By: Irwin Scherago ischerago@mlg.com

In New York City, nobody pays the retail, or "sticker" price for anything. In the Big Apple and its immediate environs, if you pay the advertised price, you are viewed as playing with less than a full deck. This penchant, nay, religious tenet, to pay anything less than the full price for an article or service, probably had its genesis on Seventh Avenue. Its adherents (worshippers) had their compulsion to pay at least one (1 cent) penny less memorialized in the book and movie, "I Can Get It For You Wholesale." (circa 1950).

If you can hondle (negotiate) the price of cars, coats, calico cats, and callpersons, why pay the full price, or stated rate, for estate or gift taxes? In fact, no less a judicial figure than the late Judge Learned Hand (2nd Circuit Court of Appeals, sitting in New York City) stated:

"...[N]obody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions." (Commissioner vs. Newman, 47-1 USTC 9175m 1947)

Hand went on to say that each person may order his affairs in such a manner as to pay the least possible taxes.

Now, Mr. Justice Hand was revered for his legal thinking and he was often mentioned in the company of two legal giants -- Benjamin Cardozo and Oliver Wendell Holmes. Notwithstanding the august legal company he kept, when it came to taxes and paying the sticker price, Judge Hand, engulfed with the discount atmosphere of New York, philosophized that you do not have to fork over one more penny in taxes than what is legally required.

Accepted Ways of Legacy Discounting
the Estate and Gift Tax Bill

There are many fashionable and accepted ways of legitimately discounting the potential tax bill on a family's estate. The safety deposit box, or the little tin box buried in the backyard, each lined with green paper, is not one of the approved ways.

LIFE INSURANCE: As the industry is well aware, this is probably the most effective estate tax discounting tool available. The discount -- 80% to 90% of the future estate tax dollar. All too often the prospective insurance purchaser is plied with sophisticated estate plans embodied with esoteric and arcane charts and compound tables. The life insurance buyer really needs to know that he/she: is creating an estate where there is none presently; replacing substantial dollars lost to debts, death, cleanup expenses, and estate taxation; and all this is being done at a large discount. The cost -- 11 cents on the dollar. Do not talk up the alternative investment aspects of life insurance. Tell it like it is: Life insurance is future dollars purchased at a discount. "For you, special. Today, while you you're in certifiable good health, I can get your family a bunch of (future) dollar bills for $0.11 each. In fact, if you die quickly, I might get you a dollar for a nickel ($0.05)."

Seriously, there is no business buyout problem, divorce or second marriage situation, or estate tax burden that is not soluble in, and solvable with, life insurance dollars bought at a discount.

Qualified Personal Residence Trusts (QPRTS)

The QPRT is a most effective way of removing a substantial asset -- the personal residence -- from an individual's estate at, of course, a discount from full value.

Cash Investment Rich, Property Poor:

In a recent situation, a 60 year old widow came to the office with a substantial portfolio of cash derived in part from a wrongful death action and in part from life insurance, both received by reason of her husband's death. The total liquid assets were $3,000,000 and the widow lived in an apartment in New York City. Stocks and bonds and investment realty were not to her liking. We suggested she purchase a cooperative apartment or condominium for $1,000,000 and then immediately put it into a Qualified Personal Residence Trust.

The widow would reserve the right to live in the residence for fifteen (15) years. Her life expectancy is probably twenty-four (24) years.

At the end of the fifteen year trust term, if the widow wished to remain in "her home", she could have the option to lease the residence at the end of the term. The option to lease (or purchase) must be at the fair market rental value and the lease/purchase option will not affect the value of the remainder interest nor the QPRT transaction (IRS LTR 9425028).

Is It Worth It?

NOTE: If the personal residence has a basis below the selling price, there will be a capital gain.

Assume the Donor's basis was $600,000 and the Donees sold for $1,000,000. The capital gain would be $400,000 and the capital gains tax $135,000. The net transactional benefit would be $313,000 (Estate Tax minus Gains Tax).

