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NOW THAT YOU HAVE ME HERE,
WHAT ARE WE GOING TO DO
MERITORIOUS AND OCCASIONALLY MERETRICIOUS
PLANNING FOR AN EXISTING FLP
Milford B. Hatcher, Jr., Esq.
Jones, Day, Reavis & Pogue
Atlanta, Georgia
Forming a family limited partnership (a "partnership" or "FLP") only sets the
stage for estate planning generally. More often than not, a senior family member will
contribute a majority of the assets and, to avoid a gift on formation argument by the IRS,
will receive controlling general partner and limited partner interests in exchange for his
or her contributions. Once the partnership is established, what needs to be done next
Both operational and potential transfer issues warrant consideration.
I. OPERATIONAL ISSUES
A. Separate Entity. A FLP is an entity separate and distinct from its partners. In
this regard, the FLP may actually be a limited partnership under state law, or it may be a
limited liability company in a state with favorable LLC laws. For the sake of simplicity,
both limited partnerships and LLCs will be referred to as "FLPs" or "partnerships."
Whichever form the FLP may take, its operation must be in accordance with its
governing instruments, either its limited partnership agreement in the case of a limited
partnership or its articles of organization and operating agreement in the case of an LLC.
B. Personal Pocketbook. Of all of the areas of FLP challenges by the IRS, the
IRS has had its greatest success by attacking the partnership as the "personal pocketbook"
of the senior family member/partner. In at least two instances, the Tax Court has found
that the use of FLP funds to pay a partner's personal expenses, a partner's use of FLP
assets without paying a fair rent, commingling of personal and partnership funds, and
similar operational abuses represent implied agreements that the contributing partner will
retain the right to the income or the possession or enjoyment of the property transferred
to the FLP, thus causing inclusion in the contributing partner's gross estate under IRC
§ 2036(a)(1).
In Estate of Reichardt v. Commissioner, 114 T.C. No. 144 (2000), the following
indiscretions by a senior family member/partner were held to be sufficient evidence of an
implied agreement to retain income from, or the possession and enjoyment of, transferred
property, thus resulting in estate tax inclusion under IRC § 2036(a)(1):
• Deposits of rent from FLP-owned real property in the senior family
member/partner's personal checking account;
• Rent-free use of a personal residence transferred to the FLP;
• Use of FLP funds to pay the senior family member/partner's personal
expenses (notwithstanding an after-the-fact, post-mortem attempt by
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the FLP's accountant to make corrective adjustments to that senior
family member/partner's partnership capital account); and
• The senior family member/partner's conveyance of almost all
previously personally owned assets to the FLP.
Similarly, in Estate of Schauerhamer v. Commissioner, T.C. Memo. 1997-
242 (1997), a senior family member/partner's following actions in disregard of the terms
of the governing instrument proved to be fatal:
• Deposit of income from FLP assets in the senior family
member/partner's personal checking account; and
• The absence of separate records for the FLP and non-FLP funds.
In addition, the children of the deceased senior family member/partner admitted that all
parties intended that the assets contributed to the FLP by the decedent would be managed
by the decedent exactly as they had been managed in the past.
C. Missed Payments. Another potential operational abuse involves missed
payments following a transfer by a partner to a grantor retained annuity trust (a "GRAT"),
to a grantor trust (an "IDGT") in exchange for an installment note, or to a family member
or possibly a trust in exchange for a private annuity or self-canceling installment note (a
"SCIN"). One recent case involving a SCIN has held that a taxable gift, measured by the
difference between the fair market value of the transferred property as of the date of the
transfer and the total payments made under the SCIN, occurred as of the date of the
transfer, for the missed payments indicated that the debt in question was not bona fide
and the sale in exchange for a SCIN was not for adequate and full consideration in money
or money's worth. Estate of Constanza v. Commissioner, T.C. Memo. 2001-128.
Although the Tax Court rebuffed the IRS's arguments that the transfer was revocable and
thus includible in the deceased transferor's estate under IRC § 2038, too many missed
payments serve as an open invitation for the IRS to revisit possible estate tax inclusion
arguments.
D. Retained Control. For years, the IRS has conceded that a general partner's
management control over a FLP, including the power to determine the timing and amount
of distributions from the partnership to the partners (at least where such distributions are
in proportion to the respective partner interests), does not represent either the retained
enjoyment of property transferred to the FLP within the meaning of IRC § 2036(a)(1) or
"the right, either alone or in conjunction with any person, to designate the persons who
shall possess or enjoy the property or the income therefrom" within the meaning of IRC
§ 2036(a)(2). Similarly, such powers have been held not to be a retained power to alter,
amend, revoke, or terminate within the meaning of IRC § 2038(a)(1). These historic IRS
positions are premised on the fiduciary obligations owed by the general partner, under the
governing instruments, applicable state law or both, to the partnership and the other
partners. See PLR 9026021, TAM 9131006, PLR 9310039, and PLR 9415007. See also
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GCM 38984 (May 6, 1983), which involved a Massachusetts business trust and revoked
GCM 38375 (May 12, 1980).
The basis for all of these pro-taxpayer rulings is a United States Supreme Court
decision, United States v. Byrum, 408 U.S. 125 (1972). In Byrum, a controlling
shareholder and member of the board of directors of a corporation gave stock to an
irrevocable trust and retained the right to vote the transferred stock, to veto any sale or
disposition of the stock, and to remove and replace the trustee. Effectively, the
controlling shareholder/donor controlled all decisions relating to dividends and other
corporate distributions. Because the controlling shareholder/donor owed a fiduciary
obligation to the corporation and the other shareholders, however, the Supreme Court
held that the trust assets were not includible in the gross estate of the controlling
shareholder/donor upon his ultimate death.
Emboldened by its success in the two "personal pocketbook" cases, Estate of
Reichardt, supra, and Estate of Schauerhamer, supra, the IRS now seems to be
reconsidering its prior concessions. See FSA 200049003, which emphasizes the
decedent's retained control and management in both Estate of Reichardt, supra, and
Estate of Schauerhamer, supra. Of even greater concern, the Tax Court may be buying
into this argument. In Estate of Strangi v. Commissioner, 115 T.C. 478 (2000), the Tax
Court, in dictum, volunteered that the actual control exercised by or on behalf of the
decedent "suggest[s] the possibility of including the property transferred to the
partnership in decedent's estate under section 2036." Particularly disturbing is the fact
that the decedent in Estate of Strangi did not even retain control but instead held only a
minority interest in the corporate general partner, was one of five directors of that
corporate general partner, and was incapacitated and apparently played no significant role
in the management of the partnership after it was formed. Perhaps this dictum was based
upon one instance in which the partnership arguably made a payment for the benefit of
the decedent during the decedent's lifetime. Otherwise, this dictum, and the IRS's new
focus on management control, seems to be at odds with the U.S. Supreme Court's holding
in Byrum, supra.
One warning should be highlighted. Partners often want to water down fiduciary
responsibilities in the governing instruments for the FLP. Such watered down fiduciary
responsibilities may address legitimate liability concerns which one or more of the
partners may have, but the cost may be a much greater risk of additional estate tax
inclusion under IRC §§ 2036(a)(2), 2038(a)(1), or both.
E. Retained Voting Rights. Byrum, supra, has been statutorily restricted in one
limited, albeit important, respect. Under IRC § 2036(b), the retained right to vote
(directly or indirectly) transferred shares of stock of a 20% or more controlled
corporation will result in the inclusion of the value of those shares in the gross estate of
the transferor retaining those voting rights. For these purposes, 20% or more control is
based on both actual and constructive stock ownership. See IRC §§ 2036(b) and 318.
Stock owned by related entities or family members may be considered to be owned by an
individual.
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What happens (1) if stock in a 20% or more controlled corporation is contributed
to a FLP in which the contributing general partner or general partners possess the right to
vote the stock and (2) if nonvoting limited partner interests are subsequently transferred
by a general partner to a family member or a trust for the benefit of one or more family
members The IRS has held that IRC § 2036(b) applies. See TAM 199938005.
Although the validity of this ruling is subject to challenge, discretion may be the
better part of valor. The safest course of action is to provide for pass-through voting at
least so long as any general partner who has contributed stock to the FLP remains alive.
Under this pass-through voting approach, each of the partners, whether general or
limited, will be permitted to direct the vote of a portion of the FLP's stock corresponding
to that partner's interest in FLP capital or income. Alternatively, the FLP should be able
to vote as a block all stock owned by it in accordance with the vote of a majority in
interest of all partners, including limited partners as well as general partners. See
PLR 9206026.
By its terms, IRC § 2036(b) should not apply to stock acquired from someone
other than the decedent or to stock acquired by the decedent for adequate and full
consideration in money or money's worth. Thus, stock in a 20% or more controlled
corporation should generally not be covered by IRC § 2036(b) to the extent that the stock
in question is initially issued to the FLP.
F. Economic Substance. Drawing from its income tax successes in corporate tax
shelter cases, the IRS has attempted to extend an economic substance argument to death
and gift contexts for estate and gift tax purposes. In Field Service Advice 200049003, the
IRS held that a FLP will be considered to have economic substance, and thus will be
recognized for transfer tax purposes, only (1) if the formation and maintenance of the
FLP appreciably changes the taxpayer's economic position and (2) if the taxpayer has a
valid business purpose or a profit motive. The requisite business purpose will not exist,
according to the IRS, if transfer tax savings are the primary purpose of the FLP, even
though there may also be other purposes.
In two recent reviewed decisions, Estate of Strangi v. Commissioner, supra, and
Knight v. Commissioner, 115 T.C. 506 (2000), the Tax Court has agreed that a FLP must
have economic substance, but has applied a materially different economic substance
standard than the one sought by the IRS. The decedent's continuing control and the
absence of any valid business purpose were held not to be relevant, at least in
determining whether a FLP has economic substance. See Estate of Strangi v.
Commissioner, supra. Instead, according to the Tax Court, the only relevant question in
evaluating a FLP's economic substance is whether it is validly formed under state law. If
a FLP is validly formed under state law, a would-be purchaser of a partner interest will
not disregard the FLP's existence. Therefore, the FLP should not be disregarded on
economic substance grounds for estate and gift tax purposes.
G. Gift Tax Annual Exclusion. Increased estate tax risks are not the only
problems which may be encountered if fiduciary responsibilities are watered down, or
even eliminated, by the express terms of the FLP governing instruments. If FLP
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distributions are made totally discretionary under the terms of the FLP governing
instruments, gifts of limited partner interests which have no say as to whether
distributions will be made will not qualify for the annual gift tax exclusion according to
the IRS, for the gifts purportedly will represent future interests, not the present interests
required under IRC § 2503(b) for the annual gift tax exclusion. TAM 9751003.
H. Morals. Several morals can be drawn from these precedents.
First, practitioners must carefully explain to clients that there will be material
operational differences after the FLP is established and that abiding by the formalities of
the new and separate entity, and the terms of any subsequent transfer instruments, is
absolutely imperative.
Next, transfers of personal use assets to, or the continued holding of any
transferred personal use assets by, a FLP invites special scrutiny and should, at a
minimum, be accompanied by written leases and fair market rental payments and
probably should be avoided whenever reasonably possible.
Similarly, a transfer of almost all of an individual's assets to a FLP may invite
closer scrutiny by the IRS.
Fourth, if voting control is relinquished as a result of transfers of partner interests
possessing management control, the actual exercise of control by the transferees of the
controlling partner interests is advisable. Alternatively, if an individual retains a
controlling interest, extra care should be taken not only to insure that all actions comply
fully with the FLP governing instruments but also to document such compliance.
Finally, limits on fiduciary duties should be included in the FLP's governing
instruments very sparingly and only after careful consideration of the possible transfer tax
implications.
II.
POSSIBLE TRANSFERS
A. General Transfer Considerations. A principal consideration in setting up
many FLPs, among others, is the possibility of making post-formation gifts or other
transfers to family members or trusts for their benefit, especially from senior family
members to or for children and more remote descendants. The senior family members
want to use discounted values for the transferred partner interests to minimize current and
ultimate transfer tax liabilities.
1. Timing of Transfers. Gifts occurring simultaneously with the
formation of the partnership are ill-advised. In a reviewed Tax Court decision, Shepherd
v. Commissioner, 115 T.C. 376 (2000), a father agreed to make all contributions to a
newly formed general partnership but specified in the partnership agreement that 50% of
the general partner interests to which he was entitled by reason of his contributions be
issued instead in the names of his sons, with each son receiving a 25% interest. In fact,
some of the contributions, consisting of leased timber lands, were actually transferred in
the name of the general partnership on the day before the sons signed the general
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partnership agreement, thus completing the gifts and formally creating the partnership
(since there were not previously two or more partners, as required under applicable state
law). The remainder of the contributions, minority shares of banks in which the father
continued to hold majority stakes, were transferred one month later. The Tax Court held
that the amount of the taxable gifts equaled the value of the property contributed for the
gifted interests. Effectively, the gift tax consequences were the same as though the
property contributed for each son's interest was gifted to that son, who then contributed
the gifted property to the partnership. An undivided fractional interest discount for the
contributed real estate and a minority discount for the contributed bank stocks were
allowed, but no lack of marketability or lack of control discount was allowed for the
gifted partner interests themselves.
At least in the case of the contributed real estate, the Tax Court had the
opportunity to explain its ruling in terms of the effective transfer of the contributed
property prior to the formation of the limited partnership. See LeFrak v. Commissioner,
T.C. Memo. 1993-526. In a reviewed decision, however, a majority of the Tax Court
judges opted to broaden the scope of the decision by couching it in terms of the valuation
of transferred general partner interests. Citing Reg. §§ 25.2511-2(a) and 25.2511-1(a),
the majority then found that, although the gifted property consisted of the general partner
interests, the gifts represented indirect gifts of a pro rata share of the underlying
partnership assets. Therefore, the value of the taxable gifts was the value of the property
contributed for the general partner interests held by the sons, with discounts being
allowed only for the undivided fractional interest discounts for the contributed real estate
and minority interest discounts for the contributed bank stocks. No discounts were
allowed for the "disappearing value" attributable to lack of marketability and lack of
control discounts for the gifted general partner interests themselves (but interestingly the
IRS did not argue that the "disappearing value" for the retained general partner interests
was also a gift, as it had contended in TAM 9842003).
By its terms, the Shepherd holding is relatively narrow, but significant. It
applies only where contributions of property are made to a FLP and where the
contributions are not in proportion to the respective partners' interests, taking into account
the contributions by each partner and any pre-contribution partner interests as well as
post-contribution partner interests. In this regard, it makes no difference whether the
contributions occur upon the formation of the FLP or at some later date. But see Reg.
§§ 25.2511-1(h)(1) and 25.2701-3(b)(4), the latter of which effectively spells out how
Reg. § 25.2511-1(h)(1) should be applied in a preferred partnership context and appears
to be at odds with the decision in Shepherd.
Transfers of partner interests following the completion of these
contributions to the FLP were not covered by the Shepherd holding. A later reviewed
Tax Court decision, Knight v. Commissioner, supra, involved transfers of limited partner
interests immediately following the formation of the FLP. Although the gifts were
valued on the basis of gifts of limited partner interests, and not as indirect gifts of a
proportionate share of the underlying partnership assets, the Tax Court pointedly noted
that the IRS had not raised the indirect gift of underlying partnership assets issue.
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Whether the outcome would have been the same if the IRS had raised this issue remains
an open question.
In Jones v. Commissioner, 116 T.C. No. 11 (2001), which was decided
after Knight, gifts of limited partner interests on the date of partnership formations were
respected and were valued for gift tax purposes as limited partner interests, not as indirect
gifts of a proportionate share of the underlying partnership assets. There is no indication
in this decision, however, that the IRS raised the indirect gift issue.
Irrespective of whether the rationale of Shepherd will ultimately be
sustained, this decision reemphasizes the longstanding concern that gifts or other
transfers occurring too close in time to the formation of the partnership may be attacked
on the same grounds as deathbed transfers. See TAM 9719006, TAM 9723009,
TAM 9725002, TAM 9730004, TAM 9735003, TAM 9736004, and TAM 9842003. In
addition to a possible prearranged indirect gift argument patterned after Shepherd, these
grounds include what is effectively a sham argument based on the proximity of the
respective FLP formation and subsequent transfers to the contributing partner's death.
See Estate of Murphy v. Commissioner, T.C. Memo. 1990-472 (1990). They also include
arguments that the FLP's transfer, dissolution and use restrictions should be disregarded
under IRC § 2703(a)(2) and that restrictions on a partner's right to withdraw from the
FLP should be disregarded under IRC § 2704(b).
Other than Shepherd, however, the IRS valuation-related challenges,
including challenges based on the special valuation provisions of Chapter 14, have met
with very limited success. See Church v. United States, 2000-1 U.S.T.C. 60,369 (W.D.
Tex. 2000) (which rejected gift on formation and IRC §§ 2703(a)(2) and 2704(b)
arguments); Kerr v. Commissioner, 113 T.C. 449 (1999) (which rejected the IRS's
argument that a limited partner's right of withdrawal is a partial liquidation right covered
by IRC § 2704(b), but which upheld the IRS's contention that the transferred limited
partner interests are to be valued as partner interests, not assignee interests); Estate of
Harper v. Commissioner, T.C. Memo. 2000-202 (2000) (which again rejected the IRS's
argument that a limited partner's withdrawal right is a partial liquidation right covered by
IRC § 2704(b)); Estate of Nowell v. Commissioner, T.C. Memo. 1999-15 (which held
that transferred limited partner interests have to be valued as assignee interests); Adams
v. United States, 2000 U.S. App. LEXIS 15593 (5 th Cir. 2000), rev'g. 1999 U.S. Dis.
LEXIS 3817 (N.D. Tex. 1999) (which held that transferred general partner interests are to
be valued as assignee interests); Estate of Strangi v. Commissioner, supra (which rejected
the IRS's economic substance, IRC § 2703(a)(2), and gift on formation contentions);
Knight v. Commissioner, 115 T.C. No. 36 (2000) (which rejected the IRS's economic
substance and IRC § 2704(b) arguments); and Jones v. Commissioner, supra (which
followed Kerr and rejected the IRS's IRC § 2704(b) argument and also held against the
IRS on its gift on formation argument, but rejected the taxpayer's attempt to value the
transferred interests as assignee interests, not limited partner interests).
In light of Shepherd and these other lingering concerns, prudence dictates
waiting a "reasonable time" between the date of formation of the partnership and the date
of the subsequent gift or other transfer. There is no safe harbor as to what constitutes a
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"reasonable time." At a minimum, it is probably advisable to wait until all partnership
contributions are completed. But see Church v. United States, supra. Otherwise, a lapse
of at least two weeks to a month after the partnership formation and the completion of all
initial contributions may serve as a good rule of thumb, although this guideline
admittedly has no express statutory, regulatory, or judicial support.
In addition, it may be advisable not to determine, in advance of the FLP
formation, exactly what transfers will be made after the lapse of a "reasonable time."
Instead, the possibility of post-formation transfers may be entertained before the FLP
formation, but an abundance of caution may warrant postponing any final determinations,
including precisely which partner interests, if any, will be transferred, until the
partnership has been formed.
2. Valuation of Transfers. As noted above, the IRS has challenged
discounted valuations of limited partner interests on the basis of the IRC §§ 2703(a)(2)
and 2704(b) special valuation rules.
If the IRC § 2703(a)(2) challenges are sustained, the restrictions on
transfer and dissolution and other restrictions on the use and enjoyment of the underlying
partnership assets which are built into partnership agreements will be disregarded, and
any partner interest transferred will be valued as though a pro rata share of the underlying
partnership assets is being transferred. This argument by the IRS has been rejected in the
two decisions which have been rendered to date. See Church v. United States, supra, and
Estate of Strangi v. Commissioner, supra.
The IRS's IRC § 2704(b) contention is that restrictions on partner
withdrawal should be disregarded as restrictions on partial liquidation rights, at least
where the restrictions on withdrawal are more onerous than the default provisions of
applicable state law. Again, however, to date, the courts have not been persuaded and
have found that IRC § 2704(b) applies only to restrictions on liquidation, not to
restrictions on partner withdrawal (at least where such withdrawal will not cause the
dissolution of the partnership under the applicable state law default provisions). See Kerr
v. Commissioner, supra, Estate of Harper v. Commissioner, supra, Knight v.
Commissioner, supra; and Jones v. Commissioner, supra.
Assuming that the IRS's special valuation arguments are ultimately
rejected and that the IRC § 2703 or 2704(b) special valuation rules do not cause any
partnership restrictions to be disregarded, the focus will be on traditional valuation
concepts, including lack of marketability discounts and minority or other lack of control
discounts. Needless to say, the valuation of the respective transferred partner interest will
depend upon the particular facts and circumstances. Typically, however, partnerships
have contained more transfer restrictions than corporations, and these transfer restrictions
are consistent with the default provisions of state laws modeled after either the Uniform
Limited Partnership Act or the Revised Uniform Limited Partnership Act. See also Reg.
§ 301.7701-2, the now superceded Regulation which was previously used to classify an
entity as an association or partnership. Therefore, a very good argument can be made
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that a transferred partner interest warrants a larger lack of marketability discount than an
otherwise analogous corporate stock transfer.
There are comparatively few partnership valuation precedents.
Historically, most of the precedents have involved general partner interests, especially in
general partnerships. In these historic general partner interest cases decided prior to
November, 2000, the smallest combined lack of marketability and minority interest
discounts which have been discovered to date were 35%, and in several instances, the
combined discounts exceeded 40%. See Estate of Watts v. Commissioner, 823 F.2d 483
(11 th Cir. 1987), aff'g T.C. Memo. 1985-595 (combined minority interest and lack of
marketability discounts of 35%); Estate of McCormick v. Commissioner, T.C. Memo.
1995-371 (minority discounts ranging from 24% to 32% and lack of marketability
discounts ranging from 20% to 22%); Moore v. Commissioner, T.C. Memo. 1991-546
(combined minority interest and lack of marketability discounts of 35%); and Estate of
Barudin v. Commissioner, T.C. Memo. 1996-395 (minority interest discount of 19% and
lack of marketability discount of 26%). Although cases involving limited partner
interests are less numerous, there are also some historic limited partner interest valuation
precedents decided prior to November, 2000. Again, the combined discounts in these
historic precedents are quite substantial. The smallest combined discounts for a limited
partner interest in the pre-November, 2000 precedents which have been uncovered to date
were 45%. See Estate of Harrison v. Commissioner, T.C. Memo. 1987-8 (combined
minority interest and lack of marketability discounts of 45% resulting from the stipulated
value of the limited partner interest in question); Harwood v. Commissioner, 82 T.C. 239
(1984), aff'd without published opinion, 786 F.2d 1174 (9 th Cir. 1986) (combined
minority interest and lack of marketability discounts of 50%); and Estate of Weinberg v.
Commissioner, T.C. Memo. 2000-51 (valuation based on both capitalization and net asset
value approaches resulted in combined minority interest and lack of marketability
discounts of just under 50%).
More recently, the IRS has revisited the application of more traditional
valuation concepts in the context of FLP interests. See FSA 200049003.
In two reviewed Tax Court decisions issued on November 30, 2000, these
IRS efforts have met with limited success.
In Estate of Strangi v. Commissioner, 15 T.C. No. 35 (2000), the Tax
Court found that 31% combined discounts were appropriate for the decedent's limited
partner interests and that 19% combined discounts were appropriate for the decedent's
minority interest in the corporate general partner. In valuing these FLP and FLP-related
interests, the Tax Court focused on the fact that a hypothetical willing seller would take
into account the liquidity of the underlying FLP assets, 75% of which consisted of cash
and marketable securities. Also, even though the decedent's stockholdings in the
corporate general partner represented less than a majority interest, the voting rights of
these stockholdings warranted materially lesser combined discounts.
In Knight v. Commissioner, supra, the results were even more weighted
toward the IRS. Instead of the 44% combined lack of marketability and minority interest
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discounts claimed on the donor's gift tax return for gifts of limited partner interests, only
15% combined discounts were determined to be appropriate by the Tax Court. In part,
these materially lesser combined discounts were attributable to the excessive advocacy
and factual errors of the taxpayer's appraiser, which clearly detracted from his credibility.
In part, however, the decision represents a questioning, if not repudiation, of general
studies commonly used to determine appropriate lack of marketability discounts,
including restricted stock studies, comparisons of pre-initial public offering ("IPO") sales
prices with IPO prices, and conglomerate studies to justify a discount for unfavorable
asset mix. Similarly, general closed-end bond fund discount data was held not to be
sufficiently comparable to the FLP municipal bond holdings to sustain the claimed
minority interest discount. To be persuasive, general studies must be compared with the
specific facts of the respective FLP and the FLP interests being valued.
A word of caution should thus be raised. Citing general valuation studies
in a vacuum, without evaluating those general studies in the context of the particular FLP
and FLP interests, is increasingly less likely to be persuasive. The valuation of each
transferred FLP interest must be based on its own unique facts. Presumably general
studies may be used as a starting point, but the taxpayer's appraiser must make a
comprehensive evaluation of the relative impact on valuation of the particular factual
setting. See Estate of Mandelbaum v. Commissioner, T.C. Memo. 1995-255, aff'd, 91
F.3d 124 (3 rd Cir. 1996).
In a subsequent case involving real estate limited partnerships, Jones v.
Commissioner, the Tax Court determined that a 44.8% combined lack of marketability
and minority interest discount was appropriate for a gifted limited partner interest which
did not have the power under the limited partnership agreement to force the dissolution of
the partnership but that only an 8% lack of marketability discount was appropriate where
the gifted limited partner interest had the power to force a dissolution, subject to possible
breach of fiduciary duty and similar claims by the other partners. The latter Tax Court
decision seems to buttress the argument that Knight, and possibly Estate of Strangi,
should be explained on the basis of unconvincing or poor appraisals by the taxpayer's
expert witnesses and should not be regarded as precedents indicating a departure by the
Tax Court from historic valuation norms.
An additional valuation consideration needs to be taken into account. One
of the threshold issues in determining the appropriate discounts is whether the transferred
partner interests are to be valued as assignee interests or as partner interests, for typically
an assignee has considerably fewer rights than a partner. To date, the courts are split.
Estate of Nowell v. Commissioner, supra, and Adams v. United States, supra, have
determined that the transferred interests should be valued as assignee interests, but Kerr
v. Commissioner, supra, and Jones v. Commissioner, supra, have upheld the IRS's
contention that the transferred interests should be valued as partner interests.
B. Gifts. Gifts are the only true freeze vehicle. To the extent that a gift does not
run afoul of the retained interest or power rules of any of IRC §§ 2035 through 2039 or
the general power of appointment rules of IRC § 2041, the date of gift value of the gifted
FLP partner interest will control for gift and ultimate estate tax purposes. See IRC
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§§ 2001(b), 2503, and 2512(a). Post-gift appreciation in value and income will not be
includible in the donor's subsequent gift or estate tax base. Therefore, the amount of the
taxable gift, as finally determined for federal gift tax purposes, will be locked in as the
donor's gift and estate tax value.
Taxable gifts up to the donor's "unified credit" equivalent or "applicable credit
amount" through the end of 2001 and commencing again in 2011, or the "applicable
exclusion amount" from 2002 through 2010 (each of which will hereinafter be referred to
as the "applicable exclusion amount") will generate no current gift tax liability.
Presently, the applicable exclusion amount will shelter $675,000 of taxable gifts, or
$1,350,000 if the donor and his or her spouse agree to split gifts. See IRC §§ 2505,
2010(c), and 2513. This applicable exclusion amount for gift tax purposes is scheduled
to increase to $1,000,000 (or $2,000,000 for split gifts) after 2001. See IRC §§ 2505 and
2010(c).
For these purposes, the amount of a donor's taxable gift will be determined by
subtracting from the date of gift value any allowable annual exclusion gifts up to $10,000
per year per donee (or $20,000 for split gifts). See IRC §§ 2503(b) and 2513. Only a
present interest gift will qualify as an annual exclusion gift. A gift of a limited partner
interest may not qualify as a present interest, and thus may not qualify for the $10,000 (or
$20,000) annual exclusion, if the general partner has total discretion over partnership
distributions (without respect to normal fiduciary principles) and if the gifted limited
partner interest is nontransferable. See PLR 9751003, which denied the annual exclusion.
But see TAM 91311006 and PLR 9415007, which allowed the annual exclusion.
Donors are understandably reluctant to make taxable gifts which trigger an out-ofpocket
gift tax liability. Nonetheless, the payment of the gift tax may ultimately save
transfer taxes if the donor survives the date of the gift by more than three years, although
the drop in gift and estate tax rates from 2002 through 2010 and the restoration of the
current rates after 2010 may reduce or even eliminate these savings. See IRC § 2035(b).
This ironic result, the saving of transfer taxes by reason of paying gift taxes, is based on
the tax-inclusive nature of estate taxes and the tax-exclusive nature of gift taxes, which is
probably best demonstrated by illustration.
EXAMPLE: Assume that Mother has previously made $3,000,000 of
taxable gifts and is therefore already in the top gift tax bracket, which is
55% for 2001. Mother has $7,000,000 of other assets and wants to give
another $1,000,000 to her children. She has already used all available
annual exclusion gifts.
If Mother makes a $1,000,000 gift in 2001, she will owe $550,000 of gift
taxes. If she then lives for more than three years and passes away after
2010 holding $5,450,000 ($7,000,000 - $1,000,000 - $550,000),
representing no post-gift appreciation, her estate will owe estate taxes of
$2,997,500. Transfer taxes on the $550,000 paid in gift taxes will be
avoided, for those taxes are not included in either the gift or estate tax
AT-1152260v1 11

