New Tax Court Cases’ Settlement Provides Guidance on How to Successfully Structure Asset Sales to Grantor Trusts - April 2016

April 2016

Installment sales of assets to grantor trusts (sometimes known as "defective income trusts") allow clients to transfer large amounts of wealth to their children and grandchildren free of gift, estate, and generation-skipping taxes. Under this tax planning technique, future appreciation of the trust's assets is shifted from the parents to the children and grandchildren. A grantor trust (especially when combined with valuation discounts) is an effective tax-savings technique.

In the past month the IRS settled two related Tax Court cases, Estate of Marion Woelbing and Estate of Donald Woelbing (Tax Court Docket Nos. 30260-13 and 30261-13), addressing tax issues of asset sales to grantor trusts. 1 The Woelbing cases' settlement provides guidance on how to properly structure asset sales to grantor trusts in exchange for promissory notes.

1. Description of a Grantor Trust Tax Plan.

Under a typical grantor trust tax planning structure, the parents sell assets (such as a limited partnership, limited liability company interests, real estate, corporate stock or business interest) to a grantor trust in exchange for a promissory note payable in installments to the parents. The promissory note's interest and principal payment schedule is tailored to the trust's underlying cash flow. Prior to the sale of the assets to the trust, the parents first gift and contribute assets to the grantor trust (the so-called "seeding" of the trust). This seeding of the trust is done in part so that the parents are the trust's "grantors" for federal income tax purposes under the Treasury Regulations. Also, having the parents contribute "seed" assets to the trust enhances the chances that the promissory note will be classified as debt (and not as equity, which would result in raising Section 2036 estate tax issues).

The grantor trust's taxable income and deductions are then taxed to the parents as the trust's grantors (and the trust's income is not taxed to the trust, children or grandchildren). The sale of the parents' assets to the grantor trust is free of taxable gain since the buyer of the assets (the trust) and the seller of the assets (the parents) are deemed to be the same person for income tax purposes. Furthermore, since the grantor trust is irrevocable, upon the parents' deaths the trust's assets pass free of gift, estate, and generation-skipping taxes to the children and grandchildren.

The parents are taxed on the grantor trust's income because the trust contains special tax provisions which cause the trust's deductions and income to be taxed to the parents and not to the trust, the children, or the grandchildren beneficiaries (resulting in the trust being classified as a grantor trust for income tax purposes).2

Income tax-free sales to grantor trusts were approved by the IRS in Rev. Rul. 85-13, since for income tax purposes the grantors (the parents) are still deemed to own the sold assets. The IRS also previously issued a published Revenue Ruling whereby the parents (and not the children or the trust) pay income taxes gift tax-free on all of the grantor trust's income, which further increases the trust's worth (and thereby shifts additional value tax-free to the children and grandchildren). See Rev. Rul. 2004-64.

Through the additional use of valuation discounts, the parents are able to sell and transfer a greater amount of assets tax-free to the grantor trust, both in the gifting of the seed assets and by the sale of assets to the trust. Valuation discounts (such as for minority interests, lack of control and lack of marketability) have increased the tax benefits of grantor trusts by reducing the value of the assets sold and gifted to the grantor trust, thereby effectively shifting more value tax-free to the children and grandchildren.3

2. Using Defined Value Formula Clauses to Reduce Gift Tax Exposure When Transferring Property to the Grantor Trust.

To reduce gift tax exposure, the sale and gift of assets to the grantor trust can be structured by using a "formula gift clause". Under a formula gift clause the parents' sale and gift of assets to the trust is automatically adjusted based upon the final determination of the gift tax value of those assets which are gifted and sold to the trust. The IRS in the past has attempted to disallow such defined value formula clauses, but such formula gift clauses have been upheld by the courts, such as in the Wandry case.4

In Wandry the parents made a specific formula gift of their limited liability company membership interests to their children and grandchildren. The gifting document expressed the membership interest gift in terms of a formula so that no taxable gift would occur. The Wandry gifting documents provided that if the final gift tax determination of a different value was made by the IRS or the courts, then the number of gifted limited liability company membership units would be adjusted. The Tax Court in Wandry found that the donees (the children) were entitled to receive a predefined number of limited liability company units based upon a mathematical formula. Even though the value of the limited liability company units was unknown at the time of the gift, the Tax Court found that the formula gift clause of the limited liability company units' value was valid because the formula just operated to adjust the number of units between the donors and the donees.