Things to Remember in Structuring a QPRT

(i) Only permitted for two residences per Grantor--a principal residence and one vacation home. There must be a separate trust for each home.

(ii) There is a limited amount of cash in each QPRT; the amount necessary to meet three months of normal operating expenses, such as mortgages, improvements, cash sufficient to purchase a new residence within 3 months of contribution.

(iii) If the residence is sold, condemned, or destroyed, proceeds must be reinvested within two (2) years.

(iv) Any excess cash in the QPRT must be distributed to Grantor each calendar quarter.

(v) If the proceeds of a disposition of a residence are not reinvested within 2 years, then the QPRT will be converted to a Grantor Retained Annuity Trust (GRAT) (discussed below).

(vi) If the Grantor does not survive the QPRT Trust term, the trust property, valued at date of death, is included in Grantor's estate.

Grantor Retained Annuity Trust (GRAT)

Historically, pre 1990, the Grantor Retained Income Trust (GRIT) was one of the preferred methods of obtaining a discount on a gift into a Trust with a retention of income for a period of years. The traditional GRITS became "fried" in 1990. In the place of a "traditional GRIT" is the Grantor Retained Annuity Trust (GRAT).

(a) If an individual makes a transfer into a trust and retains all of the income and gives a remainder to his children, the value of the retained interest is zero (0) and the value of the gift is the full value of the transferred property with no discount. [IRC 2702(a)(2)(A)]

The exception to the $0 (zero) value rule is where the transferror retains a "qualified interest."

(b) A "qualified interest" must be in the form of a GRAT or a GRUT.

(i) A Grantor Retained Annuity Trust is a Trust in which the Grantor has the right to receive fixed amounts of money payable, at least, annually.

(ii) A Grantor Retained Unitrust is a trust in which the Grantor has the right to an annual amount of money determined as a percentage of the fair market value of the trust assets at the beginning of each year.

(c) The failure to reserve a GRAT (GRUT) interest results in immediate and full valuation of the gift at its present value (L/R 9109033, Nov. 30, 1990, CCH Estate and Gift 90 12,257, March 25, 1991). In the ruling, the retained interest was valued at zero because the interest reserved was an "income interest" only and not a "Qualified Interest" described in 2702(b).

(d) Valuation of the Gift Portion of a GRAT and GRUT

The valuation of a Qualified Interest is made under Section 7520 and the value of the "Qualified Interest" property is subtracted from the total value of the property transferred to arrive at the value of the gift.

Example: Mischa Pitts, age 70, transfers $1,000,000 into a trust, reserving to herself an annuity of $106,000 a year for 10 years, or until her prior death.

The value of the remainder (gift) at 6.6% is $358,202[Table H(6.6), publication 1457]

(e) Death Before End of Term

If Mrs. Pitts lives the full term (10 years), there will be nothing included in her gross estate. However, the adjusted taxable gift will be added back to her gross estate. If she does not live the full term, all of the trust will be in her estate.

(f) The GRAT can hold any income-producing property:

An investment portfolio, real estate, even "S" Corp stock (LTR 9415012 and LTR 9416009)

(g) The Grantor can be the Trustee (LTR 9352007).

(h) The GRAT must be irrevocable and unamendable (except the Trustee may have right to amend to ensure that the annuity interest is a Qualified interest).

(i) The annuity must be a fixed percent of original principal contributed to GRAT.

(j) The Income Exceeding Annuity is added to principal. However, the Trust is a Grantor Trust under IRC Sect 671-676, and all the income, deductions, and credits belong to the Grantor and the Grantor would be taxed on the income in excess of the income used to pay the annuity. The Grantor may provide that the Trustee may pay to the Grantor the amount of tax resulting from Grantor picking up income in excess of required annuity amount (That is a questionable provision, if the Grantor doesn't need the income.)