ase. The total estate and gift taxes on the $7,000,000 of pre-gift holdings
will be $3,547,500.
In contrast, if no gift is made and Mother holds $7,000,000 of assets at the
time of her death, she will owe $3,850,000 of estate taxes, or $302,500
more than the combined gift and estate tax liability that will be payable if
the $1,000,000 gift is made. The extra transfer tax cost is attributable to
the payment of estate taxes on the amount owed for estate taxes.
C. Freeze Techniques. Freeze techniques include installment sales to grantor
trusts, grantor retained annuity trusts, preferred partnerships, self-canceling installment
notes ("SCINs"), and private annuities. These five freeze techniques will be discussed at
length in the following sections.
Mortality risks and considerations factor into the ultimate estate planning
effectiveness of SCINs and private annuities. Otherwise, all freeze techniques are
transfer leveraging techniques. As a general rule, value will be shifted to or for the
benefit of younger generations, and transfer taxes will be saved, only to the extent that
the total return on the transferred assets exceeds the freeze technique's interest factor or
the equivalent. If the total return does not exceed the freeze technique's interest factor or
the equivalent, no value will be shifted.
Again, absent the mortality risks and considerations inherent in SCINs and private
annuities, freeze techniques are probably better described as "leaky" freeze techniques.
The transferor's gift and estate tax base will not be truly frozen but will instead be
increased by an interest factor or the equivalent. The freeze techniques, by themselves,
only place caps on the amount of the increase. However, the combination of forming a
FLP, followed by a transfer of discounted partner interests to a freeze structure, may in
fact reduce transfer taxes.
III.
INSTALLMENT SALES TO GRANTOR TRUSTS
A. Overview. An installment sale to an intentionally defective grantor trust
("IDGT"), like all other freeze techniques, is a transfer leveraging technique. The IDGT
structure attempts to shift income and appreciation above an extremely favorable interest
factor to the IDGT and thus slow the growth in the value of the assets ultimately
includible in the gross estate of the seller to, and grantor of, the IDGT ("grantor" or
"seller"). Value is likely to be shifted to the IDGT only if the projected total return from
the transferred assets is reasonably expected to exceed the extremely favorable interest
rate charged under the installment note.
EXAMPLE: Mother owns a FLP limited partner interest with a current
value of $1,000,000. The FLP is projected to generate a total return at or
above the S&P 500's historic annually compounded total return of over
10%.
During July, 2001, Mother sells her FLP limited partner interest to a
grantor trust for $1,000,000. The sale is on an installment basis. The
AT-1152260v1 12

grantor trust issues an installment promissory note payable to Mother.
Under the terms of the note, interest accrues at a 5.12% annually
compounded rate, the July, 2001 mid-term "applicable federal rate"
("AFR"), for the first 9 years. A balloon payment of principal and accrued
interest is due on the ninth anniversary of the issuance of the note. Even if
the transferred FLP limited partner interest appreciates at a modestly
disappointing 10% annually compounded rate over the 9-year term of the
installment note, the IDGT should have a $2,357,948 limited partner
interest available to pay $1,567,358 of principal and accrued interest under
the note. Thus, a limited partner interest with a value of $790,590 will be
left in the IDGT after the note is satisfied. Effectively, this $790,590
amount will have been shifted from the grantor to the IDGT without any
transfer tax liability.
B. Structure of Installment Sale.
1. Overview. Structurally, an installment sale is comparatively straightforward.
The grantor creates a grantor trust. The grantor then sells a FLP partner interest
to the grantor trust for the fair market value of the partner interest. As consideration, the
grantor/seller takes back an interest-bearing promissory note secured by all of the grantor
trust's assets.
2. Installment Note Structure.
a. Interest. No gift will occur if the interest rate specified in the
installment note is at least the "applicable federal rate" ("AFR") in effect as of the date of
the sale and resulting note. See IRC §§ 7872 and 1274(d). There are actually three sets
of AFRs, depending on the term of the note: (1) short-term AFRs if the note term is 3
years or less; (2) mid-term AFRs if the note term is more than 3 years but not more than 9
years; and (3) long-term AFRs if the note term is more than 9 years. The AFRs change
monthly to reflect U.S. Treasury rates during the prior month, when the rates for the
following month are published.
These rates are extremely favorable. The IDGT will effectively be
able to borrow at the same rate as the U.S. Treasury, irrespective of the IDGT's actual
credit-worthiness. For example, for July, 2001, if payments are due annually, the shortterm
AFR is 4.07%, the mid-term AFR is 5.12%, and the long-term AFR is 5.82%.
Although the statute refers to semiannual compounding, the monthly rulings published by
the IRS provide monthly, quarterly, semiannual and annual rates for each term, with
adjustments being made for appropriately lower rates if payments are made more
frequently than semiannually and for appropriately higher rates if payments are made less
frequently than semiannually.
There is no requirement that interest be paid currently. Instead,
IRC § 7872(f)(2)(A) expressly adopts use of the IRC § 1274(d) rates used to determine
the amount of original issue discount ("OID"). This use of an OID standard supports the
scheduled deferral of interest under an IDGT installment note. The only statutory limit
AT-1152260v1 13

on the deferral of interest is the requirement that, to avoid a gift, the interest rate under
the IDGT installment note must be at least the appropriate AFR (with semiannual
compounding). The only other concern is that the combination of a deferral of all interest
and a lengthy note term may raise debt-equity questions.
b. Term. The term of the installment note is not inherently
limited to any finite maximum. Installment notes with 20 and 25 year terms are not
unusual, but debt-equity classification questions may warrant a lesser term, such as 15 to
18 years, if substantial amounts of interest are being deferred. See PLR 9436006 (a 25-
year note with quarterly interest payments) and PLR 9535026 (interest only for 20 years).
Not atypically, a 9-year term will be used if the mid-term AFR is materially below the
long-term AFR as of the date of sale. Otherwise, a 10 year or longer term is more likely.
c. Collateral and Credit Enhancements. The installment note
should be secured with all IDGT assets, and not just the assets sold on an installment
basis to the IDGT. See Fidelity-Philadelphia Trust Co. v. Smith, 356 U.S. 274 (1958).
Furthermore, it is generally assumed that a prior gift to the IDGT by the grantor should
provide enough assets so that the previously gifted assets should represent at least 10% of
the IDGT's assets immediately following the sale. See Mulligan, "Sale to a Defective
Grantor Trust: An Alternative to a GRAT," 23 Est. Plan. 3, 8 (1996). The beneficiaries'
pro rata guarantees of at least 10% (or 11.1%, as discussed subsequently) of the
installment sale price should be a viable alternative to a 10% seed gift. See Hatcher and
Manigault, "Using Beneficiary Guarantees in Defective Grantor Trusts," 92 J. of
Taxation 152 (March, 2000).
3. IDGT Structure. The IDGT is often structured as a generationskipping
tax ("GST") exempt trust for the benefit of children and more remote
descendants. The grantor's spouse may also be a permissible beneficiary -- even the
primary beneficiary if that is what the grantor wants. Potentially, the IDGT can continue
for the maximum period permitted by the rule against perpetuities. Some states now even
provide for an unlimited rule against perpetuities.
It is not necessary, however, that the IDGT continue for two or more
generations. If the grantor wants the trust to terminate shortly following the installment
note term and be distributable to his or her children, that is doable, even though it does
not maximize potential transfer tax savings.
C. Tax Analysis.
1. Income Tax Considerations.
a. Disregarded Entity. If the IDGT is a grantor trust, and if the
grantor is the only person who is treated as an owner, then the grantor's sale of assets to
the IDGT, the IDGT's payment of interest to the grantor, and any satisfaction of the
installment note by an in kind distribution from the IDGT to the grantor should be a
nontaxable event for income tax purposes. The grantor will simply be treated as having
sold property to himself or herself and as having paid interest to himself or herself, and
AT-1152260v1 14

such self-dealing should be nontaxable. See Rev. Rul. 85-13, 1985-1 C.B. 184,
PLR 9535026, and PLR 9838017. But see Rothstein v. United States, 735 F.2d 704 (2 nd
Cir. 1984). Instead, all IDGT taxable income should be taxable to the grantor almost as
though the IDGT did not exist.
b. Means of Qualifying IDGT as Grantor Trust. The IDGT can
qualify as a grantor trust as a result of the grantor's inclusion of any number of trust
provisions. Among the provisions used most often, either alone or in tandem, to qualify
the IDGT as a grantor trust are the following:
(1) Spouse as Beneficiary. If the grantor's spouse is a
permissible beneficiary, and if distributions to the spouse of income and principal are
permissible, the IDGT should be a grantor trust in its entirety. See IRC § 677(a)(1) and
(2). Such a provision provides considerable flexibility, even if the primary beneficiaries
are children and more remote beneficiaries. However, a divorce or legal separation, or
the spouse's death, will cause the loss of grantor trust status unless another grantor trust
provision applies. See Reg. § 1.677(a)-1(b)(2). Also, the inclusion of the grantor's
spouse as a permissible beneficiary may limit, or even preclude, gift splitting by the
grantor and his or her spouse under IRC § 2513. See Reg. § 25.2513-1(b)(4).
Furthermore, to avoid IRC § 2036 problems, the IDGT should spell out that the
distributions to the spouse cannot be used to satisfy the grantor's legal support obligations
to the spouse.
(2) Lending Powers and Actual Loans. Two grantor
trust provisions are based on loans, or the ability to make loans, from the would-be
grantor trust to the grantor or possibly his or her spouse.
The first provision, IRC § 675(2), enables a trust to be
classified as a grantor trust if the trust agreement does not generally authorize lending
without adequate interest or security but permits the grantor to borrow from the trust
without adequate security. Although the same statutory provision technically confers
grantor trust status if the grantor or a nonadverse party has the power to make a loan from
the trust to the grantor without charging adequate interest, such a provision invites
inclusion in the grantor's gross estate for estate tax purposes and should be avoided.
The second provision, IRC § 675(3), applies only if there is
an actual loan from the trust to either the grantor or his or her spouse and that loan is not
adequately collateralized or, in the case of a loan to the grantor's spouse, does not charge
reasonable interest. Grantor trust status will be triggered if such a loan to the grantor or
his or her spouse is not repaid in full before the beginning of a taxable year. A major
concern is that grantor trust status may not extend to the entire trust but may instead be
limited to the portion of the trust represented by the loan.
(3) Payment of Insurance Premiums. The ability to
apply the IDGT's principal and income to pay insurance premiums on the life of the
grantor or his or her spouse literally should result in grantor trust status under IRC §
677(a)(3). The IRS initially acquiesced in two early cases which held that grantor trust
AT-1152260v1 15