In the recently settled Woelbing cases the IRS had challenged a Wandry type of formula gift clause. However, in the Woelbing Tax Court settlement the IRS ultimately accepted the use of a Wandry type of formula gift clause. Thus, the Woelbing settlement supports the use of a Wandry type of formula gift clause in the sale and gift of assets to a grantor trust in order to limit a client's gift tax exposure.

3. Avoiding Section 2036 Issues.

In order for the grantor trust tax planning technique to produce the desired favorable estate tax result, the installment promissory note (which the parents receive in exchange for their sale of assets to the trust) must be recognized for tax purposes as part of a sale and not as a retained life estate by the parents (which retained life estate would then cause inclusion of the trust's assets in the parents' taxable estate at the parents' deaths under Section 2036). To avoid inclusion under Section 2036, the promissory note's repayment obligation should not be solely based upon the income of the property sold to the trust (rather additional trust income should be obtained from the seed assets gifted to the trust, which income is then used to service the interest and principal payments due under the promissory note). Accordingly, to avoid Section 2036 inclusion, the grantor trust should own other assets in addition to those assets which were sold to the trust in exchange for the promissory note. The greater the value of these other non-sale assets, the better the chances of avoiding the application of Section 2036. It has generally been accepted that first contributing assets to the trust (the "seeding assets") which equal or exceed 10% of the total trust assets will be a sufficient contribution amount to avoid Section 2036. The IRS in the Woelbing cases asserted that under Sections 2036 and 2038 the sold assets should be included in the deceased parent's estate because there were not enough "seeding assets" gifted to the grantor trust. The taxpayers in the Woelbing cases attempted to use personal guarantees to provide necessary value in the grantor trust. The Woelbing case settlement appears to confirm the IRS's acceptance of this 10% figure for the seeding amount.

The formation of a new legal entity in connection with the grantor trust asset sale should have a valid nontax business purpose in order to assist in avoiding an IRS Section 2036 assertion. In the March 2016 Tax Court case of Estate of Sarah D. Holliday, T.C. Memo 2016-51, the court applied Section 2036 where the taxpayer failed to prove a significant legitimate business reason for the formation of a family limited partnership. In Holliday the Tax Court found an implied agreement of the decedent retaining enjoyment of the assets transferred to the partnership.

4. Other Planning Items to Avoid IRS Section 2036 Arguments.

Proper planning would have the distributions from the underlying trust assets to the grantor trust not be made in the exact same amount as the promissory note payments. Additionally, the gift and contribution of the seeding assets to the grantor trust should be done before (such as more than 30 days before) the sale of assets is made to the grantor trust in exchange for the promissory note, thereby allowing the parents to claim that they have sold assets to the trust for full and adequate consideration (which is an additional exception to applying the Section 2036 statute). Also, separating the promissory note sale as long as possible from the gift of the seeding assets to the trust reduces the ability of the IRS to argue that the gift and sale should be aggregated to reduce valuation discounts.

5. Section 2702 Issues.

The IRS in the Woelbing cases asserted that the promissory note had a zero dollar value, and that the entire amount of the sold assets should be treated as a taxable gift to the children under the provisions of Section 2702. Thus, the IRS asserted that the promissory note which the parents received back had no value under Section 2702(a)(2). However, in the Woelbing cases' settlement the IRS conceded this Section 2702 issue.