(l) The Grantor can substitute property of Equal Value
for Trust Principal without realizing a Gain or Loss on the Transaction.

(m) If the Trust income is insufficient, the Trustee can satisfy an Annuity payment with Trust Principal and without realizing a gain or loss on the transaction.

(n) There is no gain or loss in (l) and (m), above, because of Revenue Ruling 85-13. If a Grantor is treated as the owner of an entire Trust, then the Grantor is the owner of the Trust assets for Federal Income Tax purposes. Thus, a transfer of trust assets to a Grantor who owns the entire trust is not recognized as a sale for gain or loss.

(o) Opportunity for Estate Planning

Towards the end of a term, the Grantor can purchase for cash, the low basis GRAT asset. When the Grantor later dies, the asset purchased from the GRAT gets a "step-up" basis in the Grantor's estate.

Minority Interest Discount Applied to a GRAT
IRS Fought the Minority Interest Discount

(A) Revenue Ruling 81-253 (1981-1CB187) held that when a gift of closely held stock is made by a taxpayer to a family member and the aggregate of all the shares owned by the family after the gift is a control percentage --more than 50%-- then the shares given will not be allowed a "minority interest" discount.

(B) In the Estate of Charles W. Hepworth (18TCM, CCH 16, 838M 1949) allowed a minority interest discount when taxpayer owning 50+% of corporation (2,310 shs) gave 300 shares to his wife and children (individually and in the aggregate, the gift was of a minority interest).

(C) In the Estate of Bright vs U.S. (CCH USTC 81-2

USTC 13,436, 5th circuit 1981) The Decedent owned 55% of the shares of a corporation. The decedent conveyed 27 1/2% to her husband. The gift was allowed a minority interest discount.

The Service Sanctions Minority Interest Discounts

(D) (Revenue Ruling 93-12)

In Rev Rul 93-12, the taxpayer gave each of his five children a 20% interest in a closely held corporation. The ruling held that, notwithstanding the family relationship of the donor and the donees, the shares of the other family members will not be aggregated with the transferred shares to determine whether the transferred shares are part of a controlling interest. Thus each separate interest received could qualify for a Minority Interest discount.

(E) Example: Assume a situation where a family member wants income from an "S" Corp. for ten years.

The Parent sets up 3 Grantor Retained Annuity Trusts--one for each of their children--with 33 1/2 of the shares of the "S" Corporation in each Trust. The trust is a GRAT--10 year 6.6 return. The fair market value of the corporation is $3,000,000.

The value of the gift, arrived at below, is	$752,223
Market value of 1/3 of XYZ Corp.	1,000,000
Less: Minority Discount (30%)	( 300,000)
Value of Stock for Gift Tax purposes	700,000
Retained Interest (64.1798%)	( 459,259)
Given Interest	$ 250,741
Multiply by	3
Total for Gift Tax Purposes	$ 752,223

Gift Tax (no splitting)		(Splitting)
Federal	$56,757	Federal	$ 0
NYS	$35,657	NYS	$ 26,611

(F) "S" Corp stock may be held by a GRAT (see L/R 9415012, CCH Vol 894 1/13/94 and L/R 9416009 CCH Vol 895 4/27/94).

Family United Partnerships

The Family Limited Partnership is the new boy on the tax and estate planning street. Its efficacy boils down to three points:

1) that transfers of fractional shares of an operating business and/or a real estate investment can be made to the relatives (the "kiddies") at a discount from fair market value for gift tax purposes; and

2) that the limited partnership interests cannot be reached by creditors; and, finally,

3) that the elder generation parent - the control person- (you know, "that tape in the back of your brain") can continue to control the assets until death and not have it included in his/her gross estate. (LTR 9415007, CCH Vol 894).

Income Tax-Free Transfer - The transfer to a partnership of appreciated (depreciated) property is income tax-free (Sec 721 of the Internal Revenue Code).