status only applies to the extent that trust income (including capital gains) is actually used
to pay these premiums. See Moore v. Commissioner, 39 B.T.A. 808 (1939), acq. 1939-2
C.B. 25; and Weil v. Commissioner, 3 T.C. 579 (1944), acq., 1944 C.B. 29. See also
Rand v. Helvering, 116 F.2d 929 (8 th Cir. 1940), cert. denied, 313 U.S. 594 (1941). The
IRS then seemingly reversed itself and held that the ability to pay the premiums, and not
the actual payment, is sufficient to cause the trust to be a grantor trust. See
PLRs 8103074 and 8552003. Most recently, the IRS has acknowledged that the matter is
under advisement and has refused to rule on the issue. See Rev. Proc. 99-3 1999-1 I.R.B.
103. See also PLR 9413045. To be on the safe side, the IDGT should probably actually
own a life insurance policy and pay the premiums if the trust is to qualify as a grantor
trust under this provision.
(4) Power to Substitute Property of Equivalent Value.
The power to reacquire trust property by substituting other property of an equivalent
value will cause the IDGT to be treated as a grantor trust, but only if the power is
exercisable in a nonfiduciary capacity without the approval or consent of a person in a
fiduciary capacity. See IRC § 675(4)(C). Typically the grantor reserves this power, and
the IRS has conceded that this power does not cause inclusion in the decedent's gross
estate under IRC § 2036 or 2038. See Jordahl v. Commissioner, 65 T. C. 92 (1975), acq.,
1977-2 C.B. 1. The power of substitution may also be held by a nonadverse third person.
See Reg. § 1.675-1(b)(4)(iii) and PLRs 9037011, 9642039, 9713017, and 199908002.
Currently, the IRS is refusing to rule under IRC § 675(4)(C) on the alleged ground that
the nonfiduciary capacity of the powerholder is inherently a question of fact. See
PLRs 9437022, 9524032, 9642039, and 9713017.
(5) Power to Add Beneficiaries. A nonadverse party's
power to add beneficiaries (other than afterborn or afteradopted children or pursuant to a
testamentary power of appointment) is another fairly common provision used to achieve
grantor trust status for the IDGT. See IRC § 674(a), (b)(3), (5), (6), and (7), (c) and (d).
For example, the nonadverse powerholder may be given the power to add a charitable
beneficiary. See Madorin v. Commissioner, 84 T.C. 667 (1985), and PLRs 9304017,
9709001, and 9709007. Similarly, a nonadverse powerholder's ability to add a spouse as
a beneficiary should suffice, apparently even if the added spouse may only be an income
beneficiary. See Reg. § 1.674(a)-1(b)(1). If the power is held by a beneficiary of the
IDGT, however, the powerholder may be adverse, and the IDGT may not qualify as a
grantor trust. Needless to say, for estate tax reasons, the grantor should not retain the
power to add beneficiaries. See IRC §§ 2036(a)(2) and 2038.
(6) Discretionary Power to Spray and Sprinkle Corpus
and Income. Under IRC § 674(c), an IDGT will be a grantor trust if a majority of the
trustees are related or subordinate and if the trustees have the ability to make
discretionary distributions of principal and income. For these purposes, the grantor's
spouse, descendant, parent, sibling, or subordinate employee will be regarded as related
or subordinate. See IRC § 672(c). If the trustees are also adverse (e.g., because all of the
related and subordinate party trustees are beneficiaries), however, grantor trust status may
not be available. See IRC § 674(a). In addition, a trustee-beneficiary's right to make
discretionary distributions to himself or herself, other than in conjunction with an adverse
AT-1152260v1 16

party, may be a general power of appointment causing inclusion of the trust property in
his or her gross estate under IRC § 2041. See IRC § 2041(a)(2), (b)(1)(A), and (C)(ii).
c. Turning Grantor Trust Status Off and On. Many people
assume that grantor trust status may be turned off and on at will by the grantor or a third
person. For example, if the grantor does not want to be taxed on a very large capital gain
that may be shortly realized by the IDGT, he or she can irrevocably waive the IRC §
675(4)(C) right to reacquire corpus by substituting property of equivalent value for a term
extending beyond the likely realization of the capital gain. After that term, the power of
substitution will be restored.
Although the matter is not free from doubt, an irrevocable waiver
by the grantor of a power which causes that power to be lost permanently should add
nothing to common law or state statutory rights of disclaimer and should not cause
adverse gift or estate tax consequences to the grantor. But see Coleman, "The Grantor
Trust: Yesterday's Disaster, Today's Delight, Tomorrow's What," ALI-ABA Est. Plan.
Course Materials J. 15, 42 (Feb., 2000). Under Reg. § 25.2701-1(b)(2)(i)(C)(1),
however, a termination of grantor trust status will trigger application of a subtraction
method valuation analysis for any interests in a preferred partnership held by the trust.
If the grantor retains the right to turn the power off and then turn it
back on, however, the failure to turn the power off may be regarded by the IRS as a gift
to the trust to the extent of the grantor's trust-related income tax liability. In addition, the
grantor's retention of the on and off switch may present the IRS with a reasonably
persuasive argument that the grantor has retained a right of enjoyment under IRC §
2036(a)(1), a power to alter beneficial enjoyment under IRC § 2036(a)(2), or a right to
alter or amend under IRC § 2038(a)(1), any of which may cause inclusion in the grantor's
gross estate.
If an on and off switch is desired, it will probably be advisable to
designate one or more third persons, not the grantor, as switch holders. It may even be
advisable to have one or more third persons serve as switch holders if only a one-time off
switch is included. See Coleman, "The Grantor Trust" Yesterday's Disaster, Today's
Delight, Tomorrow's ," 30 U. Miami Philip E. Heckerling Inst. on Est. Plan. Ch. 8, 804
(1996).
d. Partial Grantor Trust Status. A grantor trust may be a grantor
trust only in part. For example, under IRC § 674, the grantor may be taxable only on the
fiduciary income but not on capital gains allocable to principal. See Reg. § 1.671-3.
Such partial grantor trust status will cause potential problems in an IDGT context. Part of
the installment sale will be a taxable event, the trust will be taxable on part of its taxable
income (except to the extent of any offsetting interest deduction), and a satisfaction of the
trust's installment obligation in kind will be partially a taxable event.
e. Multiple Grantors. A grantor trust may be a grantor trust in its
entirety but have multiple grantors. For example, a husband and wife may both
contribute to an IDGT. Some persons have also suggested that Crummey powers may
AT-1152260v1 17

cause the Crummey power holder to be treated as a second grantor, but IRC § 678(b)
should cure any potential problem to the extent that the grantor continues to be treated as
the sole owner under that provision. Similarly, some persons have suggested that a
beneficiary's guarantee may cause the beneficiary to be treated as a second grantor. A
bona fide pro rata guarantee by a beneficiary who has the financial wherewithal to make
good on the guarantee, however, should not be treated as a constructive gift by the
guarantor to the IDGT, although the issue is not totally free from doubt. See Hatcher and
Manigault, "Using Beneficiary Guarantees in Defective Grantor Trusts," 92 J. of
Taxation 152 (March, 2000).
To the extent that an IDGT has more than one grantor, the
potential problems are basically the same as those confronted by a partial grantor trust.
In particular, part of the installment sale, and any in kind transfer in satisfaction of the
installment obligation, may be a taxable event, although the IRC § 1041 nonrecognition
rules for interspousal transfers may provide relief if the multiple grantors are a husband
and wife.
f. Cessation of Grantor Trust Status During Grantor's Lifetime.
If the IDGT ceases to be a grantor trust during the grantor's lifetime, and if the
installment note is still outstanding at the time of such cessation, a taxable event may be
deemed to have occurred at the time the trust ceases to be a grantor trust. See Reg. §
1.1001-2(c), Example (5), Madorin v. Commissioner, supra, Rev. Rul. 1977-2 C.B. 222,
and PLR 200010010. Presumably, any gain will be based on the excess of the amount
then due under the installment note over the adjusted basis of the IDGT's assets.
g. Grantor's Death During Installment Note Term. The grantor's
death before the satisfaction in full of the installment note will cause any number of
income tax uncertainties and potential problems. The only given is that the IDGT will no
longer be a grantor trust following the grantor's death. After loss of grantor trust status,
interest payments (at least to the extent that the interest is attributable to the post-death
period) should be deductible by the trust and includible as taxable income by the grantor's
estate or other successor in interest. A post-death in kind satisfaction of the installment
note with appreciated property will be a taxable event that may trigger realization of gain
taxable to the trust. Beyond the loss of grantor trust status and these rather obvious
income tax consequences of such loss of grantor trust status, however, the income tax
consequences of the grantor's death are not clear.
(1) Deemed Taxable Transfer. One possibility is that
the grantor's death triggers a deemed transfer of the trust's assets for the installment note,
which deemed transfer will be a taxable event for income tax purposes. Supporting this
possible deemed transfer, at least to some extent, are Reg. § 1.1001-2(c), Example (5),
Madorin v. Commissioner, supra, and Rev. Rul. 77-402, supra, but all of these
precedents involve a partnership interest held by a trust that ceases to be a grantor trust
and becomes a regular trust during the grantor's life. Even if the grantor's death triggers
a taxable event, however, will the taxable event be considered to have occurred
immediately before or immediately after death The income tax consequences will vary
materially, depending upon the answer to this question.
AT-1152260v1 18

(a) Deemed Pre-Death Recognition Event. The
taxable event may be considered to have occurred immediately prior to the grantor's
death. If installment sale treatment is not available, or if an election is made on the
grantor's final income tax return not to report on the installment basis, then the gain from
the taxable event will be includible in the grantor's final income tax return, and his or her
estate should be entitled to deduct the resulting income tax liability for estate tax
purposes under IRC § 2053.
From the trust's perspective, the basis of the trust's
assets should be increased to equal the indebtedness under the installment note, or
possibly the value of the note, if the trust's aggregate adjusted basis for all of its assets is
otherwise less than that indebtedness under, or value of, the note. This increase in the
trust's basis will be based upon the normal cost basis rules of IRC § 1012 and the bargain
sale rules of Reg. § 1.1015-4. The increase in the trust's basis will not be predicated on
IRC § 1014(a) and (b), for the trust assets will not be includible in the decedent's gross
estate for estate tax purposes and thus will not be regarded as having passed from the
decedent.
(b) Deemed Pre-Death Installment Sale. Again, the
taxable event may be considered to have occurred immediately prior to the grantor's
death. If installment gain treatment is not only available but is also availed of (either
intentionally or unintentionally since an affirmative election out of installment sale
treatment would be required) by the grantor's estate when it files the grantor's final
income tax return, no gain will be reported on the grantor's final return. Instead,
recognition of the realized gain should be deferred in accordance with the installment sale
rules of IRC § 453 until the grantor's estate or other successor in interest receives
payments due under the note. The note will be an item of income in respect of a decedent
under IRC §691 and therefore will not be entitled to a step-up in basis as of the grantor's
death. When gain is recognized by the grantor's estate or other successor in interest upon
payment of principal and pre-death accrued interest under the note, the grantor's estate or
other successor in interest should be entitled to an IRC § 691(c) deduction for any estate
tax liability attributable to the note.
If gain is recognizable, even under the installment
method, the trust should be entitled to increase the basis of its assets to the balance due
under the note as of the date of death, or possibly the value of the note, if the aggregate
adjusted basis of the trust's assets is otherwise less than that outstanding balance or value.
See Treas. Reg. § 1.1015-4.
(c) Post-Death Transfer. The deemed transfer of
assets to the trust, and thus the taxable event for income tax purposes, may be considered
to have occurred immediately after the date of death. If the note is not treated as an item
of income in respect of a decedent, the basis of the note in the hands of the grantor's
estate or other successor in interest will be stepped up to the balance due under the note,
or the estate tax value of the note, possibly excluding pre-death accrued interest in either
case. Therefore, principal payments under the note will not generally trigger the
realization of gain by the grantor's estate or other successor in interest.
AT-1152260v1 19

The trust should be entitled to increase the basis of
its assets to the balance due under the note as of the date of death or the estate tax value
of the note if the aggregate adjusted basis of the trust's assets is otherwise less than that
outstanding balance or value. See Manning and Hesch, "Deferred Payment Sales to
Grantor Trusts, GRATs and Net Gifts: Income and Transfer Tax Elements," 24 T.M.
Est., Gifts and Tr. J. 3, 26 (1999).
(2) No Taxable Event. A second possibility, and the
one which appears more appropriate in the author's opinion, is that the grantor's death
does not cause a taxable event to occur. In this regard, a transfer upon death is not
typically regarded as a taxable event. See Rev. Rul. 73-183, 1973-1 C.B. 364, updating
and restating O.D. 219, 1 C.B. 180 (1919). This long-standing position evidenced by the
IRS ruling relies upon the legislative history of IRC § 641. The House and Senate
Reports both provide the following: "The mere passing of property to an executor or
administrator on the death of the decedent does not constitute a taxable realization of
income even though the property may have appreciated in value since the decedent
acquired it." H. Rep. No. 1337, 83 rd Cong., 2d Sess., reprinted in 3 U.S.C.C.A.N. 4017,
4331 (1954); S. Rep. No. 1622, 83 rd Cong., reprinted in 3 U.S.C.C.A.N. 4621, 4981
(1954). (Emphasis added) The absence of a "realization" event upon death is clearly
inconsistent with any attempt to extend Reg. § 1.1001-2(c), Example (5), Madorin and
Rev. Rul. 77-402 principles to a death context.
Reg. § 1.1001-2(c), Example (5), Madorin and Revenue
Ruling 77-402 should be regarded as being limited to their comparatively unique facts
involving (1) an inter vivos cessation of grantor trust status and (2) third party debt in
excess of a particular asset's basis, and possibly should apply only to partnership interests
with debt over basis problems because of the constructive distribution of cash rules of
IRC §§ 752(b) and 731(a)(1). Otherwise, a legitimate question can be raised as to
whether the IRS will also take the position that a deemed transfer and taxable event will
occur generally upon the death of any grantor who has established a typical funded
revocable trust which is a will substitute and which includes any property, such as a
refinanced second residence or margined stock, with debt in excess of pre-death basis.
In contrast, the grantor's debt should be regarded as debt to oneself
and should be disregarded for income tax purposes throughout the grantor's life. See
Rev. Rul. 85-13, supra; and PLR 8709001. Therefore, for income tax purposes, there
should be no debt immediately before the grantor's death that will trigger a taxable event,
and the general rule that death is not a taxable event should control.
If no taxable event occurs by reason of death, the remaining
income tax consequences should be different than those resulting from a premise that a
deemed transfer and taxable event occurs upon death. Since payments during the
grantor's lifetime would not have been taxable to him or her under the grantor trust rules,
the note should not be an item of income in respect of a decedent. Therefore, the note's
basis in the hands of the grantor's estate or other successor in interest should be its estate
tax value under IRC § 1014, and the grantor's estate or other successor in interest should
ultimately realize gain only to the extent, if any, that the remaining payments under the
AT-1152260v1 20

note with respect to principal and pre-death accrued interest exceed the note's estate tax
value.
Since no taxable transfer will be deemed to have occurred by
reason of the grantor's death, the trust should not be entitled to any increase in the basis
of its assets. Thus, gain will not be avoided but simply will be deferred until the trust
sells the respective asset. Since satisfaction of the note will probably require a sale of a
substantial portion of the trust's assets or a taxable in kind transfer of assets from the
trust, the day of income tax reckoning for the trust might not be deferred for that long.
(3) Possible Note Prepayment Before Death. Because
of the income tax uncertainties, commentators often tout the advantages of satisfying the
note with an in kind distribution of assets from the trust to the grantor during his or her
lifetime, especially if the grantor's death is believed to be imminent. In many, if not
most, instances, satisfaction of the note during the grantor's lifetime will be advisable, but
that will not always be the case. For example, the term of the note may extend for
another 20 or 25 years, and interest rates may have risen materially subsequent to the
execution of the note. Under these circumstances, the potential estate tax savings
resulting from the allowable discounting of the note for estate tax purposes may far
exceed any potential income tax risks. Also, the grantor may live for a considerable
period of time after the in kind satisfaction of the note, for rarely is the timing of a death
predictable with any degree of certainty. If the assets distributed in kind appreciate
materially between the time of their distribution to the grantor and the date of the
grantor's death, the added estate tax cost may exceed the potentially higher income tax
liability, even disregarding the uncertainty of that income tax liability. The bottom line is
that an accelerated in kind satisfaction of the note, of and by itself, involves inherent
risks. Those risks need to be weighed against the risks associated with the income tax
uncertainties if the grantor holds the note at his or her death.
2. Gift Tax Considerations.
a. Grantor's Valuation Issues.
(1) Undervaluation of Property Sold. If the
consideration which the grantor receives in the exchange is less than the value of the
assets sold to the trust, then the grantor will be deemed to have made a taxable gift of the
excess to the trust. Depending upon the amount of the undervaluation and the remaining
amounts of the grantor's applicable exclusion amount for gift tax purposes, that taxable
gift may trigger an out-of-pocket gift tax liability. Far worse, as discussed in greater
detail in the following discussion of "Estate Tax Considerations," the gift may even cause
the assets in the trust to be includible in the grantor's gross estate at their date of death or
alternate valuation date values, including any appreciation after the initial transfer of the
assets to the trust.
(2) Undervaluation of Note. The second valuation risk
inherent in the IDGT strategy relates to the value of the note. If the note itself is not
valued at its face amount, the grantor will not have received full and adequate
AT-1152260v1 21

consideration in exchange for the fairly valued assets sold to the trust and will be deemed
to have made a gift in the amount of the difference between the note's actual value and
the value of the assets sold.
(a) Applicable Federal Rates. To avoid
characterization as a "gift loan" under IRC § 7872, the note must have an interest rate
equal to or above the appropriate applicable federal rate ("AFR") in effect at the time of
the sale. If the note bears interest at the appropriate AFR, and if it is determined to be
debt and not equity, then it should be valued at face value and be full consideration. See
Frazee v. Commissioner, 98 T.C. 554 (1992), and PLR 9535026. As discussed
previously, the statutorily sanctioned use of the AFRs as the standard for measuring a fair
interest rate for gift tax purposes is extremely generous in its own right. The AFRs are
based upon the credit-worthiness of the United States government. Much less creditworthy
purchasers, such as the IDGT, are effectively allowed to "piggyback" the federal
government's credit rating and pay much lower rates of interest than will otherwise be
required to avoid a gift. The ability to use such favorable interest rates is one of the
major advantages of the IDGT, if not the primary one.
(b) Debt, Not Equity. Inclusion of the appropriate
AFR in the note is not necessarily a panacea, however. Although the IRS has issued
favorable rulings in regard to IDGTs, it has expressly caveated those rulings if the
promissory notes are determined to be equity, and not debt. See PLRs 9436006 and
9535026. By negative implication, the downside risks of the note being characterized as
equity, and not debt, are as follows:
• The extremely favorable IRC § 7872 applicable federal rates will not
be available for purposes of determining the value of the note.
• The trust may effectively be treated for gift tax purposes as a preferred
partnership subject to IRC § 2701, with the note representing a
preferred partnership interest. The "good news" is that interest
payments under the note should be "qualified payments" if they are
payable at least annually (see IRC § 2701(a)(3)(A) and (c)(3) and Reg.
§ 25.2701-2(b)(6)) and that a fixed maturity date should be taken into
account for valuation purposes under IRC § 2701 (see IRC
§ 2701(c)(2)(B)(i)). The "bad news" is that the AFR will be materially
below the preferred rate which will be required to avoid a substantial
gift. The worst case scenario will occur if the note does not call for
annual or more frequent payments but instead defers all interest
payments. In that event, the grantor will probably be treated as having
made a taxable gift equal to a substantial portion, if not all, of the
value of the property transferred to the trust. See IRC § 2701(a)(3)(A)
and (c)(3) and Reg. § 25.2701-2(b)(6). See also IRC §
2701(c)(2)(B)(i), which may permit the present value of the payment
at the maturity of the note to be taken into account to reduce the
amount of the taxable gift, but only to the extent that a "specific
amount" is payable as of a "specified date."
AT-1152260v1 22