6. Plan to Repay the Promissory Note Before the Parents' Deaths.

If the promissory note is repaid in full by the grantor trust to the parents before the parents' deaths (so that there is no outstanding balance due on the promissory note when the parents die), then there are several tax advantages.5 First, Section 2036 should not apply based upon the fact that there is no further alleged "retained interest" by the parents (since there are no further payments being made to the parents under the promissory note). Second, the promissory note does not appear as a reported asset on the parents' Federal Estate Tax Return Form 706, which in turn reduces the likelihood of an IRS challenge (although question 13e of Part 4 of the Federal Estate Tax Return Form 706 asks if the decedent at any time during the decedent's lifetime ever sold or transferred an interest in a partnership, limited liability company or closely-held corporation to a trust which the decedent created during that decedent's lifetime).

7. Have the Seed Assets Gifted to (and Other Assets Owned by) the Grantor Trust Be as Large as Possible.

The IRS in the Woelbing cases settlement did accept a 10% seeding amount. Clients in the past have sometimes used personal guarantees in lieu of this 10% cushion. Having a greater value of gifted "seeding" assets to the grantor trust can reduce the risk of a Section 2036 inclusion.

8. Have the Grantor Trust Sale Structured So That There is Enough Cash Flow to Make Regular Payments on the Promissory Note.

Have the sale transaction structured so that the promissory note's interest and principal payments are covered by the cash flow from the underlying grantor trust's owned partnership, real estate, or stock assets. Balloon payments under the promissory note in later years can produce IRS arguments that the parents retained a prohibited Section 2036 interest, based upon IRS assertions that a balloon payment promissory note appears more like retained equity and less like true debt.


The grantor trust is an effective estate planning tool to avoid gift, estate, and generation-skipping taxes, and for clients to transfer large amounts of the family's wealth tax-free to their children and grandchildren. However, careful attention to the tax details is required to achieve a successful result.

© 2016, Law Offices of Robert A. Briskin, a Prof. Corp. All rights reserved.

Nothing in this Article shall be deemed legal or tax advice as to any person or transaction.

1 Estate of Donald Woelbing was settled for gift and estate taxes by a stipulated decision entered in the Tax Court March 25, 2016; and Estate of Marion Woelbing was settled for gift taxes only by a stipulated decision entered in the Tax Court March 28, 2016.

2 There are a number of trust provisions whereby a "grantor trust" can be classified for income tax purposes as being taxed entirely to the parents, but which provisions do not cause inclusion of the grantor trust corpus in the parents' estates for federal estate tax purposes. One common provision, which the IRS has approved for estate tax purposes in Rev. Rul. 2008-22, is to allow an individual other than the parents/grantors a power to reacquire the trust corpus by substituting other property into the trust of equivalent value under Section 675(4)(c).

3 The IRS has recently stated through spokespersons that they intend to issue new Treasury Regulations under Section 2704(b) disallowing certain types of valuation discounts.

4 Wandry, T. C. Memo 2012-88, non acq. 2012-46. The IRS in the future may still choose in another case to challenge Wandry types of formula clauses. Additionally, the IRS in its 2016 business plan has listed potential Treasury Regulations for formula gift clauses as a topic.

5 An area of tax controversy is whether at the parents' deaths the grantor trust's assets receive a step-up in their income tax basis under Section 1014. Some tax practitioners take the position that the income tax basis of the grantor trust's assets should receive a step-up in their income tax basis even though those assets are not included in the parents' gross estate for federal estate tax purposes. The IRS has stated that it will not issue revenue rulings as to whether the assets in a grantor trust receive a Section 1014 basis adjustment at death of the deemed owner of the trust for income tax purposes when those assets are not included in the gross estate of that owner under the federal estate tax provisions. [See Rev. Proc. 2015-37.] There had been earlier conflicting pronouncements by the IRS on this issue (see PLR 201245006 which stated that an income tax basis adjustment would be available for grantor trust assets at the grantor's death, while in CCA 200937028 an apparently different conclusion was arrived at).

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