Given the current historically low interest rates, many high-net-worth clients have looked at the estate tax benefits of a short-term grantor retained annuity trust (GRAT). Many of these GRATs have been structured as "zeroed-out" GRATs that require little or no use of the grantor's unified credit (see Walton, 115 T.C. 589 (2000)). And some of these GRATs have been structured with annuity payments that increase 20% per year over the term of the GRAT to potentially "leverage" the estate tax benefits (see Regs. Sec. 25.2702-3(b)(1)(ii)(A)).
A GRAT has many advantages, namely: (1) It is a technique that is statutorily allowed under Sec. 2702; (2) the regulations provide for a recalculation of the annuity amount in the event the "value" of the initial trust property is ever challenged (see Regs. Sec. 25.2702-3(b)(2)), which really reduces any valuation risk; and (3) with a "zeroed-out" GRAT, the grantor is only "giving up" the upside to the extent the overall investment return exceeds the Sec. 7520 rate. (The Sec. 7520 rate is 120% of the midterm applicable federal rate (AFR) under Sec. 1274(d)(1) for the month in which the property is contributed to the GRAT, rounded to the nearest two-tenths of 1%.)
While the grantor must survive the term of the GRAT to reap any estate tax benefits, the biggest disadvantage of a GRAT is that any generation-skipping transfer (GST) tax exemption may not be allocated to the GRAT until the end of the GRAT's term (see Sec. 2642(f)). This is often referred to as the end of the estate tax inclusion period (ETIP) (see Oshins and Sederbaum, "Generation-Skipping and the GRAT: Sale or Gift of the Remainder," 30 Estate Planning 259 (June 2003)). This is particularly important for clients who desire to minimize transfer taxes for generations so as to pass wealth on effectively to grandchildren and great-grandchildren. The amount of GST tax exemption that must be allocated at the end of the GRAT term is equal to the value of the assets held in the trust on that date. Due to the uncertainty of the amount of GST tax exemption needed to ensure the trust is not subject to GST tax, many taxpayers and planners choose to not include beneficiaries other than the current generation. Many will choose to use their GST tax exemption in planning with more certainty.
To avoid these disadvantages, the authors have suggested that certain high-net-worth clients might achieve superior results by using a preferred family limited partnership (PFLP) rather than an intentionally defective grantor trust (IDGT) or a GRAT (see Lusby and Burnett, "Preferred Family Limited Partnerships Offer Estate Tax Advantages," 83 Practical Tax Strategies 79 (August 2009)).
The statutory authority for a PFLP is Sec. 2701, which allows for equity interests to be created in a corporation or partnership (or a limited liability company or a limited liability partnership) with:
1. A preferred interest paying a fixed and certain rate of return; and
2. A common interest that participates in all income, growth, and appreciation above and beyond the preferred return.
Sec. 2701 determines the value of the common interest when it is transferred to (or for the benefit of) a member of the transferor's family and the transferor retains the preferred interest. The value of the PFLP's common interest must be at least 10% of the total value of the partnership (see Sec. 2701(a)(4)(A)). Sec. 2701 defines a family member to include the transferor's spouse, any lineal descendant of the transferor or the transferor's spouse, and the descendants' spouses.
When a PFLP is created, the preferred interest's value is "frozen" at the fixed rate of return, so it really acts more like a bond than a partnership interest. "Freezing" the value of the preferred interest allows the holders of the common interests to reap the benefits of appreciation free from estate or gift tax.
Under Sec. 2701, the common interests are valued using a "subtraction method." The value of the interest equals the value of the entire partnership less any value attributable to the preferred interest. A preferred interest will always be valued at zero unless there is a right to receive a qualified payment, which is defined as any cumulative dividend payable on a periodic basis at a fixed rate (see Secs. 2701(a)(3) and 2701(c)(3)). As a planning point, qualified payment rights should always be included. The inclusion of these rights will result in a taxable and reportable gift, which, in turn, is reported on the gift tax return. The reporting of the gift starts the three-year statute of limitation with the IRS and also ensures that the preferred interest is respected and not later treated as a deemed gift of value to the trust holding the PFLP's common interests.
Sec. 2701 provides a grace period for payments to the holders of preferred interests. Any payment of a distribution during the four-year period beginning on the payment's due date is treated as having been made on the due date (see Sec. 2701(d)(2)(C)). This allows for cash flow flexibility while hopefully further compounding the investment returns within the PFLP (and provides another advantage over a GRAT, since GRAT annual annuities must be paid timely).
The PFLP also offers significant downside protection for the client. With a PFLP, the partnership can be liquidated if the underlying assets do not appreciate as anticipated. Also, on the death of a preferred partner, the estate will receive the benefits of a step-up in tax basis in the partnership's assets if a Sec. 754 election is made.
The exhibit below summarizes and compares the estate tax benefits of PFLPs, GRATs, and IDGTs.
While the authors of this article suggested in a previous article that a client might want to combine a PFLP with an IDGT to hold the common interests, they never considered combining a PFLP with a GRAT. This creative estate tax strategy may be the perfect solution for the right client who can understand the opportunities (and the complexities). The details of this strategy were set forth in another tax article (see Angkatavanich and Yates, "The Preferred Partnership GRAT: A Way Around the ETIP Issue?" 35 ACTEC Journal 289 (2009)). With this technique, the preferred interests effectively "freeze" the estate value for the grantor to the extent of the preferred return and are ultimately contributed to a GRAT, while the common interests are owned by a GST tax-exempt trust or similar entity, thereby eliminating the ETIP issue. Additional benefits are achieved by using the GRAT if the preferred return is greater than the Sec. 7520 rate.
The combination of a PFLP and a GRAT will generally require a longer term to be used. However, given President Barack Obama's continued call to eliminate short-term GRATs by imposing a minimum term of 10 years, a required minimum of 25% value to charity, and the elimination of the power to substitute assets, this combined estate tax strategy may gain significant interest in the coming years.
Michael Koppel is with Gray, Gray & Gray LLP in Canton, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.