• The note may be regarded as a retained interest with respect to the
transfer of an interest in trust, causing the retained interest to be valued
under the special valuation rules of IRC § 2702. If the note provides
for equal annual (or more frequent) installments of principal and
interest over a specific term, the payments may be a "qualified
interest" with a present value for gift tax purposes based on 120% of
the mid-term AFR at the time of the transfer. See IRC
§§ 2702(a)(2)(B) and 7520. There will be some taxable gift.
However, the amount of that taxable gift should not be that great,
although it is likely to be material, for it will primarily be based on the
lesser present value resulting from the required use of 120% of the
mid-term AFR, as opposed to the present value determined by using
the more favorable AFR incorporated in the note. In contrast,
provision for annual or more frequent payments of interest only over
the term of the note, or provision for the deferral of all interest, with a
balloon payment of principal and any deferred interest as of the
maturity date, will cause a gift tax fiasco. Since the final payment will
be more than 20% greater than the immediately preceding payment,
none of the debt service will be a "qualified interest" and the entire
value of the property transferred to the trust will be a taxable gift for
gift tax purposes (see IRC § 2702(a)(2)(A) and Treas. Reg.
§ 25.2702-3(b)(1)).
If no "old and cold" gift of "seed" money is made to
the trust, or if the IDGT beneficiaries do not execute a guarantee, it is extremely difficult
to escape the conclusion that IRC § 2702 should control, for how can a note from a
totally leveraged trust with no other source of funds be substantively distinguished from a
GRAT, and probably a nonqualified GRAT treated for gift tax purposes as having a zero
value If any material "old and cold" gift of "seed" money or guarantee is furnished, IRC
§ 2701 seems to be the more likely downside risk, although the matter is not free from
doubt. These conclusions are based on the IRC § 7701 entity characterization
regulations. A joint enterprise among associates is more likely to be classified as a
partnership, whereas the absence of associates in a joint enterprise for the conduct of a
business for profit indicates that the entity is more likely to be classified as a trust. See
Reg. § 301.7701-4(a).
The issue then becomes the amount of the "old and
cold" gift of "seed" money or guarantee required to avoid characterization of the note as
equity, and not debt. The determination of whether an instrument should be treated as
debt or equity is inherently factual. Courts have stressed any number of factors,
including the presence of a maturity date, the source and enforcement of payments, and
the debt to equity ratio. See Harllee, 536-2nd T.M., Interest Expense Deductions, A-17.
In an effort to cut down on the uncertainty caused by confusing and often apparently
inconsistent decisions, Congress finally enacted IRC § 385. This statute, which by its
terms is limited to the income tax treatment of corporate debt and thus applies only by
analogy to a grantor trust's note, authorizes the IRS to issue debt-equity regulations and
directs that the factors to be taken into account should include (1) whether there is an
AT-1152260v1 23

unconditional promise to repay a specific amount upon demand or on a specific date, and
to pay a fixed rate of interest, (2) whether the indebtedness is subordinated, (3) whether
the debt to equity ratio is inordinately high, (4) whether the indebtedness is convertible
into an equity interest, and (5) whether the loans are made by the equity holders,
especially if the debt and equity holdings are in the same proportion. IRC § 385 was
effective on December 31, 1969, more than 30 years ago, and the IRS has still not issued
final regulations. On three occasions, the IRS has issued proposed regulations and then
withdrawn the proposals when confronted by strong Congressional opposition. See T.D.
7747, 1981-1 C.B. 149, T.D. 7801, 1982-1 C.B. 60, T.D. 7822, 1982-2 C.B. 84 and T.D.
7920, 1983-2 C.B. 69. Over 17 years have now passed since the last proposal was made,
only to be withdrawn. Obviously, trying to determine in a close case whether an
instrument is debt or equity is, at best, an unpredictable Delphic exercise.
On its face, the IDGT installment note clearly
appears to be debt. It calls for payment of a fixed principal amount, plus interest based
on a fixed rate, on specific dates. Generally, the grantor is given a first priority security
interest in all of the trust assets (although the note might allow for superior security
interests for debts incurred to third parties that are used to pay the principal on the note).
The note and collateralization of the trust's assets typically represent the grantor's only
interests in the trust. The two potentially troublesome issues are the debt to equity ratio
and possibly the convertibility of the note.
The primary focus in a debt-equity analysis is
almost inevitably the ratio of debt to equity. At some point, capitalization can be so thin
that it has more of the attributes of risk capital than legitimate debt. There is no hard and
fast rule for how thin is too thin. The IRS has acquiesced in one case in which a 19.6 to
1 debt to equity ratio was found not to be too high, thus resulting in the note in question
being classified as debt and not equity. See McDermott v. Commissioner, 13 T.C. 468
(1949), acq., 1950-1 C.B. 3. Even higher debt to equity ratios have been sustained. In
one case, a debt to equity ratio of 700 to 1 did not preclude both a trial court and an
appellate court from finding that the instrument in question was properly characterized as
debt, but this case probably represents the outer limits of permissible debt to equity ratios
and should not be used for planning purposes. See Baker Commodities, Inc. v.
Commissioner, 48 T.C. 374 (1967), aff'd., 415 F.2d 519 (9 th Cir. 1969), cert. denied, 397
U.S. 988 (1970).
Several commentators, some citing discussions with
the IRS, suggest an initial "seed" gift of at least 10% of the purchase price. See Mulligan,
"Sale to a Defective Grantor Trust: An Alternative to a GRAT," supra, at 8 (1996), and
Mulligan, "Sale to an Intentionally Defective Irrevocable Trust for a Balloon Note -- An
End Run Around Chapter 14," 32 U. Miami Philip E. Heckerling Inst. on Est. Plan.,
Ch. 15, 1505.2 (1998). Such a 10% "seed" gift corresponds to a debt to equity ratio of
10 to 1. The basis for this suggested 10 to 1 or lower debt to equity ratio is apparently the
analogy to the 10% minimum value rule of IRC § 2701(a)(4); to avoid a taxable gift, the
value of the nonpreferred junior equity interests must equal at least 10% of the sum of the
value of all equity interests plus the total indebtedness of the entity to the transferor and
other family members. However, if one bases the 10% "seed" funding on IRC
AT-1152260v1 24

§ 2701(a)(4), and if constant values are assumed between the date of the "seed" gift and
the date of the installment sale, then the actual "seed" gift should be approximately 11.1%
of the initial IDGT note principal (that is, 10% of the total assets transferred to the trust,
counting the "seed" gift itself). For example, if the grantor transfers $11.10 to the trust as
"seed" money and later sells an asset worth $100 to the trust for a $100 promissory note
from the trust, the "seed" amount will be worth approximately 10% of the total transfers
to the trust (the $11.10 "seed" plus the $100 of assets sold). If the "seed" gift is 11.1% of
the IDGT note principal, that is the equivalent of a 9 to 1 debt to equity ratio. Thus, the
debt to equity ratio should be 9 to 1 or lower. Although a 9 to 1 or lower debt to equity
ratio has not been publicly sanctioned as a safe harbor by the IRS, this appears to be a
reasonable debt to equity ratio guideline which has considerable judicial support in
addition to being analogous to IRC § 2701(a)(4). More conservative persons may wish to
lower the debt to equity ratio, but that does not appear to be necessary if the only
significant cause for concern is thin capitalization.
As a practical matter, a bona fide 11.1% or higher
guarantee from a person who has the net worth to back it up should be the equivalent of,
and may be preferable to, an "old and cold" infusion of at least 10% "seed" money.
Would the grantor prefer to have a security interest in a trust holding a limited partner
interest in a securities FLP where the note initially has an outstanding balance equaling
90% of the trust's total asset value and where a stock market correction or similar decline
in value could wipe out this 10% net value, or would the grantor prefer the credit
enhancement to be in the form of a guarantee from the beneficiaries who, at the time of
the IDGT transfer, have sufficient net worth (typically from more diversified sources) to
make any payments which they may be obligated to make under the guarantee if the
trust's assets fall short There should be no real difference from a tax perspective, as the
IRS has effectively recognized in at least one Chapter 14 private letter ruling. See PLR
9515039, which effectively held that a financially well-situated trust beneficiary's
guarantee to issue personal notes in the event that the trust was unable to meet the
required qualified interest payments satisfied the requirements of IRC § 2702, thus
avoiding a taxable gift by the grantor.
Another factor which may come into play is
convertibility. At first blush, this factor would seem either inapplicable or to weigh in
favor of debt, as the note is not convertible on its face. How could a promissory note in
the IDGT context ever be convertible Some promissory notes might provide for
satisfaction of principal and interest payments by payment in kind. If the creditor has the
right to demand payment in kind, the instrument looks somewhat more like an equity
interest, either in the assets of the trust or in the trust itself. If the trust has the right to
pay in kind only at its option, then there is less of an equity flavor. If the note does not
provide for in kind payments, but the grantor subsequently acquiesces to such in kind
payments in lieu of cash, there should be no problem with the note being considered
convertible.
Not atypically, the grantor will retain the right to
substitute assets with equivalent value for assets held by the trust. The extent to which
such a right of substitution may be regarded as a possible "backdoor" conversion right is
AT-1152260v1 25

unclear. Even if it is, the existence of a conversion right will not be determinative. It
will simply be one factor evidencing equity characteristics. If all other factors indicate
debt, the note should be classified as debt.
Beyond the statutory factors referred to in IRC
§ 385, other issues might affect the debt-equity tests. Most importantly, if the grantor
does not enforce the debt, the IRS will likely view it as equity. See Estate of Constanza
v. Commissioner, T.C. Memo. 2001-128. Similarly, if the grantor gives the beneficiaries
reason to believe that they will never be called upon to honor any guarantee, such
guarantee may very well not be regarded as bona fide and may be ignored.
(3) Prearranged Note Cancellation. The IRS takes the
position that a current taxable gift occurs to the extent that the parties do not intend for
the note to be satisfied but instead have prearranged that all or part of the note will be
cancelled at some future date (e.g., to take advantage of otherwise allowable annual
exclusions, scheduled increases in the applicable exclusion amount, or both). See
FSA 1999837. See also Rev. Rul. 77-299, 1977-2 C.B. 343. But see Estate of Kelly v.
Commissioner, 63 T.C. 321 (1974), nonacq., 1977-2 C.B. 2, and Haygood v.
Commissioner, 42 T.C. 911 (1964), nonacq., 1977-2 C.B. 2, which focused on the
enforceability of the notes, not any intent to forgive part or all of the note at some future
date.
(4) Prearranged Distribution or Dissolution. Some
planners have been recommending an installment sale of a FLP partner interest to a
grantor trust, for the discounted value of the FLP partner interest, followed by either the
distribution of assets from the FLP to the trust to satisfy the note or a dissolution of the
partnership before the due date of the note. Either of these techniques will enable
undiscounted assets to be used to pay for assets purchased at a discount. There may be
perfectly valid reasons for deciding to distribute assets or dissolve a FLP before the due
date of an installment note. On the other hand, if there is substantial evidence that the
distribution or dissolution before the installment note due date was prearranged before the
formation of the FLP and the installment sale of the partner interest to the grantor trust,
the very existence of the FLP may be disregarded under IRC § 2703 or under substance
over form or step transaction principles. At a minimum, the amount of any discounts
claimed at the time of the installment sale will be vulnerable to an IRS challenge.
b. Guarantor's Gift Issues. It is possible that the IRS may argue
that any guarantee by the beneficiaries of the IDGT will result in taxable gifts from the
beneficiaries to the trust, as the IRS has asserted in the past. Of particular concern is
PLR 9113009, which the IRS withdrew in PLR 9409018 without any comment as to the
gift tax provisions of the previous ruling. In this ruling, a father guaranteed debts of
corporations in which his children were shareholders. The IRS found that these
guarantees were gifts to those children, citing an example under Reg § 25.2511-1(h)(1)
for the proposition that a transfer to a corporation is a gift from the donor to the
corporation's shareholders. The IRS may argue, at least in the absence of reasonable
guarantee fees, that the guarantee by the beneficiaries will effectively permit the
gratuitous use of the beneficiaries' credit for the benefit of the trust.
AT-1152260v1 26

If such an argument by the IRS is successful, it will clearly cause
gift tax problems for the beneficiary/guarantors, as well as possible estate, generationskipping,
and income tax problems. In all probability, if any guarantee results in a
taxable gift, it will be a future interest gift that will not be offset by the annual exclusion,
at least in the absence of withdrawal rights and notices, and will thus be a taxable gift to
the full extent of the value of the guarantee. See IRC § 2503(b). The timing and amount
of the gift, if any, is unclear. Probably the closest commercial analogy is a bank's charge
for a letter of credit. Generally, the bank makes an annual or more frequent charge for
such a letter. By analogy, there will be an annual gift, probably in the range of one to two
percent of the amount guaranteed, so long as the guarantee is outstanding. However, it
may also be argued that a much larger, one-time taxable gift will occur at the inception of
the guarantee, especially if the loan precludes prepayment. See Rev. Rul. 94-25, 1994-1
C.B. 191. The final possibility is that no gift will occur until a beneficiary actually has to
make a payment under the guarantee. In this event, the measure of the gift will
presumably be the amount of the payment under the guarantee. See Bradford v.
Commissioner, 34 T.C. 1059 (1960).
It is by no means a given that a guarantee by a beneficiary is a gift.
Instead, the clear weight of authority seems to support the absence of any gift by the
beneficiaries to the trust, at least where the guarantee is a bona fide obligation of the
beneficiary making the guarantee and where the beneficiary has sufficient net worth to
make good on the guarantee in the event of a default by the trust. See Hatcher and
Manigault, "Using Beneficiary Guarantees in Defective Grantor Trusts," 92 J. of
Taxation 152 (March, 2000), which sets forth a detailed rebuttal of a taxable gift being
imputed by reason of a bona fide, pro rata guarantee by an IDGT beneficiary.
3. Estate Tax Considerations.
a. Grantor's Estate Tax Issues.
(1) Retained Income Interests. The primary estate tax
risk is that because of the thin capitalization, the grantor may be regarded as having
retained an income interest in the trust within the meaning of IRC § 2036(a)(1). An
adverse finding will be the worst nightmare of the client (and the estate planner, if
adequate risk discussions have not taken place); the entire value of the trust's assets will
be includible in the grantor's gross estate for estate tax purposes.
Again, the initial question is how thin is too thin. Fidelity-
Philadelphia Trust Co. v. Smith, supra, and Rev. Rul. 77-193, 1977-1 C.B. 273, offer the
following three tests, all of which must be satisfied in "bootstrap" sale situations to
escape inclusion under IRC § 2036(a)(1):
• The size of the payments to the seller should not be based upon the
actual income of the assets sold to the trust.
• The assets sold should not be the sole source of the debt repayment.
AT-1152260v1 27

• The liability incurred should be a personal obligation of
transferee/purchaser.
There is substantial favorable authority, especially in the
private annuity area, holding on the basis of the facts in the particular case that IRC
§ 2036(a)(1) does not apply in "bootstrap" sales situations. See Cain v. Commissioner,
37 T.C. 185 (1961), acq. 1961-2 C.B. 4; Estate of Bergan, 1 T.C. 543 (1943), acq. 1943
C.B. 2; Estate of Becklenberg v. Commissioner, 273 F.2d. 297 (7th Cir. 1959); Lazarus v.
Commissioner, 513 F.2d 824 (9th Cir. 1975); LaFargue v. Commissioner, 689 F.2d 845
(9th Cir. 1982); Stern v. Commissioner, 747 F.2d 555 (9th Cir. 1984); and Estate of
Fabric v. Commissioner, 83 T.C. 932 (1984). See also Rev. Rul. 77-193, supra, which
involved 80% seller financing. But see Ray v. United States, 762 F.2d 1361 (9th Cir.
1985).
Applying the Fidelity-Philadelphia Trust Co. three part test
to the note and trust, and relying upon the other "bootstrap" sale cases and the IRC
§ 2701(a)(4) analogy cited in the grantor's gift tax discussion, the use of an "old and cold"
gift to provide at least 10% (or 11.1 percent) "seed" money should satisfy these tests by
providing a source of funding above and beyond the assets sold. This assumes that the
note provides for full recourse against the assets of the trust, including the assets
traceable to the "old and cold" gifts as well as those traceable to the sale. See Rev. Rul.
77-193, supra.
A guarantee of at least 10% (or 11.1%) of the initial note
principal, or possibly the highest projected balance due under the note if interest is
deferred, should also suffice. In Estate of Fabric, supra, an individual transferred to a
Cayman Islands trust stock with a fair market value exactly equal to the present value of a
private annuity, as determined under applicable Treasury Regulations. Under Cayman
Islands law, the trustee bank was liable for making any annuity payments if the trust
assets were depleted. Effectively, the trustee bank was a guarantor of the private annuity.
This extra source of funding was held by the Tax Court to be sufficient to avoid inclusion
of the trust's assets in the seller's gross estate under IRC § 2036(a)(1). Similarly, citing
Rev. Rul. 77-193, supra, the IRS has privately ruled that the guarantee of a child who had
sufficient personal wealth to satisfy her potential personal liability under her guarantee
provides the additional source of funding needed to avoid inclusion under IRC
§ 2036(a)(1). See PLR 9515039.
Under any circumstances, however, IRC § 2036(a)(1)
expressly excepts "a bona fide sale for an adequate and full consideration in money or
money's worth." Therefore, under the literal terms of IRC § 2036(a)(1), that statute
should not apply to a bona fide sale for full and adequate consideration. The IRS has
made it clear that a too thinly capitalized sale may be regarded as a part sale and part gift,
not as a bona fide sale for adequate and full consideration. That is a major reason for the
IRS caveating its generally favorable IDGT ruling by stating that that ruling would be
void if the promissory notes were subsequently determined to be equity, as opposed to
debt. See PLR 9535026.
AT-1152260v1 28

A bargain sale to the trust will clearly heighten the estate
tax risk, for the IRC § 2036(a)(1) exception for a bona fide sale for full and adequate
consideration will not apply. See PLR 9251004, which involved a "sale/gift," with the
bargain sale price representing a mere 30% of the fair market value of the property
transferred, but which was nonetheless held to be a transfer with a retained income
interest includible in the seller's gross estate under IRC § 2036(a)(1) (for reasons that are
difficult to fathom). To minimize the risk of such a bargain sale argument, it is advisable
to make any gift of "seed" money as far in advance of the IDGT transfer as is reasonably
possible so that the prior gift will be regarded as "old and cold" and thus separate and
distinct from the IDGT transfer. A reasonable lapse of time between a gift of "seed"
money and the IDGT transfer will not eliminate the bargain sale risk, however. If the
property sold to the trust in the IDGT transfer is undervalued, a bargain sale will occur,
and the potential for IRC § 2036(a)(1) to apply will increase appreciably. This risk of an
unintended bargain sale, and the resulting loss of the IRC § 2036(a)(1) exception for a
bona fide sale for full and adequate consideration, should temper any enthusiasm to take
an especially aggressive valuation position in an IDGT transaction. A premium should
be placed on relatively conservative valuations by well-qualified independent appraisers.
(2) Power to Substitute Assets of Equivalent Values.
Another estate tax issue is posed if the grantor retains the right to substitute assets with
equivalent values for assets held by the trust. Such substitution rights are likely to be one
of the principal means of qualifying the trust as a grantor trust for income tax purposes.
See IRC § 675(4)(C). Such a right of substitution has been held not to be a retained right
to alter, amend or revoke a trust and thus should not cause inclusion of the trust's assets in
the grantor's gross estate under IRC § 2038. See Estate of Jordahl v. Commissioner, 65
T.C. 92 (1975), acq. 1977-2 C.B. 1, PLR 9548013, and PLR 9227013.
Some concern has been expressed about the fact that the
grantor in Estate of Jordahl was acting in a fiduciary capacity, as noted by the Tax Court
in rendering its opinion. In contrast, grantor trust status under IRC § 675(4)(C) will not
be available if the grantor is acting in a fiduciary capacity. When one asset can be
exchanged only for another asset of equal value, the power should not be regarded as
anything more than an investment power conferring no rights which should cause
inclusion under IRC § 2036(a) or 2038(a)(1). See Mulligan, "Installment Sale to an
Intentionally Defective Irrevocable Trust: Is It Better Than a GRAT," 2000 Notre Dame
Estate Planning Institute, Ch. 13. But see Coleman, supra, at 25 (Feb., 2000), and
PLR 200120021, in which the IRS did not rule on a nonfiduciary power of substitution
(apparently in accordance with its policy of not ruling on whether a particular
nonfiduciary power of substitution, of and by itself, results in grantor trust status).
(3) Retained Right to Income Tax Reimbursement. If
the grantor is unwilling to be subject to "phantom" income tax liability on what would be
the IDGT's taxable income but for the fact that the IDGT is a grantor trust, the IDGT can
be structured to include an income tax reimbursement provision. Under such a provision,
so long as the trust continues to be a grantor trust for income tax purposes, the IDGT
would be required to make distributions to the IRS and state taxing authority for the
benefit of the grantor; such distributions would equal the additional income taxes payable
AT-1152260v1 29

y the grantor and attributable to the IDGT's taxable income. The IRS has ruled that such
a mandatory income tax reimbursement provision will not be a retained right to income
causing inclusion of the IDGT in the grantor's gross estate for estate tax purposes under
IRC § 2036(a). PLR 199922062. The IRS has even gone so far as to permit a
discretionary right to make a direct payment from the IDGT to the IRS or any state
taxing authority if the discretion is exercisable by a trustee or trust protector who is not
related or subordinate to the grantor within the meaning of IRC § 672. PLR 200120021.
(4) Valuation of Note. Escaping IRC §§ 2036 and 2038
does not mean escaping estate taxation. Although the value of the trust's assets as of the
date of death or alternate valuation date may not be includible in the grantor's gross
estate, the value of the note, or its proceeds, will be so includible. Based on normal estate
tax valuation, the actual fair market value of the note may vary materially from its face
amount and accrued interest, although the burden will be on the grantor's estate to prove
that any discounted value is appropriate. In this regard, Reg. § 20.2031-4 states that the
note will be presumed to have a fair market value equal to unpaid principal, plus accrued
interest, unless the executor establishes a lower value because of the interest rate, date of
maturity, doubtful collectibility "or other cause." See also Estate of Taylor v. United
States, 96-1 USTC 60,222 (S.D. Miss. 1996).
It is unclear under IRC § 7872, however, whether "normal"
estate tax valuation factors can be considered. By its terms, IRC § 7872 seems to apply
only to a determination as to whether a person has received a compensation-related loan
or a gift loan. However, IRC § 7872(h)(2) authorizes the IRS to issue coordinating estate
tax regulations, but only with respect to term loans "made with donative intent." The
proposed regulations initially seem to limit the estate tax coordination to "gift term loans"
(that is, term loans providing for interest below the appropriate applicable federal rates in
effect at the time the loans are made). See Prop. Reg. §§ 20.2031-4, 1.7872-3(a),
1.7872-4(b), and 20.7872-1. Despite this apparent limitation, Prop. Reg. § 20.7872-1
then concludes by taking what ostensibly is an inconsistent position:
"This section applies with respect to any term loan made
with donative intent . . ., regardless of the interest rate
under the loan agreement, and regardless of whether that
interest rate exceeds the applicable Federal rate in effect on
the day on which the loan was made."
If estate and gift taxes are required to be coordinated even
in the case of a term loan which does not provide for interest below the appropriate
applicable federal rate in effect at the time that the loan is made, and thus is not a "gift
term loan," the promissory note evidencing the loan will be valued for estate tax purposes
at the lesser of (1) the unpaid stated principal, plus accrued interest, or (2) the sum of the
present value of all principal and interest payments due under the note, using the date of
death applicable federal rate for a loan with a term equal to the remaining term of the
note. No discount will be allowable for collectibility considerations unless there has been
a demonstrably significant deterioration of the credit-worthiness of the borrower,
guarantor, or both subsequent to the initial loan. See Prop. Reg. § 20.7872-1.
AT-1152260v1 30

