Example With Key Best Practices for Sale to Grantor Trust Transaction

Institute by Ann Burns, John Bergner and David Handler.

a. Business Interest -- Gift and Sale to Grantor Trust.

• A starting point is to create voting and non-voting units. One planner typically creates 999 non-voting shares for every 1 voting share. Non-voting shares can be transferred without fear of the client losing control of the business.

• Gift of 10% and sale of 90%, leaving 1/9 ratio of equity to debt.

• The installment sale allows tremendous leverage. For example, the client could make a gift of $5 million and then sell $45 million worth of closely held business interests.

• Cash from the investment assets or other assets could be used to make the gift to fund the initial equity of the trust. (This couple has the assets to make that happen.) Make the gift to the trust a significant time before the sale (i.e., 30, 60 or 90 days, or even the prior taxable year). John Porter suggests transferring an initial gift of cash to the trust—something other than the illiquid asset that will be sold to the trust—so that the cash is available to help fund note payments. • The key of using the installment sale is to get an asset into the trust that has

cash flow. For example, if the business does not have cash flow, the real estate could be transferred to the trust because it does have cash flow. (See the following subparagraph.)

• Cash flow from the business may be sufficient to assist making payments on the promissory note.

• Model anticipated cash flow from the business in structuring the note.

• For pass-through entities, cash distributed from the entity to owners so they can pay income taxes on the pass-through income will be distributed partly to the grantor trust as the owner of its interest in the entity; that cash can be used by the trust to make note payments; the grantor could use that cash to pay the income tax. This “tax distribution cash flow” may be enough to fund a substantial part of the note payments.

• The goal is to be able to pay off a note during lifetime.

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• Best practices for avoiding §2036, 2038 argument: Do not make entity distributions based on the timing and amount of note payments (make distributions at different times than when note payments are due and in different amounts than the note payments)(John Porter suggestion). Be as certain as possible that consideration paid in the sale transaction is “adequate and full consideration” so that the full consideration exception to §§2036 and 2038 applies.

• Cash from the investment assets or other assets could be used to make the gift to fund the initial equity of the trust. (This couple has the assets to make that happen.)

• Use a defined value clause to protect against gift consequents of the gift and sale of hard-to-value assets to the trust. (If a charitable entity is used for the “excess value” typically a donor advised fund from a Communities Foundation is used. It should act independently in evaluating the values. It should hire an appraiser to review the appraisal secured by the family. The donor advised fund will want to know an exit strategy for being able to sell any business interest that it acquires. An advantage of using a donor advised fund as compared to a private foundation is that it is not subject to the self-dealing prohibition, so the family is able to repurchase the business interest.)

• The interest rate is very low. For example, in January 2012 a nine-year note would have an interest rate of 1.17%. If there is a 30% discount, effectively the interest rate as compared to the underlying asset value is 0.8%, so if the business has earnings/growth above that, there is a wealth shift each year. • This approach takes advantage of things available today that could be

eliminated in the future – discounts, $5 million gift and GST exemptions, and extremely low interest rates.

b. Real Estate Used In Business.

• If the business does not produce excess cash flow, consider first transferring (by gift and sale if appropriate) the real estate to the trust. The lease of the real estate from the business will produce consistent cash flow. The trust can use some or all of the lease payments to pay down the note. After nine years when the note has been paid, the continued cash flow from the lease payments could be used to purchase some of the closely held business interests.

• Reverse planning strategy (depending on client’s objectives): transfer the closely held business interest into the trust, and have the client retain the real estate. The client may want to retain the cash flow coming from the real estate. • If the client is considering selling the business at some point, inquire whether

the real estate would also likely be sold. If not, the real estate could provide continuing cash flow. (The third-party buyer of the business may or may not allow that.)

• When the ownership of the business and real estate are not the same, determining and structuring appropriate fair market rental rates becomes very important.

• Document the lease with commercially reasonable terms.

c. Timing of Gift and Sale Transactions. Do not make the gift and sale on the same day. The Pierre case aggregated assets that were given and sold on the same day for valuation purposes, to reduce the lack of control discount of the

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respective blocks that were given and sold. In addition, if the gift and sale is made the same day, that would open up a potential argument from the IRS that §2036 applies to the sale transaction, because the aggregate transfer is a transfer that does not come within the bona fide sale for full consideration exception in §2036 (i.e., it involves a gift element).

14. Summary of Trust Provisions That Cause Grantor Trust Status. Observe: Many