Creditor Proof: A Parent can give a child a limited partnership interest and the child's creditors cannot access the partnership. All a limited partner's creditor has is a right to a "charging lien"-- the right to the income paid to the child's (limited partner's) interest, if anything is paid at all.

The General Partner need not, within reason, distribute partnership profits but the creditor, who is the Assignee of the debtor partner's interest, may have to pick up the income on a "K-1". This latter hooker should lead many creditors to settle their judgments at -- guess what? -- a discount.

As I stated above, the control of the family limited partnership by a general partner will not cause an asset transferred to the limited partnership to be included in the General Partner's gross estate (LTR 9415007, cited above). The retained interest of the General Partner is not an applicable retained interest under Section 2702 where the general partner's right to distribution is of equal kind, stature, and nature as those of the limited partners.

Investment Partnerships

The use of the Family Limited Partnership would be much preferable to a "family trust" when the creator of the entity wishes to retain control of the timing of distributions. If there is too much control over the timing of distributions in a Trust, then the investment property conveyed to the Trust would be put in the Grantor's estate by reason of Section 2038 of the Internal Revenue Code.

Self Canceling Installment Notes (SCINS)

This transaction is an installment sale of an asset from the elder generation parent to the younger generation child. However, it is a sale with "oomph."

In the traditional installment sale, if the Seller dies while still owning installment notes receivable, the value of the notes are included in his or her gross estate.

At Death, Remaining SCIN Value NOT in Seller Estate

The SCIN arrangement provides that if the Seller dies, the balance of the installment sale notes are canceled (Estate of Moss 74 T.C. 1239 1980).

Example: A sells Blackacre to B for $500,000. A takes back from B, installment notes for the full price. The notes are due in twenty (20) equal annual installment of $25,000. If A dies after ten (10) years, there are 10 installments, of $250,000, due A on the date of death. However, per the installment note agreement, the $250,000 of unpaid installment notes are canceled and are not included in the estate.

Gift Tax: There will generally be no gift tax on the sale of the business/investment because the sale is at fair market value.

Interest on Notes: The interest is at a premium over the applicable Federal rate. The reason for the increased interest is to compensate the Seller for the risk attendant to the possibility that the Seller will not receive all the installments.

Capital Gains Tax: Upon the death of the Seller, the capital gains tax on the unpaid principal (outstanding amount) is due and payable from Seller on Decedent's final return (Estate of Frane, 98T.C. No. 26)

Possible Gift Tax: There could be a gift tax if the maximum term of the Note exceeds the Seller's life expectancy and if there is an insufficient premium on the interest rate because it is more likely from the inception that a part of the installment note will not be paid.

The careful tailoring of a SCIN transaction is vital and before one embarks upon this transaction, please read "SCINS ARE STILL USEFUL TOOLS DESPITE RECENT DECISION" by Howard M. Esterces, in the January/February, 1994 issue of ESTATE PLANNING.

Conclusion

Space does not permit an in-depth analysis of the Private Annuity. This will be the subject of a separate article in the October or November issue of THE BULLETIN.

Oliver Wendell Holmes is alleged to have said to a law clerk:

"I like to pay taxes. With them I buy civilization." (Paul, Taxation for Prosperity, 1947, Page 279).

I wonder what Holmes' view of the conversion ratio of taxation to civilization would be today?

In any event, most taxpayers are Handsians and not Holmesians. One owes a duty to himself, herself, the kiddies and the kinfolk to arrange one's affairs in such a manner as to pay the least amount of estate taxes (income taxes during life). Obtaining the maximum discounts for transfers made during life (without stripping yourself of assets or tying yourself up like a pretzel) for gift and estate tax purposes should lead one to examine, in depth,: purchasing life insurance; creating residence trusts; creating grantor annuity trusts; and using the Self-canceling Installment rule and the private annuity (next month's issue) as tools for getting your estate taxes wholesale.