Interestingly, the Tax Court has recently held in Jones v.
Commissioner, supra, that a right to pay the purchase price in installments, basing
interest on the applicable federal rate in the event of a possible exercise of a right of first
refusal under a family limited partnership, justifies an additional lack of marketability
discount. It seems ironic that the mere possibility of an installment sale using applicable
federal rates warrants a material additional discount but that an installment note which
provides for interest at the applicable federal rates and which is issued by reason of an
actual sale is entitled to no discount or a significantly lesser discount.
The bottom line is that there is no clear guidance as to how
the note will be valued if the grantor dies before it is satisfied in full.
b. Guarantor's Estate Tax Issues. If the guarantee of a beneficiary
is not a gift for gift tax purposes, then presumably none of the trust assets should be
includible in the gross estate of the beneficiary/guarantor for estate tax purposes,
assuming that the assets are not otherwise so includible due to a general power of
appointment under the trust.
Buttressing the non-inclusion of any portion of the trust in the
gross estate of a beneficiary/guarantor for estate tax purposes is Goodnow v. United
States, 302 F.2d 516 (Ct. Cl. 1962), a case involving the payment of premiums on a trustowned
policy by a life insurance trust beneficiary. The IRS argued that the beneficiary
made a transfer with a retained income interest, causing inclusion under IRC
§ 2036(a)(1), but the Claims Court found that the beneficiary did not retain an interest in
the funds she transferred. Since a guarantee involves no actual transfer of funds by the
beneficiary/guarantor (absent a default by the trust under the installment note), the estate
of the beneficiary/guarantor should be in a materially stronger position than the estate of
a life insurance trust beneficiary who has paid one or more premiums on a trust-owned
policy.
4. Generation-Skipping Tax Considerations.
a. Grantor's Generation-Skipping Tax Considerations.
(1) Potential Generation-Skipping Advantages. An
IDGT is often touted, and appropriately so, as an excellent vehicle for generationskipping
planning, for it effectively leverages the GST exemption amount, which is
$1,000,000 (adjusted for cost-of-living increases) through the end of 2003 and
commencing again after 2010, and which increases serially from $1,500,000 to
$3,500,000 from 2004 through 2009. If the total return on the property in the trust
substantially exceeds the favorable IRC § 7872 applicable federal rate used in the
installment note, a veritable fortune can be passed along for the benefit of lower
generations without the imposition of gift, estate, or generation-skipping transfer taxes.
(2) No Estate Tax Inclusion. These generationskipping
advantages assume that the property transferred to the trust will not be
includible in the grantor's gross estate for federal estate tax purposes if he or she were to
AT-1152260v1 31

die. Otherwise, the GST exemption amount will be allocated only on the basis of the
value of the trust's assets when those assets will no longer be subject to estate tax
inclusion. See IRC § 2642(f).
(3) GST Exemption Amount Allocation. For transfers
before 2001, these generation-skipping tax advantages also assume that a GST exemption
allocation election is appropriately made on the grantor's timely filed gift tax return for
each year in which a gift is made to the trust. If the GST exemption allocation elections
are appropriately made on timely filed gift tax returns, the GST exemption allocations
can be based on date of gift values. Otherwise, values as of the date of any late allocation
election (or possibly values as of the first day of the month of the late allocation election)
will have to be used. See Reg. §§ 26.2632-1(b)(2) and 26.2642-2. If a timely allocation
election is not made, and if the trust's assets appreciate significantly, the potential
additional generation-skipping tax liability can be staggering. In this regard, it is
especially easy to forget to file a GST exemption allocation election for a small initial gift
made by the grantor to the trust. Such a small initial gift is especially likely if the
guarantee approach is used. A failure to make a timely GST exemption allocation
election with respect to a pre-2001 gift of $1,000 or less may literally prove to be a
multimillion dollar generation-skipping tax mistake, and an open invitation for a
malpractice suit against the professional who is responsible for the late allocation.
Realizing the patent unfairness of these elective GST
exemption allocation rules, Congress has provided relief, but generally only for certain
transfers after 2000. An allocation of the requisite unused portion of the transferor's GST
exemption amount will automatically be made for any indirect skip to a GST trust
occurring after 2000. IRC § 2632(c).
Newly added IRC § 2642(g)(1) may also provide
extensions for late elections with respect to pre-2001 transfers, but the scope of any such
retroactive relief remains to be defined by regulations.
b. Guarantor's Generation-Skipping Tax Considerations. Without
any taxable gift by a beneficiary/guarantor, there should not be any generation-skipping
transfer by that beneficiary/guarantor. See Reg. § 26.2611-1. However, if the IRS
successfully argues that a gift results from a guarantee by a beneficiary/guarantor, then
the beneficiary will be treated as a transferor for purposes of GST taxes. Administration
of a non-GST exempt trust, or partially non-GST exempt trust, with multiple transferors
will be a true challenge.
D. Comparison of Advantages and Disadvantages of Installment Sales to Grantor
Trusts. From a purely economic perspective, an IDGT will generally be superior to any
of the other freeze structures for a wealthy individual with a normal life expectancy.
Overall, an IDGT will be tough to beat, although it does have some significant
drawbacks.
1. Advantages. The advantages of IDGTs include (1) the lowest
permissible interest rates, (2) the ability to backload interest and principal payments,
AT-1152260v1 32

(3) the potential leveraging of debt service payments, (4) the additional estate planning
benefit that the grantor may be required to pay all income tax liabilities attributable to the
IDGT's taxable income, (5) the potential use of the IDGT as an excellent generationskipping
tax avoidance vehicle, and (6) the ability to combine use of the IDGT with other
freeze techniques.
a. Lowest Rates. Of all of the freeze vehicles, the IDGT offers
the lowest interest rates, generally by a significant margin. For July, 2001, the short-term
AFR, assuming annual payments, is 4.07%, the mid-term AFR is 5.12%, and the longterm
AFR is 5.82%. The IDGT's ability to use the AFRs as the basis for its interest rates
puts the IDGT on the same credit footing as the U.S. Treasury, even though the IDGT
will be a much less credit-worthy borrower.
In contrast, the stated interest rate payable by a GRAT will be
120% of the mid-term AFR. For July, 2001, that stated interest rate is 6.2%. If mortality
and possible exhaustion factors need to be taken into account, the effective interest rate
may be considerably higher.
Similarly, preferred rates are not only higher, but also are based on
the credit-worthiness of the partnership issuing the preferred interests. There are no safe
harbor preferred rates. For July, 2001, the preferred rates for a credit-worthy partnership
are likely to range from 7.0% to 7.75%, although various factors may warrant even lower
or higher rates.
b. Backloading. Assuming that a partnership's total return is
expected to exceed the interest factor or its equivalent of the respective freeze vehicle, the
shifting of value to or for younger generations will benefit from deferring payments, to
the maximum extent possible, to the senior family member setting up the freeze vehicle.
interest and principal.
An IDGT installment note may provide substantial backloading of
Of all of the freeze techniques, the IDGT offers the greatest
flexibility in regard to the deferral of interest, for there is no requirement that any
payments be made annually or more frequently.
There are practical limits, however, on the length of deferral.
Excessive deferral may raise the question of whether the installment note should be
classified as debt or equity. The classification of the installment note as debt should not
be jeopardized by a term of up to 20 to 25 years if all interest is payable currently. A
shorter term, such as 15 to 18 years, is probably in order if a significant amount of
interest is deferred.
Only a preferred partnership offers competitive backloading
potential. In fact, the preferred partnership's equivalent of the principal component of an
IDGT does not have to be paid until the partnership dissolves, which is likely to be well
beyond the recommended term for an IDGT's installment note.
AT-1152260v1 33

In contrast, a "zeroed out" GRAT will rarely extend for more than
a 2 to 3 year term, and very substantial payments must be made at least annually.
c. Leveraging of Debt Service Payments. An installment sale of a
FLP interest to an IDGT potentially serves as an excellent vehicle for leveraging
payments of debt service, for debt service on the installment note will be satisfied with
undiscounted distributions from the FLP to the IDGT which are attributable to FLP
interests purchased by the IDGT for discounted values.
EXAMPLE: Assume that a 50% limited partner interest in a FLP
with $2,000,000 of underlying assets is sold to an IDGT for
$600,000, representing a 40% discounted value, in July, 2001. The
annual interest payments will be $30,720, representing the July,
2001 5.12% mid-term applicable federal rate. If the FLP annually
distributes 4% of its net asset value, calculated as of the first day of
the year, to its partners in proportion to their respective percentage
interests, the IDGT will receive $40,000 during the first year of the
sale. This 4% distribution, based on undiscounted underlying asset
values of the FLP, will more than cover the 5.12% annual interest
payment charged on the discounted sales price.
The leveraging potential afforded by annual or other periodic
distributions from the FLP to the IDGT may even outweigh the benefits of deferring all
payments of principal and interest until the maturity date of the note and then satisfying
the outstanding balance in kind with discounted FLP interests held by the IDGT.
If deferral is sought, it may make more sense to accumulate the
annual or other periodic FLP distributions to the IDGT in an invested sinking fund held
by the IDGT. The balance in that sinking fund will then be available to satisfy at least
part of the outstanding balance owed under the installment note at the time of its
maturity. Such a sinking fund approach not only will offer the potential return leveraging
advantages of deferrals but will also enable the IDGT to leverage its debt service
payments by making payments with undiscounted FLP distributions which are
attributable to FLP interests purchased for discounted values.
d. Estate Planning Benefits of Phantom Income. An IDGT is a
grantor trust for income tax purposes. Effectively, the IDGT's taxable income will be
taxed to the grantor, even though the grantor will not be a trust beneficiary. This
"phantom income" can bring about two related estate planning benefits. First, the assets
in the IDGT can accumulate without reduction to pay income taxes, thus facilitating the
IDGT's satisfaction of its installment note obligations. Second, the grantor's payment of
his or her income tax liability attributable to taxable income from the IDGT will serve to
reduce his or her personal net worth, which should ultimately result in additional estate
tax savings.
The grantor needs to be in the financial position, however, to be
able to pay all IDGT-related income tax liabilities. Since the size of the ultimate income
AT-1152260v1 34

tax liability payable by reason of the "phantom income" from the IDGT is not readily
predictable, a grantor may be understandably reluctant or unwilling to assume this openended
liability.
e. Generation-Skipping Planning. An IDGT is an excellent
vehicle to leverage use of the GST exemption amount and maximize generation-skipping
tax avoidance planning. No other freeze vehicle, when used alone, will come close to
offering the same generation-skipping tax avoidance advantages. As a result, an IDGT is
often structured as a "dynasty" trust continuing for the benefit of two or more generations
below the grantor.
f. Tandem Use of Freeze Vehicles. An IDGT may be used very
effectively in conjunction with one or more other freeze vehicles, especially a preferred
partnership. The tandem use of freeze structures may operate collectively as the
proverbial freeze vehicle on steroids.
2. Disadvantages. An IDGT has certain significant disadvantages,
including (1) the need for "seed" gifts or guarantees, (2) possible adverse income tax
consequences if the grantor passes away before the installment note is satisfied, (3) a
higher valuation risk, (4) the complexity of explanation, and (5) the absence of express
statutory sanction.
a. "Seed" Gifts or Guarantees. To meet anecdotal safe harbors, a
grantor of an IDGT must make at least a 10% (or 11.1 percent) "seed" gift, or trust
beneficiaries must guarantee at least 10% (or 11.1%) of the initial principal balance of the
installment note. If the "seed" gift approach is taken, taxable gifts in excess of the
applicable exclusion amount for gift tax purposes, which is $675,000 for 2001 (or
$1,350,000 if the grantor and his or her spouse split gifts) and is scheduled to increase to
$1,000,000 after 2001 (or $2,000,00 for split gifts), will result in a gift tax liability.
"Seed" gifts or guarantees accentuate risks of economic
underperformance by the partnership. If the partner interests held by the IDGT
experience a total return which is less than the interest payable by the IDGT, taxable gifts
may be wasted (that is, the gifts, valued as of the dates on which they are made, will be
includible in the grantor's estate tax base as "adjusted taxable gifts," even though the
gifted assets decline in value or become worthless), or the trust beneficiaries who are
guarantors may be required to make good on their guarantees. Therefore, an IDGT may
not be the appropriate vehicle if the underlying partnership assets are volatile.
b. Possible Adverse Income Tax Consequences of Grantor's
Premature Death. If the Grantor dies before the installment note is satisfied in full, the
income tax consequences are, at best, uncertain.
There is a very distinct possibility that the basis of the IDGT's
partner interests will not be stepped up by reason of the grantor's death.
income tax liability.
There is even a possibility that the grantor's death may trigger an
AT-1152260v1 35

c. Higher Valuation Risks. Inherently, the value of the FLP
partner interests sold to the IDGT is not quantifiable with certainty. Valuation is an art,
not a science, and the IRS's artistic perceptions may vary materially from those of the
grantor of the IDGT and his or her appraiser. If the sales price to the IDGT is ultimately
determined to be less than the actual value, the excess of the finally determined value
over the sales price will be a taxable gift for gift tax purposes.
Potentially even more importantly, especially for a grantor who is
older or in poor health, a bargain sale will increase the possibility that the assets in the
IDGT will be includible in the grantor's gross estate for estate tax purposes if the grantor
dies before the installment note is fully satisfied, or even within three years after the
satisfaction of that note. The bona fide sale for adequate and full consideration exception
to IRC § 2036(a)(1) will not apply if a bargain sale is found to have occurred. If the
grantor is otherwise found to have retained the right to income from the IDGT because of
his or her interest in the installment note, which is by no means a given, the value of the
assets in the IDGT will be includible in the grantor's gross estate under IRC § 2036(a)(1).
As a result of this higher valuation risk, there may be an incentive
to be relatively conservative in valuing the FLP partner interests sold to the IDGT.
d. Complexity of Explanation. The basic structure of an
installment sale is relatively easy to explain. However, experience has shown that it is
extremely difficult for a would-be grantor/seller to grasp the tax complexities, especially
the income tax liability on "phantom income" and the possible income tax risks of a
premature death. This complexity of explanation should by no means be an
insurmountable hurdle, but its potential dampening effect should not be underestimated.
e. Absence of Express Statutory Sanction. The installment sale to
a grantor trust is the only one of the three most commonly used freeze techniques which
does not have an express statutory sanction. This absence of an express statutory
sanction should not be a major factor, however, for the IRS has issued favorable private
rulings and those private rulings appear to be supported by applicable law. See
PLRs 9436006 and 9535026.
IV.
GRANTOR RETAINED ANNUITY TRUSTS
A. GRAT Overview. A grantor retained annuity trust ("GRAT") involves a trust
structure under which the grantor retains the right to annuity payments for a specified
term (the "GRAT term"). At the end of the GRAT term, the property remaining in the
GRAT after the grantor receives all retained annuity payments will be distributed to, or
held in trust for, remainder beneficiaries designated in the GRAT agreement.
From an estate planning perspective, the objective of the GRAT is to limit any
taxable gift to the value of the remainder interest, which should be materially less than
the value of the property initially contributed to the GRAT. The value of the remainder
interest is determined by subtracting the value of the "qualified" annuity payments
retained by the grantor from the value of the property initially contributed to the GRAT.
AT-1152260v1 36

If the "qualified" retained annuity payments are set at sufficiently high levels, the value of
the GRAT's remainder interest conceptually should be zero, although the IRS takes the
position that any transfer to a GRAT will result in at least some taxable gift, even if it is
very small when compared with the value of the property initially contributed to the
GRAT. A GRAT which is structured to have a remainder interest with a zero value (but
for the IRS's imputing at least some value through application of a mortality or possible
exhaustion factor) is commonly referred to as a "zero" GRAT or a "zeroed out" GRAT.
For retained annuity payments to be "qualified," they must meet certain statutory
and regulatory requirements, including, without limitation, the following:
• The payments must be made at least annually. See Reg. §§ 25.2702-
3(b)(1)(ii)(A) and (B) and 25.2702-3(b)(3)
• The annual payments must be a specified dollar amount or a specified
fraction or percentage of the initial value of the property contributed to
the GRAT. See Reg. § 25.2702-3(b)(1)(ii)(A) and (B).
• Under no circumstances may the retained annuity payments for any
year exceed the retained annuity payments for the immediately
preceding year by more than 20%. See Reg. § 25.2702-3(b)(1)(ii)(A)
and (B).
• Additional contributions to the GRAT must be prohibited by the
GRAT agreement. See Reg. § 25.2702-3(b)(5).
• The grantor's retained annuity payments must stop at the end of a fixed
term. The GRAT term will generally run either for a specified term of
years or until the earlier of a specified term of years or the grantor's
death. See Reg. § 25.2702-3(d)(3).
• No one other than the grantor may receive any distributions from the
trust during the GRAT term. See Reg. § 25.2702-3(d)(2).
• The retained annuity payments may not be prepaid. See Reg.
§ 25.2702-3(d)(4).
• The GRAT agreement must explicitly bar use of a GRAT note, other
debt instrument, option, or similar financial arrangement to satisfy a
retained annuity payment to the grantor. See Reg. § 25.2702-3(d)(5).
If any of these statutory or regulatory requirements are not met, the
retained annuity payments will not be "qualified" and will be deemed to have a zero value
for gift tax purposes. As a result, the full value of the property contributed to the GRAT
will be treated as a taxable gift by the grantor.
AT-1152260v1 37

