structured as a grantor trust so it can be disregarded as a separate taxpaying entity for income tax purposes. Second, the transfer for fair market value must be a bona fide sale for full and adequate consideration to avoid any gift tax issues. After the note has been paid in full, whatever remains in the trust may be distributed to the beneficiaries (usually the trustmaker’s children and/or grandchildren) free of estate and gift taxes, and if appropriately structured, generation-skipping transfer taxes as well.

If the assets in the trust appreciate at a rate greater than the interest rate due on the note, there will be assets remaining in the trust at the end of the note term to pass to the beneficiaries. Ideally, we would like the income produced by the assets to be greater than the interest only payment due on the note. This allows for maximum compounded growth of the principal. The trustee, however, may use the trust’s capital assets to pay the note if necessary.

Generally, any assets with appreciation potential or yield in excess of the note interest rate are candidates for this installment sale strategy. Assets that can be valued at a discount, such as a minority interest in a family business or a fractional interest in real estate produce significant savings because the face amount of the note will be based on the discounted value of the assets sold rather than on the full economic value. At some point in the future, however, when the assets are sold, the discount is recaptured and the discounted benefit fully realized.

In the coming weeks we will continue to blog further about GRAT’s and Installment Sales.
Make sure your client’s are working with an Excellent Estate Planning Attorney who understands both planning and tax.