EXAMPLE: Assume that during July, 2001, a grantor contributes FLP
limited partner interests with a value of $1,000,000 to a 2-year "zeroed
out" GRAT which provides for annual annuity payments to the grantor on
the first and second anniversaries of the GRAT. Disregarding the IRS's
mortality and possible exhaustion factors, each of these two annual
annuity payments will equal 54.69560% of the initial value of the property
contributed to the GRAT, as finally determined for federal gift tax
purposes. If these retained annuity payments are otherwise "qualified,"
the $999,999.65 present value of such payments will be treated as having
been retained by the grantor, and only the $0.35 difference between the
initial $1,000,000 contribution and the present value of the retained
annuity payments will be regarded as a taxable gift.
In contrast, if the GRAT agreement does not expressly bar satisfaction of a
retained annuity payment with a note from the GRAT, the retained annuity
payments will not be "qualified," and the grantor will be deemed to have
made a $1,000,000 taxable gift.
Certain stated interest assumptions are built into a GRAT. These stated interest
assumptions are revised each month. For July, 2001, the stated interest assumptions are
6.2%. The effective interest rate may be significantly higher than these stated interest
assumptions, however, in light of mortality factors and possible exhaustion factors which
the IRS insists on using. A GRAT serves as an effective freeze technique only if the total
return on the GRAT's assets materially exceeds the effective interest rate, in which event
the economic benefits of such excess return will be shifted to the GRAT's remainder
beneficiaries.
EXAMPLE: Assume that a 60 year old grantor transfers FLP limited
partner interests with a value of $1,000,000 to a 2-year "zeroed out"
GRAT. The grantor retains the right to receive "qualified" annual annuity
payments of 54.69560%, or $546,956, on the first and second
anniversaries of the GRAT formation. Using IRS assumptions, including
mortality and possible exhaustion factors, the grantor will be treated as
having made a taxable gift of $12,306.86 upon the formation of the
GRAT.
If the annualized total return on the GRAT's assets turns out to be 12%,
the remainder beneficiaries will receive $94,853 at the end of the 2-year
GRAT term.
If the annualized total return proves to be only 6.2%, the stated interest
assumption, the remainder beneficiaries will receive nothing.
B. GRAT Advantages. A GRAT offers four principal advantages over
alternative freeze techniques. First, a GRAT serves as a hedge against economic
underperformance. Second, it minimizes gift tax audit risks. Third, a "zeroed out"
GRAT does not require a substantial taxable gift by the grantor, a significant guarantee
AT-1152260v1 38

y the remainder beneficiaries, or a substantial contribution by other family members.
Fourth, a GRAT is probably the easiest freeze technique for a practitioner to explain and
for a client to understand.
1. Economic Underperformance Hedge. If the total return from the
GRAT's assets during the GRAT term does not exceed the effective interest rate (that is,
the stated interest assumption, adjusted for mortality and possible exhaustion factors if
the IRS has its way), all of the GRAT's assets will be returned to the grantor in the form
of the retained annuity payments. The only real downsides are (1) that the comparatively
small taxable gift, if any, resulting from the formation of the GRAT may waste part of the
grantor's applicable exclusion amount for gift tax purposes and may have triggered a gift
tax liability to the extent that the grantor's applicable exclusion amount for gift tax
purposes is exhausted and (2) that such taxable gift will be includible in the grantor's gift
and estate tax base for purposes of determining any subsequent gift or estate tax liability.
In light of the fact that the GRAT functions well as an economic
underperformance hedge, a GRAT is likely to be the freeze vehicle of choice for
relatively volatile assets. If the assets go down in value, the downside risk will be
limited. On the other hand, if the assets go up in value by an amount materially in excess
of the GRAT's effective interest rate, substantial value will be shifted to the GRAT's
remainder beneficiaries. In such an upside setting, the shifted value may not be as much
as the value which could have been shifted through use of another freeze technique with a
lower interest rate, such as an installment sale to a grantor trust, but the results should still
be good, if not optimal.
2. Minimization of Gift Tax Audit Risks. A GRAT can be structured to
minimize any gift tax audit risk by defining the retained annuity payments as a specified
percentage of the initial value of the property contributed to the GRAT, as finally
determined for federal gift tax purposes. See Reg. § 25.2702-3(b)(1)(ii)(B).
If the value of the contributed assets is ultimately determined to be more
than the value initially reported on the grantor's gift tax return, there may be a
comparatively small increase in the amount of the taxable gift. The primary
consequence, however, will be a make-up payment to the grantor to put him or her in the
same position which he or she would have enjoyed if the contributed assets had been
properly valued at the inception. See Reg. §§ 25.2702-3(b)(2) and 1.664-2(a)(1)(iii).
If the final gift tax value is determined to be less than initially reported,
the grantor will be required to restore any annuity overpayments to the GRAT. See Reg.
§§ 25.2702-3(b)(2) and 1.664-2(a)(1)(iii). Also, there may be a comparatively small
downward adjustment in the amount of the taxable gift.
If the property contributed to a GRAT consists of an interest in a FLP,
valuation is an inherent risk, for experience has shown that, all too often, the IRS believes
that the values of FLP interests are materially understated on the gift tax returns of the
donors or other transferors of those FLP interests. If a would-be transferor of a FLP
interest tends to be risk averse and wants to limit his or her potential gift tax exposure, a
AT-1152260v1 39

GRAT may be the freeze vehicle of choice. There will be much less incentive for the
IRS to challenge the reported value of the property contributed to a GRAT, and even if
the IRS does successfully contest the reported value, the resulting deficiency, if any, is
not likely to be too great, at least in relative terms.
3. Absence of "Seed." It is generally believed that an installment sale to
a grantor trust will require either a prior gift or a guarantee by a credit-worthy trust
beneficiary in an amount that is at least 10% (or 11.1%) of the installment sale price.
Similarly, if a FLP is recapitalized, the value of the nonpreferred interests after the
recapitalization must equal at least 10% of the value of the partnership interests plus all
partnership debt to the extent that family members are the lenders.
In contrast, by definition, the contribution to a "zeroed out" GRAT is
intended to have a value equal to the actuarial value of the grantor's retained annuity
payments. No equity kicker or guarantee by a trust beneficiary is required. Thin
capitalization is the norm, not the problem.
4. Relative Simplicity. Probably the foremost advantage of the GRAT
over other freeze techniques is more practical than legal. Of all of the freeze techniques,
the GRAT is the easiest to explain to, and to be understood by, a client. If a client knows
what an annuity is, and most obviously do, then the explanation of the GRAT is relatively
straightforward.
C. GRAT Disadvantages. When compared with other freeze options, GRATs
have a number of significant disadvantages. First, the effective interest rates tend to be
higher, and may very well be the highest of all of the basic freeze alternatives. Second,
the timing and amount of the GRAT's payments to the grantor are inflexible. Third,
annual valuations of the FLP interests used to satisfy the grantor's retained annuity
payments will probably be required. Fourth, if the grantor dies before the end of the
GRAT term, there is a very distinct possibility that the assets remaining in the GRAT will
be includible in the grantor's gross estate for federal estate tax purposes. Fifth, a GRAT
is far from an ideal vehicle for generation-skipping tax planning. Sixth, it may be more
advisable to include a tax reimbursement provision in a GRAT, and such a provision may
lessen the freeze benefits. Seventh, a GRAT cannot be used to freeze the value of a QTIP
marital trust. Eighth, a GRAT is not an appropriate vehicle for annual gifting.
1. Effective Interest Factor.
a. Stated Interest Factor. All too often, the interest or rate focus is
limited to the stated interest factor. The value of the grantor's retained qualified annuity
interest is determined on the basis of the IRC § 7520 rates, which in turn use 120% of the
mid-term applicable federal rates, compounded annually. IRC § 2702(a)(2)(B) and
7520(a). These IRC § 7520 rates are redetermined monthly. IRC § 7520(a)(2). For July,
2001, the IRC § 7520 rate is 6.2%.
b. Other Factors. This stated interest factor is deceptive,
however, for the IRS takes the position that mortality and potential exhaustion factors
AT-1152260v1 40

must also be taken into account. Especially for an older grantor, the mortality factor may
dramatically increase the effective interest rate, even for a short-term "zeroed out"
GRAT. When the potential exhaustion factor is also taken into account, there is a distinct
possibility that the "zeroed out" GRAT may be the least rate effective of all of the estate
freeze options.
Furthermore, these mortality and potential exhaustion factors are
not only used by the IRS to inflate the effective interest factor, but according to the
Service, they make a zeroing out of the value of the GRAT remainder interest impossible.
Under this IRS approach, there will always be some taxable gift when a GRAT is used.
Therefore, use of the term "zeroed out" GRAT is a misnomer if the IRS position
ultimately prevails, although the Tax Court has already ruled against this IRS position in
one situation which will be discussed below.
(1) Mortality Factor. The grantor's retained annuity
interest may continue until the earlier of a specified term, such as 2 or 3 years, or the
grantor's death. Under this structure, use of a mortality factor to calculate the value of the
grantor's retained annuity interest is clearly appropriate.
Much more problematic is an alternative GRAT structure
under which the grantor retains an annuity interest for a specified term. If the grantor
dies during that specified term, the remaining annuity payments will be paid to the
grantor's estate. When IRC § 2702 was initially passed, few practitioners anticipated that
the IRS would try to interject a mortality factor where a specified term GRAT structure is
used. The IRS did exactly the opposite of what was generally expected, however, when it
issued regulations including the infamous "Example 5." Reg. § 25.2702-3(e), Example 5
provides that the grantor's retained annuity interest is to be valued as though the grantor
retains the right to receive an annuity until the earlier of the specified term or the grantor's
death, even though the GRAT itself calls for annuity payments to be made for the full
specified term to the grantor or, if the grantor dies during that specified term, to the
grantor's estate. The IRS's position in Example 5 has recently been found to be invalid by
the Tax Court. See Walton v. Commissioner, 115 T.C. No. 41 (2000). See also
McCaffrey and Schneider, "The Flaw in Example 5: Did the 2702 Regs. Try to Extend
the Repeal of the Doctrine of Worthier Title," 93 J. of Taxation 219 (Oct. 2000), for a
comprehensive, in-depth analysis of why Example 5 should be overturned. Whether the
IRS will continue to contend that Example 5 is valid remains to be seen. Unless and until
the validity of Example 5 is finally determined, a conservative planner may still want to
take into account the downside risk posed by a mortality factor.
Another technique designed to minimize the mortality
factor has not met with success. A contingent marital provision was touted for several
years as a means of circumventing, or at least mitigating, the mortality factor. Under this
approach, the GRAT would call for any remaining annuity payments during the specified
term to be payable to the grantor's spouse or to a marital trust if the grantor died during
the specified term, but the grantor would reserve the right during the specified term to
revoke the provision for the spouse or marital trust. In first Cook v. Commissioner, 115
T.C. 15 (2000), and then Schott v. Commissioner, T.C. Memo. 2001-110, this contingent
AT-1152260v1 41

marital provision approach was held by the Tax Court to be ineffective as a means of
reducing the mortality factor.
(2) Possible Exhaustion Factor. The mortality factor
makes sense, at least where the grantor retains an annuity interest until the earlier of the
end of the specified term or the grantor's death. If the grantor dies before the end of the
specified term, the grantor will receive less, and the remainder beneficiaries will receive
more. To avoid a taxable gift, then, the retained annuity can be increased by an amount
that will enable a "zeroing out" of the value of the remainder interest after taking into
account both the IRC § 7520 interest factor and the mortality factor. As a result of the
increased annuity payments retained by the grantor, the total return on the GRAT assets
must be more, and possibly materially more, than the IRC § 7520 stated interest rate, or
nothing will be left for the remainder beneficiaries.
Through some strange twist of logic, the IRS argues that
this possibility that nothing will be left for the remainder beneficiaries of the GRAT
increases the amount of the taxable gift. See Reg. § 25.7520-3(b)(2) and Rev. Rul. 77-
454, 1977-2 C.B. 351. Furthermore, in a "zeroed out" GRAT context, the potential
exhaustion factor can be material even if the grantor is comparatively young. See also
PLR 9248016, which seems to indicate that an even higher possible exhaustion factor
may be appropriate if the GRAT permits highly speculative investments. If the IRS's
possible exhaustion factor position is sustained, it will be impossible to "zero out" any
GRAT. Any contribution to a GRAT will trigger some taxable gift by the grantor. Such
a taxable gift reinforces the premise that the effective interest rate for a GRAT will, under
the IRS approach, be materially higher than the IRC § 7520 stated interest rate.
Whether the IRS's possible exhaustion factor position will
be sustained, if challenged, is highly questionable. In the one case in which a similar
position was taken by the IRS, the Tax Court rejected a possible exhaustion factor
argument on the grounds that this "anomalous IRS position" was inconsistent with the
fundamental actuarial assumptions and "would vitiate the use of [published actuarial
assumptions]. . . as a bright-line approach to valuation." See Estate of Shapiro v.
Commissioner, T.C. Memo. 1993-483. See also Walton v. Commissioner, supra, which
seems to be at odds conceptually with the IRS's possible exhaustion factor position.
c. Illustration. The following example demonstrates the extent to
which the effective interest rate may be materially greater than the IRC § 7520 stated
interest rate.
EXAMPLE: A grantor, who is age 60, wants to contribute a FLP limited
partner interest with a value of $1,000,000 to a 2-year "zeroed out" GRAT
during July, 2001. If "zeroing out" can be accomplished strictly on the
basis of the 6.2% IRC § 7520 stated interest rate in effect for July, 2001,
the two annual annuity payments will need to be $546,956. When
mortality and possible exhaustion factors are taken into account, however,
a $12,306.86 taxable gift will result if the two annual annuity payments
AT-1152260v1 42

equal $546,956 each. The resulting effective interest rate will increase to
approximately 7.09%.
If the grantor wants to offset the mortality factor, he or she can increase
the two retained annual annuity payments to $553,770.80 each. Without
taking into account any possible exhaustion factor, the effective interest
rate will still be approximately 7.09%. If the possible exhaustion factor is
also taken into account, a taxable gift of $12,223.79 will be deemed to
have occurred, and the effective interest rate will be increased to
approximately 7.98%.
2. Timing of Payments. Of all of the freeze techniques, GRATs are the
most inflexible when it comes to the timing and amount of payments. The retained
annuity payments must be made in specified amounts, or specified percentages of the
initial GRAT contributions, at specified times. Not only may the prescribed payments
not be deferred, but they also may not be accelerated.
a. Limits on Backloading. For a "zeroed out" GRAT to make
economic sense, the grantor should believe that the total return on the GRAT's assets will
exceed the GRAT's effective interest rate. Otherwise, the GRAT's assets will be
exhausted by the end of the retained annuity term. If in fact the total return on the
GRAT's assets exceeds the GRAT's effective interest rate, the desired shift in value to the
remainder beneficiaries can be maximized if the retained payments to the grantor can be
"backloaded" and paid at the end of the retained annuity term.
Unfortunately, there are strict limits on backloading:
• Retained annuity payments must be made at least annually. See Reg.
§§ 25.2702-3(b)(1)(ii)(A) and (B) and 25.2702-3(b)(3). If retained
annuity payments are scheduled for the end of each calendar year, or at
the end of each calendar month, quarter, or semiannual period during
the calendar year, actual payments can be deferred temporarily until
the due date for the trust's or grantor's income tax return for the
particular year without regard to extensions, which will generally be
April 15. See Reg. § 25.2702-3(b)(4). Otherwise, all retained annuity
payments must be made on their scheduled due dates, or within 105
days after such scheduled due dates. See Reg. § 25.2702-3(b)(4).
• The payments made for a particular year may not exceed 120% of the
amounts payable during the prior year, irrespective of whether the
retained annuity payments are defined in terms of a stated dollar
amount or a fixed percentage of the initial value of the property
contributed to the trust. See Reg. § 25.2702-3(b)(1)(ii)(A) and (B).
Thus, although the retained annual annuity payments do not have to be
equal in amount, those payments may not increase by more than 20%
per year.
AT-1152260v1 43

The economic effects of the restrictions on backloading can be
graphically demonstrated by using an example.
EXAMPLE: Assume that a 35 year old grantor contributes FLP limited
partner interests with a value of $1,000,000 to a 2-year, "zeroed out"
GRAT during July, 2001. The grantor assumes that the total return on the
GRAT assets will be a consistent, annually compounded 12%, and in fact
those assumptions prove to be true.
If the GRAT provides for equal annual payments of $546,956, the "zeroed
out" amount (without regard to a possible exhaustion factor), the
remainder beneficiaries will receive $94,853 at the end of the two year
GRAT term.
If the "zeroed out" GRAT calls for a retained annuity payment at the end
of the second year which is 20% higher than the first year's payment, the
first year's payment will be $498,603.50 and the second year's payment
will be $598,324.20 in order to "zero out" the GRAT (again without
regard to a possible exhaustion factor). At the end of the 2-year GRAT
term, the remainder beneficiaries will receive $97,640. This represents the
maximum permissible backloading.
If the GRAT is permitted to defer all payments until the end of the 2-year
GRAT term and make a $1,127,844 balloon payment to the grantor on the
second anniversary of the GRAT, representing the initial $1,000,000
contribution increased by an annually compounded 6.2% rate (the July,
2001 IRC § 7520 stated interest rate), the remainder beneficiaries will
receive $126,556 (assuming that mortality and possible exhaustion factors
are not applicable). Such a balloon payment structure resembles another
freeze technique, the installment sale to a grantor trust with deferred
interest payments, although the 6.2% stated interest rate applicable to a
GRAT established in July, 2001, will be materially higher than the 4.07%
annually compounded rate which would apply to a July, 2001 short-term
installment sale. Unfortunately, a GRAT does not permit such
backloading.
Shortly after the passage of Chapter 14 in 1990, a number of wellrespected
commentators suggested that backloading could be accomplished by
indirection, even if it could not be accomplished directly. In lieu of making a timely
distribution of trust assets with a value equal to the scheduled payments, the GRAT
would issue a promissory note to the grantor. This note would provide for interest to
accrue at the short-term applicable federal rate, with semiannual compounding. A
balloon payment of principal and all accrued interest would then be made at the end of
the two year GRAT term. The IRS has cracked down on such indirect backloading. A
1999 amendment of the regulations now bars issuance of a GRAT note in satisfaction of
a retained annuity payment to the grantor. Reg. § 25.2702-3(b)(1) and (c)(1). Not only is
payment in the form of a note from the GRAT now barred in operation, but a GRAT
AT-1152260v1 44

created after September 20, 1999 must include an express provision which precludes
payment in the form of the GRAT's note. See Reg. § 25.2702-3(d)(5).
b. Limits on Acceleration. The grantor's retained annuity
payments may not be prepaid. See Reg. § 25.2702-3(d)(4). At first blush, this may not
appear to be much of a concern, especially after the discussion of the economic merits of
deferring the retained payments to the maximum extent possible. Rarely, however, does
appreciation in the value of the GRAT's underlying assets occur at a consistent pace.
Instead, especially in momentum-driven markets, values fluctuate widely. Periods of
overvaluation, using traditional measures, are likely to be followed by dropping prices
and periods of undervaluation. Furthermore, stock prices tend to be seasonal. Rising
stock prices during the first half of the calendar year often come back to earth during the
September and October period. Although the September and October swoons may
represent excellent opportunities to set up a GRAT, waiting until a following September
or October to make a retained annuity payment may not be the optimal timing.
Unfortunately, the GRAT restrictions on prepayments, as well as deferrals, limit the
grantor's flexibility to take advantage of perceived overvaluation situations.
3. Annual Valuations. If the GRAT holds only the FLP interests
contributed to it and comparatively limited cash distributions from the FLP, the grantor's
retained annuity payments will need to be satisfied largely with in-kind distributions of at
least part of the FLP interests held by the GRAT. Such in kind distributions are likely to
require expensive and time-consuming annual appraisals of the FLP interests.
4. Mortality Risks. The possibility that the grantor of the GRAT may die
before the end of the GRAT term poses two problems.
The first has previously been discussed. A mortality factor may increase
the effective interest rate. If the grantor is older, the increase in the effective interest rate
may be substantial.
The second risk involves an actual death during the GRAT term and may
prove to be much more costly from a tax perspective. If the grantor dies during the
GRAT term, will all or part of the balance in the GRAT at the time of the grantor's death
be includible in the grantor's gross estate for federal estate tax purposes
Many practitioners have taken the position that only the value of the
grantor's retained annuity payments, calculated as of the date of the grantor's death on the
basis of the IRC § 7520 rates then in effect, will properly be includible in the grantor's
estate. Under this analysis, any remaining balance in the GRAT over and above the value
of the retained annuity payments will escape inclusion in the grantor's gross estate.
This possible partial inclusion argument does have support in the context
of IRC § 2036(a)(1), which includes in the gross estate transferred assets to the extent
that the decedent/transferor retains an income interest. The IRS has held, in the context
of a charitable remainder annuity trust, that only that part of the trust corpus needed to
pay the retained annuity, using return assumptions prescribed by regulation, is includible
AT-1152260v1 45

in the deceased grantor's gross estate. See Rev. Rul. 82-105, 1982-1 C.B. 133. The IRS
has extended this ruling position to GRATs by holding that, under IRC § 2036(a)(1), only
the value of the grantor's retained annuity payments, determined as of the date of death
through use of the IRC § 7520 rates then in effect, will be includible in decedent's gross
estate. See PLR 9345035 and FSA 200036012.
IRC § 2036(a)(1) unfortunately is not the only estate tax provision which
needs to be considered. In the same rulings which concluded that only part of the GRAT
was includible under IRC § 2036(a)(1), the IRS has found that the entire balance is
includible under IRC § 2039(a) and (b), which includes in the gross estate annuities to the
extent that the decedent is the source of payments or contributions for those annuities.
According to the IRS, the term "annuity," for purposes of IRC § 2039(a), applies not only
to the grantor's retained annuity payment rights but also to the payment rights of the
remainder beneficiaries upon the grantor's death during the GRAT term. See
PLR 9451056, PLR 9345035, and FSA 200036012. Therefore, according to the IRS, the
entire balance in the GRAT at the grantor's death is includible under IRC § 2039(a).
A persuasive argument can be made that IRC § 2039 should not apply to
the GRAT remainder interest if the GRAT provides for a specified term that does not
terminate upon the grantor's death. At least for planning purposes, however, it should
probably be assumed that the value of the entire balance remaining in the GRAT at the
time of the grantor's death during the GRAT term will be includible in his or her estate.
But see Handler and Dunn, "'Guaranteed GRATs: GRATs Without Mortality Risk," 138
Tr. & Est. 30 (1999), in which the authors propose a sale of the grantor's contingent
reversion as a means of overcoming the mortality risk. The downside risks of mortality
can be minimized by having each of a husband and wife set up a separate GRAT, by
structuring a remainder interest to qualify for the marital deduction if the grantor's spouse
survives, or by shortening the GRAT term to the shortest reasonable period, such as 2 or
3 years. Notwithstanding these defensive steps, the best advice is that the grantor not die
during the GRAT term.
5. Generation-Skipping Tax Exemption Limits. Optimal freeze planning,
at least from a purely tax perspective, involves a shift in value for the benefit of children
and more remote descendants without incurring a transfer tax liability at the transferor's
generation level and for as many generations as possible below the transferor. Hence, if
an individual makes a transfer to a trust as part of a freeze plan, the results will be best if
as much of the initial contribution and subsequent appreciation as possible is not subject
to gift or estate tax at the transferor's generation level and escapes any estate or
generation-skipping tax liability at the children's and more remote descendants'
generation levels.
It is commonly believed that a GRAT cannot be effectively used as a
generation-skipping tax avoidance technique. This is an overstatement. It is more
accurate to state that other freeze techniques lend themselves much more readily to
generation-skipping tax planning.
AT-1152260v1 46

The key to generation-skipping tax planning involves taking maximum
advantage of the IRC § 2631 GST exemption amount. Through 2003 and then again after
2010, up to $1,000,000 of transfers, adjusted for cost-of-living increases, may qualify for
the IRC § 2631 GST exemption amount. From 2004 through 2009, the GST exemption
amount is scheduled to increase from $1,500,000 to $3,500,000. The problem is that no
allocation of part or all of the GST exemption amount to a transfer to a GRAT will be
effective so long as the GRAT will be includible in the grantor's gross estate if the
grantor then dies. See IRC § 2642(f). Since the IRS takes the position that the GRAT
will be fully includible in the grantor's gross estate if he or she dies during the GRAT
term, an allocation of the unused portion of the grantor's GST exemption amount will not
be permitted prior to the end of the GRAT term and will then be based on the value of the
GRAT assets as of the end of the GRAT term.
The bottom line is that a freeze may be accomplished for gift and estate
tax purposes when the GRAT is initially set up, but any freeze for generation-skipping
tax purposes will be postponed until the end of the GRAT term.
EXAMPLE: Assume that a grantor contributes a FLP limited partner
interest with a value of $1,000,000 to a 2-year "zeroed out" GRAT.
If the grantor was able to make an allocation of his or her GST exemption
amount as of the formation of the GRAT, the transfer would be
comparatively small, and little, if any, of the grantor's GST exemption
amount would need to be used to make the remainder interest of the
GRAT exempt from generation-skipping taxes. No allocation is
permitted, however, as of the formation of the GRAT or at any other time
prior to the end of the 2-year GRAT term.
Assume further that the GRAT assets experience a windfall gain. As a
result, $2,000,000 is distributed at the end of the two year GRAT term to
the remainder beneficiary, a dynasty trust for children and more remote
descendants which will continue for the maximum period permitted by the
rule against perpetuities. At the time of the distribution to the remainder
trust, the GST exemption amount is $1,500,000. Assuming that the
remainder trust is a GST trust and that the grantor has not previously used
any of his or her GST exemption amount, the entire $1,500,000 GST
exemption amount will automatically be allocated to the transfer to the
remainder trust at the end of the two-year GRAT term. IRC § 2632(c)(4).
The remainder trust will thus be 75% exempt and 25% nonexempt. If a
distribution is subsequently made to a grandchild, 25% of that distribution
will, except in 2010, be subject to a generation-skipping tax at the thenapplicable
rate, which will range from 45% to 55%. Alternatively, the
residuary trust might be divided into two separate trusts, a $1,500,000 trust
which is fully exempt and an $500,000 trust which is fully nonexempt.
See IRC § 2642(a)(3).
AT-1152260v1 47

In contrast, if an installment sale to a grantor trust had been used instead
of a GRAT, a GST exemption allocation would have occurred at the inception, with the
result being the use of very little, if any, of the GST exemption amount and a wholly
exempt grantor trust. All post-sale appreciation in value ultimately shifted to the grantor
trust, and all subsequent distributions from that trust to the grantor's grandchildren or
more remote descendants, would be free from any generation-skipping tax liability.
An indirect generation-skipping planning technique has been suggested. If
a child of the grantor receives a vested remainder interest upon the formation of the
GRAT but is willing to forego any benefits after the grantor's death, that child can make a
gift of the vested remainder interest to a trust for that child's descendants and may be able
to make such trust GST exempt by using only a comparatively small amount of that
child's GST exemption. See Gossman and Gulecas, "Comparing the GRAT to the
Installment Sale to a Defective Grantor Trust, And Who's Afraid of the Exhaustion
Test," 14 No. 1 Prac. Tax Law 43, 45 (Fall, 1999). But see PLR 200107015, a
charitable lead trust ruling which indicates by analogy that the grantor still may be
regarded as the transferor of the largest part, if not all, of the GRAT.
Similarly, a sale of a remainder interest by the GRAT remaindermen to a
"dynasty" trust for the fair market value of the remainder has been suggested. See
Handler and Oshins, "GRAT Remainder Sale to a Dynasty Trust," 138 Tr. & Est. 20 (Dec.
1999).
6. Tax Reimbursement. Since the grantor retains the rights to annuity
payments which will come from the income and principal of the GRAT, the GRAT, in its
entirety, will be treated as a grantor trust for federal income tax purposes. See IRC
§ 677(a)(1) and (2). See also IRC § 671 and Reg. § 1.671-3(a)(1). As the owner of the
grantor trust, the grantor will be taxed on all items of income, deduction, and credit of the
GRAT, including capital gains and losses. See IRC § 671 and Reg. § 1.671-3(a)(1).
Effectively, the existence of the GRAT will be disregarded for federal income tax
purposes, and any additional income tax liability attributable to the GRAT's taxable
income will be the grantor's personal obligation, although some states give the grantor the
right to reimbursement from a grantor trust for the income taxes attributable to the
income of that trust. See Matter of Davis, 148 Misc. 2d 37, 559 N.Y.S. 2d 993 (1990).
In at least one private letter ruling, the IRS has held that an addition to a
GRAT may result from the GRAT's failure to make a tax distribution to the grantor, over
and above the grantor's retained annuity payments, to reimburse the grantor for the excess
of any GRAT-related personal income tax liability for a particular year over the retained
annuity payments for that year. See PLR 9416009. Since additions to a GRAT are
expressly prohibited, this private letter ruling raises the specter that a failure to include
such a tax reimbursement provision in a GRAT may disqualify it and cause the initial
contribution to be treated in full as a taxable gift. Whether the private letter ruling in
question involved a state which permits income tax reimbursement is not clear, although
there is no indication that any state law reimbursement right was determinative or even a
factor. If state law entitled the grantor to reimbursement, the ruling would be much more
understandable. Furthermore, it is not clear whether the IRS is continuing to take the
AT-1152260v1 48

position that a failure to include an income tax reimbursement provision authorizes a
prohibited additional contribution, thus causing the GRAT to be disqualified, or whether
the failure to make an income tax reimbursement amounts to a prohibited additional
contribution, thus causing the GRAT to be disqualified. In reconsidering the same ruling
request, the IRS deleted the provision in the initial ruling which seemed to indicate that
an addition to a GRAT may result if an income tax reimbursement is not made and
instead held, without comment, that a GRAT including a tax reimbursement provision
will satisfy the GRAT requirement, including the prohibition of additions. Compare
PLR 9416009 with PLR 9543049. See also PLRs 9352007, 9352004, and 9345035.
From a tax-oriented estate planning perspective, it is preferable for the
grantor to pay the full income tax liability with his or her personal funds, thus reducing
his or her ultimate gross estate for estate tax purposes. Therefore, any required inclusion
of a tax reimbursement provision in a GRAT is a drawback.
As a practical matter, however, inclusion of a tax reimbursement provision
in a 2 or 3 year "zeroed out" GRAT may not pose a major problem unless the GRAT
realizes an economic windfall or unless the GRAT has substantial taxable income during
a short year during which only a comparatively small annuity payment, if any, is received
by the grantor. Generally, the grantor's income tax liability attributable to the 2 or 3 year
"zeroed out" GRAT will not exceed the very substantial annuity payments retained by the
grantor for a particular year during the 2 or 3 year GRAT term. The GRAT will probably
need to throw off taxable income that is more than 2 times the initial value of the
property contributed to the GRAT before the grantor's GRAT-related personal income tax
liability will exceed his or her retained annuity payments for the respective year.
EXAMPLE: Assume that a 45 year old grantor residing in Florida, which
has no personal income tax, contributes a FLP limited partner interest with
a value of $1,000,000 and a basis of $100,000 to a newly formed GRAT.
The contribution is made on July 1, 2001. The GRAT calls for two
retained annual annuity payments of $546,956 each as of the first and
second anniversaries of the GRAT formation. The FLP realizes a windfall
gain during 2002, the calendar year including the first anniversary of the
GRAT. The GRAT's allocable share of the FLP long-term capital gain is
$2,500,000. This long-term capital gain will be taxable to the grantor,
resulting in a $500,000 personal income tax liability. Because this
$500,000 personal income tax liability is less than the $546,956 retained
annual annuity payment for the year, no income tax reimbursement will be
due even if an income tax reimbursement provision is included in the
GRAT.
In contrast, if the allocable long-term capital gain is $3,000,000 instead of
$2,500,000, or if the gain is realized at the end of 2001, a year in which no
retained annual annuity payments are received by the grantor, an income
tax reimbursement provision would force an actual income tax
reimbursement to be paid to the grantor, irrespective of whether that is the
grantor's preference.
AT-1152260v1 49

Given the possible IRS position that an income tax reimbursement
provision may be a precondition for GRAT qualification, and given the likelihood, or at
least distinct possibility, that a reimbursement will not be required even if such a
provision is included, the inclusion of an income tax reimbursement provision in a
"zeroed out" GRAT generally may be advisable even in a state which does not give the
grantor a right of income tax reimbursement from a grantor trust, and will definitely be
advisable in a state where the grantor has a right of reimbursement.
7. No QTIP GRAT. Any gift of an interest in a marital trust for which a
qualified terminable interest property election has been made (a "QTIP marital trust")
runs a risk of triggering a much greater taxable gift than may initially be apparent. See
IRC § 2519. A QTIP marital trust poses at least two problems if a GRAT is the preferred
estate freeze technique. First, the trust instrument generally will not authorize one trust to
establish another, especially when the trust in question is a QTIP marital trust. Even if
this first hurdle can be overcome, the normal rules for calculating the taxable gift
resulting from a GRAT are not likely to control when the transfer to the GRAT is from a
QTIP marital trust. There is a distinct possibility that the value of the property
contributed to the GRAT, reduced by the value of the surviving spouse's life estate as of
the date of the GRAT formation, will be a taxable gift. See IRC § 2519 and Reg.
§ 25.2519-1. This is likely to cause a much larger taxable gift than will be the case if a
QTIP marital trust is not involved.
This potential problem may be circumvented if the QTIP marital trust
permits an encroachment on corpus for the surviving spouse in a sufficient amount to
fund the GRAT. If authorized by the QTIP marital trust, the trustee can exercise its
encroachment power. The surviving spouse will then be in a position to use the assets
distributed from the QTIP marital trust to fund the GRAT.
8. No Annual Exclusion Gifts. The gift under a GRAT will consist of a
remainder interest distributable at some future date. Only a gift of a present interest will
qualify for the $10,000 annual exclusion. See IRC § 2503(b). Therefore, a GRAT is not
an appropriate vehicle for a $10,000 annual exclusion gift.
V. PREFERRED PARTNERSHIP RECAPITALIZATIONS
A. Preferred Partnership Recapitalization Introduction. The "orphan" FLP freeze
planning technique is the preferred partnership recapitalization. Even though preferred
partnerships have express statutory sanction under IRC § 2701, they are probably the
least understood and least utilized freeze option. In many instances, other freeze options
will be preferable. In other instances, however, preferred partnerships and preferred
partnership recapitalizations should be considered, either on a stand-alone basis or in
conjunction with one or more other freeze techniques.
B. Structure. Since preferred partnership recapitalizations have received
comparatively little attention, a more detailed description of the mechanics of the
technique will be provided. For an in-depth, three-part analysis, see Hatcher and
Manigault, "Warming Up To The Freeze Partnership," Estate & Personal Financial
AT-1152260v1 50

Planning (June, 2000), Hatcher and Manigault, "Freeze Partnerships Against the World -
- Is My Freeze Better Than Your Freeze (Part One)," Estate & Personal Financial
Planning (Aug., 2000), and Hatcher and Manigault, "Freeze Partnerships Against The
World -- Is My Freeze Better Than Your Freeze (Part Two)," Estate & Personal
Financial Planning (Sept., 2000). See also Hatcher and Kniesel, "Preferred Limited
Partnerships -- Now the FLPs of Choice," 89 J. of Taxation 325 (Dec. 1998), and Dees,
Using a Partnership to Freeze the Value of Pre-IPO Shares," 33 U. Miami Philip E.
Heckerling Inst. on Est. Plan., Ch. 11 (1999).
1. Basics of Preferred Recapitalization. The preferred recapitalization
consists of the issuance of preferred general or limited partner interests ("preferred
interests") in exchange for nonpreferred FLP general or limited partner interests. The
intent is that the preferred interests received in the recapitalization will have a value equal
to the nonpreferred FLP interests which are given up in the exchange.
EXAMPLE: A FLP holds marketable securities with a value of
$3,000,000. The FLP has two partners. Mother owns general and limited
partner interests entitling her to 66 b% of the economic benefits of the
FLP. Mother's pre-capitalization FLP interests, which represent a
controlling interest, are valued at $1,400,000, which takes into account a
30% lack of marketability discount. Son owns general and limited partner
interests entitling him to 33 a% of the economic benefits of the FLP.
Son's noncontrolling FLP interests are valued at $600,000, which factors
in a 40% combined lack of marketability and lack of control discount.
Mother has become increasingly frustrated with declining dividends and
fluctuating stock prices. She wants more security and current income.
Son is willing to accept less current cash flow in exchange for rights to
more of the ultimate appreciation. As a result, Mother agrees to swap all
of her nonpreferred FLP interests with a pre-recapitalization value of
$1,400,000 for preferred interests with a 7.25% cumulative annual net
cash flow preference, a $1,400,000 dissolution preference, and a
$1,400,000 post-recapitalization appraised value. In the aftermath of the
recapitalization, Son will hold all of the nonpreferred interests, which will
be entitled to all economic rights not held by the preferred interests. All
voting rights will remain the same. Mother's preferred interests will
continue to control to the same extent that her pre-recapitalization FLP
general and limited partner interests gave her control.
a. Preferred Interests. The economic rights of the holder of
preferred interests closely resemble the rights of preferred stockholders, although there
will be no double taxation at both the entity and equity holder levels as would be the case
for a corporation with an issued and outstanding class of preferred stock:
(1) Safety and Security. Cumulative annual net cash
flow and dissolution preferences will make the preferred interests much safer and more
secure than the pre-recapitalization nonpreferred interests.
AT-1152260v1 51

(a) Cumulative Annual Net Cash Flow Preferences.
The preferred interests will have a preferential right to partnership net cash flow. This
net cash flow preference is generally expressed as a specified percent of the stated
dissolution preference, although a variable rate is also permitted if that variable rate has a
fixed relationship to a specified interest rate. See IRC § 2701(c)(3)(A) and (B) and Reg.
§ 25.2701-2(b)(6)(ii). The net cash flow preference must be payable (but not necessarily
paid) at least annually. See Reg. § 25.2701-2(b)(6)(i). The net cash flow preference must
also be cumulative. See IRC § 2701(c)(3)(A) and Reg. § 25.2701-2(b)(6)(i)(B). If the
particular year's net cash flow is not sufficient to pay the annual amount, the net cash
flow preference shortfall for the respective year will be carried over from year-to-year
thereafter and will be paid when a later year's net cash flow is adequate to pay the prior
year's shortfall. If the shortfall for a particular year is paid within four years after the due
date, no interest will be charged on the delinquent payment. See IRC § 2701(d)(2)(C).
Otherwise, the delinquent payment will increase retroactively from the original due date
at the same annually compounded rate as the specified rate of the net cash flow
preference (that is, 7.25% in the above example). See IRC § 2701(d) and Reg.
§ 25.2701-4. There is thus a material incentive to have the annual net cash flow
preference satisfied not later than four years after its due date if it cannot be satisfied by
the due date.
EXAMPLE: In the recapitalization, Mother receives a preferred interest
with a $1,000,000 dissolution preference and a 7.25% cumulative annual
net cash flow preference, payable on the last day of each calendar year.
No partnership cash flow is available to pay the $72,500 annual net cash
flow preference due December 31, 2001. If the full $72,500 is paid by
December 31, 2005, no additional annual net cash flow preference
payment will be owed with respect to 2001. If no payment is made by that
date, however, $95,924 will be owed for 2001 as of January 1, 2006, and
any unpaid balance owed as of each December 31 thereafter will
compound at a 7.25% rate.
(b) Dissolution Preference. If the partnership
dissolves, the holders of the preferred interests will receive the stated dissolution
preference before any liquidating distributions are made to the holders of the
nonpreferred interests.
(2) Cap on Upside Participation. The greater safety and
security enjoyed by the holders of the preferred interests will be accompanied by an
important trade-off. The dissolution and net cash flow preferences will put an effective
cap on the value of the preferred interests, subject to possible swings in preferred return
rates generally. Not surprisingly, many older partners may be more prone to hedge their
risks and maximize their current distributions by opting for preferred interests, even if
they forego participation in any increase in the value of the partnership's assets except to
the extent of the preferred interests' net cash flow preferences.
b. Nonpreferred Interests. The nonpreferred interests will
generally consist of nonpreferred general partner interests and nonpreferred limited
AT-1152260v1 52

partner interests. The primary difference between these classes of nonpreferred interests
typically relates to management and voting rights. The nonpreferred general partner
interests will have the right to manage the partnership, or share management with any
preferred general partner interests, but many important actions, such as dissolution of the
partnership, the withdrawal of a partner, the transfer of a partner interest, disproportionate
distributions to the partners, and the sale of substantially all of the partnership's assets,
are likely to require the approval of a majority, a supermajority, or even all of the
nonpreferred and preferred limited partner interests as well as the general partner
interests.
Economically, the partnership's managers are entitled to reasonable
compensation. Otherwise, as a general rule, the nonpreferred general partner interests
and limited partner interests proportionately share distributions from the partnership,
including dissolution proceeds as well as periodic net cash flow distributions, but only
after the preferred interests' dissolution and net cash flow preferences are satisfied.
Because the rights of the nonpreferred interests are subordinate to
the dissolution and net cash flow preferences of the preferred interests, the nonpreferred
interests are riskier. To the extent that the partnership capitalization is more heavily
weighted toward preferred interests, the nonpreferred interests become that much riskier.
However, the upside potential for the nonpreferred interests is correspondingly greater.
Any increase in the value of the partnership's assets, whether attributable to net cash flow
or appreciation in value, will be allocable to the nonpreferred interests once the preferred
interests' net cash flow preferences are fully satisfied. Thus, the nonpreferred interests
inherently have a higher risk, and a higher potential for reward, than the preferred
interests. Younger partners with longer term investment horizons may especially be
attracted to nonpreferred interests, although older partners may also want to preserve a
greater upside potential by opting for some nonpreferred interests (especially
nonpreferred general partner interests) as well as preferred interests.
EXAMPLE: A FLP holds $3,000,000 of assets as of January 1, 2001, the
effective date of a recapitalization. Immediately prior to the
recapitalization, Mother holds controlling general and limited partner
interests entitled to 66 b% of all economic benefits. The value of those
interests is $1,400,000, representing the allowance of a 30% lack of
marketability discount from her $2,000,000 allocable share of the
partnership's underlying asset value. All remaining FLP interests are held
by Son.
In the recapitalization on January 1, 2001, Mother receives a preferred
interest with at least the same voting rights, a $1,400,000 dissolution
preference, and a 7.25% cumulative annual net cash flow preference. Son
continues to hold noncontrolling nonpreferred interests, which may
represent all of the nonpreferred interests.
If the value of the partnership's assets doubles to $6,000,000 by the end of
2001, Mother's preferred interest will have a right to ultimate dissolution
AT-1152260v1 53

proceeds of $1,400,000 and to a $101,500 annual net cash flow
preference. At most, then, Mother will have a right, either on a current or
deferred basis, to $1,501,500 of the partnership's $6,000,000 of assets. All
other economic rights will redound to the benefit of Son. On a liquidation
basis, son will have a right to $4,498,500 of the $6,000,000 of partnership
assets, or more than four times his $1,000,000 allocable share of the
underlying partnership assets immediately prior to the recapitalization,
although the present value of Son's nonpreferred interests will be much
less than that (assuming that he, acting alone, does not have the right to
dissolve the partnership).
In contrast, if the value of the partnership assets declines by 50% from
$3,000,000 to $1,500,000 during 2001, Mother, as the holder of all of the
preferred interests, will have a current or deferred claim to all $1,500,000
of the partnership's assets. The $1,500,000 decline in value will be borne
almost entirely by Son's nonpreferred interests, although Mother's net cash
flow preference will also be at risk. On a liquidation basis, the investment
by Son will be wiped out.
2. Impact of Chapter 14. The tax rules involving preferred limited
partnerships were drastically changed first in 1986 by legislation which was subsequently
repealed and then by the adoption of Chapter 14 in 1990. In particular, IRC § 2701 is
aimed at many of the abuses or perceived abuses of preferred limited partnerships during
the early 1980s.
a. Impact on Preferred Interests. IRC § 2701 impacts the value of
preferred interests in preferred limited partnerships in the following manner:
(1) Cumulative Net Cash Flow Preference. Only a
preferred interest with a cumulative net cash flow preference will be valued. Any
noncumulative cash flow preference feature of a preferred interest will be treated as
having no value. See IRC § 2701(a)(3)(A) and (c)(3) and Reg. § 25.2701-1(a)(2)(ii). But
see IRC § 2701(c)(3)(C)(ii), which permits certain distribution rights not otherwise
meeting the definition of "qualified payments" to be treated as "qualified payments."
Effectively, any contribution for a preferred interest with a noncumulative net cash flow
preference feature will, in the absence of an election to treat the noncumulative payments
as "qualified payments," be considered a transfer, and thus a potential gift, to the holders
of the nonpreferred interests.
(2) Valuations Based on Economic Fundamentals.
Preferred interest values must be sustained on the basis of solid economic fundamentals
comparable to those which support the values of publicly traded nonconvertible preferred
stocks, such as yield and the safety of the dividend and liquidation preferences. To the
extent that the cumulative net cash flow preference, the coverage of that cumulative net
cash flow preference, and the protection of the dissolution preference are not sufficient to
sustain a value of the preferred interest equal to the value of the property contributed for
it, the holder of the preferred interest will be deemed to have made a transfer, and thus a
AT-1152260v1 54

possible gift, to the holders of the nonpreferred interests. See Reg. § 25.2701-1(a)(2) and
Rev. Rul. 83-120, 1983-2 C.B. 170.
(3) Disregard of Most Liquidation, Put, Call, and
Conversion Rights. Value enhancing "bells and whistles" used during the early 1980s to
support the values of preferred interests at or about their dissolution preferences will be
ignored. These value enhancing "bells and whistles" which will be ignored include most
liquidation, put, call, and conversion rights of the preferred interests. See IRC
§ 2701(a)(1) and (3)(A), (b)(1)(B), and (c)(2) and Reg. § 25.2701-1(a)(2)(i). Therefore,
the value of the preferred interests cannot be artificially buttressed to support a value
approximating the dissolution preference.
(4) Ten Percent Minimum Value Rule. The value of
the nonpreferred interests must equal at least 10% of the value of all of the partner
interests, plus the total indebtedness owed by the partnership to family members. See
IRC § 2701(a)(4) and Reg. § 25.2701-3(c). This is the so-called "10% minimum value
rule" which is designed to assign at least some significant value to the right of the
nonpreferred interests to benefit from all increase in the value of the partnership's assets
above and beyond the preferred interests' cumulative net cash flow preference.
b. Impact on Nonpreferred Interests. Nonpreferred interest
valuations are also materially effected by Chapter 14:
(1) Shift in Value from Preferred Interests. As noted
above, to the extent that IRC § 2701 causes the value of the preferred interests to be
treated as less than the value of the property contributed for those preferred interests, the
holders of those preferred interests will be deemed to have made a transfer to the holders
of the nonpreferred interests. See Reg. §§ 25.2701-1(a)(2) and 25.2701-3.
(2) Ten Percent Minimum Value Rule. The 10%
minimum value rule will artificially inflate the value of the nonpreferred interests to at
least 10% of the sum of the value of all partner interests and the total indebtedness owed
by the partnership to family members. This assumes that the value of the nonpreferred
interests is otherwise less than 10% of the sum of the value of all partner interests and the
total indebtedness owed by the partnership to family members. See IRC § 2701(a)(4) and
Reg. § 25.2701-3(c).
(3) Restrictions on Liquidation or Withdrawal Rights.
Restrictions on the dissolution of the partnership or possibly on a nonpreferred partner's
withdrawal rights may be disregarded for purposes of valuing the nonpreferred interests
unless one of several exceptions applies. See IRC § 2704(b) and Reg. § 25.2704-2(a) and
(c). But see Kerr v. Commissioner, supra, Estate of Harper v. Commissioner, supra,
Knight v. Commissioner, supra, and Jones v. Commissioner, supra, all of which indicate
that only restrictions on liquidation, not restrictions on a partner's withdrawal, may be
disregarded under IRC § 2704(b) if the liquidation restrictions are more onerous than
under state law. Most importantly, a partnership restriction on dissolution or withdrawal
will not be disregarded to the extent that the partnership restriction in question is no more
AT-1152260v1 55

onerous than any state law restriction which would apply if the partnership agreement is
silent (the "state law default provision"). See IRC § 2704(b)(3)(B) and Reg. § 25.2704-
2(b). Also, any partnership restriction on dissolution or withdrawal which can be
removed only with the approval of a partner who is not a family member will not be
disregarded. See IRC § 2704(b)(2)(B)(ii) and Reg. § 25.2704-2(b).
(4) Transfer Restrictions. Restrictions on the transfer
or use of the nonpreferred interests which go beyond the state law default provisions may
be ignored for valuation purposes unless it can be established that the respective
restriction represents a bona fide business arrangement, is not a device to make a bargain
transfer to family members, and is comparable to similar restrictions in arm's length
transactions. See IRC § 2703. See also Church v. United States, supra, and Estate of
Strangi v. Commissioner, supra.
c. Applicability of Standard Valuation Principles Otherwise.
Except for the important exceptions noted above, the standard rules apply to the valuation
of nonpreferred interests. Fair market value is the price at which the nonpreferred
interest will change hands between a hypothetical willing buyer and willing seller, neither
being under any compulsion to buy or to sell and both having reasonable knowledge of
relevant facts. See Reg. § 20.2031-3. Minority interest and lack of marketability
discounts continue to be allowable unless one of the specific Chapter 14 valuation rules
limits use of any such discounts. See Conference Committee Report, H.R. 5835, 101st
Cong., at 157 (October 27, 1990), which states that minority and other "fragmentation
discounts" may still be taken into account. See also Reg. § 25.2701-3(b)(4), which is
phrased in terms of "minority or similar discounts." PLR 9447004 confirms that a lack of
marketability discount should be taken into account as well as a minority interest
discount.
(1) Lack of Marketability Discounts. Chapter 14
should, at a minimum, permit lack of marketability discounts with respect to nonpreferred
interests for partnership restrictions on dissolution, withdrawal, and transfer which are no
more onerous than the state law default provisions, and many of the state law default
provisions, reflecting the traditional restrictions on transfers of partner interests, are as
onerous as any partnership restrictions can be. For example, most state law default
provisions historically have required the consent of all partners or a supermajority of all
partners to the voluntary dissolution of a limited partnership and have required the
consent of other partners to transfers of general and limited partner interests.
Furthermore, an increasing number of states are adding default provisions which preclude
a limited partner's withdrawal, although few, if any, states have restricted a general
partner's withdrawal. To the extent that the state law default provision permits a general
or limited partner to withdraw, that withdrawing partner will generally only be entitled to
the "fair value" of his or her partner interest. The "fair value" of the partner interest is
likely to be considerably less than the partner would receive as a liquidation value.
(2) Lack of Control Discounts. The legislative history
of Chapter 14 and the IRC § 2701 regulations expressly allow minority interest, or lack of
control, discounts. See Conference Committee Report, supra, which states that minority
AT-1152260v1 56

and other "fragmentation discounts" may still be taken into account. See also Reg.
§ 25.2701-3(b)(4) and PLR 9447004. As a result of many of the state law restrictions on
the exercise of management rights by limited partners, the allowable minority interest, or
lack of control, discounts for limited partner interests may be substantial. A general
partner may also be in a minority position, either because he or she owns less than a
majority of the outstanding general partner interests or because he or she owns less than
the supermajority interest required by the partnership for voting control. In contrast, a
"controlling" general partner interest may be entitled to no lack of control discount, or
possibly even a control premium in unique circumstances, although that general partner
may own only a small percentage of the equity in the limited partnership. However, state
law generally imposes significant fiduciary restraints on a general partner's control, and
such fiduciary restraints will typically warrant a discount (whether that discount is
subsumed in the lack of marketability discount, which is the norm, or is phrased as a lack
of control discount.)
(3) Greater Combined Discounts for Nonpreferred
Interests Due to Subordinate Status of Nonpreferred Interests. The bottom line is that
nonpreferred interests, and especially nonpreferred limited partner interests, should be
entitled to substantial discounts for lack of marketability and minority interest.
Furthermore, because the nonpreferred interests are subordinate to the dissolution and net
cash flow preferences of the preferred interests, the allowable discounts may be
significantly greater than they would be in the absence of preferred interests. Where the
dissolution preference and accrued net cash flow preference represent a very substantial
percent of the partnership net asset value, the allowable discounts should be quite
substantial, for a nonpreferred partner may effectively be locked into an investment
which is not likely to throw off any distributions in the near future and which will
disproportionately bear the risk of loss in the event of a decline in value of the
partnership's underlying assets.
EXAMPLE: Mother and Son are partners in a FLP. Mother holds
controlling general and limited partner interests which are entitled to
66 b% of all economic benefits but does not have the unilateral right to
dissolve the partnership under either the partnership agreement itself or the
default provision of state law. Son owns the remaining FLP interests
which are noncontrolling and are entitled to 33 a% of all economic
benefits. The FLP holds assets with a $3,000,000 value and a current
yield of 1 2%, or $45,000 per year, which approximates the yield on
Standard & Poor's 500 index. The full $45,000 yield is being currently
distributed, with Mother receiving $30,000 during the year and Son
receiving $15,000 during the year. Based on these voting rights and
economic entitlements, an independent appraiser determines that Mother's
FLP interests are properly valued at $1,400,000 by applying a 30% lack of
marketability discount to the underlying net asset value and that Son's
interests are properly valued at $600,000 by applying a 40% combined
minority interest and lack of marketability discount.
AT-1152260v1 57

Mother then swaps her FLP interest for a preferred interest with a
$1,400,000 dissolution preference, a $101,500 (or 7.25%) cumulative
annual net cash flow preference, and a $1,400,000 appraised value. This
$101,500 per annum cumulative net cash flow preference is materially
greater than the partnership's projected annual net cash flow for the next 8
to 10 years, although projected capital appreciation over time and the right
to make capital gains and in kind distributions are expected to be more
than sufficient to satisfy the cumulative net cash flow preference and the
$1,400,000 dissolution preference of the preferred interests. Son
continues to hold noncontrolling nonpreferred interests, which now
represent all nonpreferred interests. Son no longer will receive an annual
distribution and does not expect to receive any distribution for at least 8 to
10 years. Furthermore, the first risk of loss will be borne by Son's
nonpreferred interests. In light of the subordinate status of Son's
nonpreferred interests, combined lack of marketability and lack of control
discounts in the 45% to 50% range could reasonably be supported for this
illiquid asset that is potentially volatile, comparatively risky, and nonincome
producing. The combined discounts for the nonpreferred interests
after the recapitalization should be at least 5 to 10 percentage points
greater than the allowable discounts before the recapitalization because of
the subordination of the nonpreferred interests to the economic
preferences of the preferred interests.
d. Subtraction Method of Valuation. The key to IRC § 2701 is
the subtraction method of valuation. See Reg. §§ 25.2701-1(a)(2) and 25.2701-3. This is
required to be used not only upon the formation of a preferred partnership but also upon
the conversion of an interest in a standard FLP into a preferred interest and upon transfers
of nonpreferred partnership interests by partners who also hold preferred interests. Reg.
§ 25.2701-1(b)(2). See IRC § 2701(e)(5).
The basics of the subtraction method are fairly straight-forward
and initially appear to create significant potential gift risks. The value of the preferred
interests is subtracted from the value of all property contributed by the family to a newly
formed partnership or from the value of all family-owned interests in an existing
partnership, and the balance is allocated proportionately among the nonpreferred
interests. See Reg. § 25.2701-3(a). As noted previously, the IRC § 2701 rules are
intended to make the value of the preferred interest dependent upon substance and not
smoke and mirrors, thus increasing the possibility of transfers and potential gifts to the
holders of the nonpreferred interests. However, this oversimplified summary of the
subtraction method fails to give sufficient weight to the extent to which a preferred
partner's nonpreferred interests and the lack of control discounts allowable for the
nonpreferred interests of other partners may greatly reduce the amount of any potential
gift.
(1) Valuation of Preferred Stock. The starting point
under the subtraction method is the valuation of the preferred interests. IRC § 2701
principles are first applied. Therefore, preferred interests with noncumulative net cash
AT-1152260v1 58

flow preferences are generally treated as having no value, and such value enhancing
"bells and whistles" as liquidation, put, call and conversion rights are usually ignored for
valuation purposes. The remaining features of the preferred interests are then valued on
the basis of normal valuation methodology, without regard to IRC § 2701 and its special
valuation principles. See Reg. § 25.2701-1(a)(2).
There has been considerable confusion concerning how the
preferred interests should be valued after IRC § 2701 principles are applied. Although
there are no precise safe harbor formulas to rely on as there are in other areas, such as
loans (the applicable federal rate) and GRATs (120% of the mid-term applicable federal
rate), there is probably more guidance from the IRS than is commonly known. Revenue
Ruling 83-120, supra, sets forth reasonably detailed guidelines for valuing preferred
interests. The primary considerations, according to this Revenue Ruling, are yield,
dividend coverage, and protection of the liquidation preference. See Rev. Rul. 83-120,
supra, at Sec. 4.01. Other considerations, such as voting rights (including possible voting
control) and lack of marketability, are expressly secondary, although they play some role.
See Rev. Rul. 83-120, supra, at Secs. 4.01, 4.05, and 4.06.
(a) Yield. Yield is evaluated initially by comparing
the rate of the net cash flow preference with the dividend rate of "high-grade, publicly
traded preferred stock." Rev. Rul. 83-120, supra, at Sec. 4.02. Interestingly, the ruling
does not state that the highest grade preferred stock should be the starting point. Instead,
a "high-grade" preferred stock could be an A or even an A- or B+ stock.
There are published sources for determining the
mean or median preferred rates for publicly traded preferred stocks. For example,
Salomon Smith Barney provides a weekly update. As of June 22, 2001, Salomon Smith
Barney's Market Watch indicated an 7.25% average rate for an A-rated perpetual
preferred stock of a single issuer.
Once the rate for an A-rated preferred is
determined, the credit worthiness of the partnership in question should be compared with
an A-rated company. "If the rate of interest charged by independent creditors to the
[partnership] on loans is higher than the rate such independent creditors charge their most
credit worthy borrowers, then the yield on the preferred [interests] should be
correspondingly higher than the yield on high quality preferred stock. . . ." Rev. Rul. 83-
120, supra, at Sec. 4.02. Presumably, the converse should also be true. To the extent that
the partnership is able to borrow at a sub-prime rate, a lesser net cash flow preference rate
should be in order.
There may also be some authority providing a
guideline for a ceiling on the preferred yield. The income tax regulations indicate that a
preferred return in excess of 150% of the applicable federal rate may be evidence that a
disguised sale has occurred. See Reg. § 1.707-4(a)(3)(i) and (ii). Although these income
tax regulations may not be controlling, they should give some indication of the likely
high end of preferred rates, at least in the absence of a distress situation.
AT-1152260v1 59

Securities limited partnerships often make
especially good candidates for being structured or recapitalized as preferred partnerships.
If a securities preferred partnership has no debt and invests substantially all of its assets
in a widely diversified blue chip stock portfolio, a very good argument can be made that
the preferred partnership's diversification and absence of debt warrant a higher rating than
a single company with an A-rated publicly traded preferred stock. Similarly, if a
securities preferred partnership's net cash flow preference is likely to be satisfied
substantially with long-term capital gains or tax-free income, a lower preferred rate may
be justified. See Standard & Poor's The Outlook, "Attractive Preferreds Issued by
Closed-End Funds," Volume 72, Number 5 (February 2, 2000).
In this regard, there are very good proxies for
determining preferred rates for diversified funds, most of which have historically passed
through substantial long-term capital gains to satisfy the specified preferences. A number
of closed-end mutual funds have publicly traded, albeit comparatively thinly traded,
preferred shares. Among these publicly traded preferred shares in closed-end funds, with
their yields as of July 5, 2001, are:
Closed End Fund
Yield
Gabelli Equity Trust Preferred 7.19%
Gabelli Global Multimedia Trust 7.80%
General American Investors 7.05%
Preferred
Royce Focus Trust Preferred 7.46%
Royce Micro-Cap Trust Preferred 7.73%
Royce Value Trust Preferred 7.63%
Tri-Continental Preferred 6.69%
In analyzing these closed-end funds over a period of
time, several investment-related trends seem to be confirmed.
First, the yields of these preferred shares appear to
be materially influenced by the capitalizations of the stocks in which the closed-end
funds invest and the risk levels of the portfolios of those funds. Tri-Continental and
General American Investors, which had the lowest yields at 6.69% and 7.05%
respectively, invest primarily in large and mid cap stocks, with comparatively moderate
risk levels. As the market cap of the respective fund investment portfolio drops to
predominantly mid and lower cap levels and volatility increases, the yields tend to
increase.
Next, yields drop as the portfolio becomes more
diversified and the preference is likely to be satisfied to a significant degree with longterm
capital gains. Whereas Salomon Smith Barney's Market Watch indicated a 7.25%
average rate for a single A-rated issuer's perpetual preferred shares as of June 22, 2001,
the average yields of the preferred stocks of the two closed-end funds investing primarily
AT-1152260v1 60

in large and mid cap stocks was only 6.87% shortly after that date, more than 5% less
than the Market Watch single issue rate, even though the average quality of the stocks
held by those funds was probably materially less than an A rating. Buttressing this
diversification analysis is the fact that even the 7.56% average yield of the preferred
stocks of the five funds investing primarily in more volatile mid and small cap stocks was
less than 5% higher than Market Watch's 7.25% average rate for a single A-rated issuer's
perpetual preferred shares as of the July 5, 2001 comparison date, and not infrequently on
other comparison dates, the average preferred yield on those five funds has been less than
the Market Watch average rate for a single A-rated issuer's perpetual preferred.
These closed-end funds thus provide objective,
quantifiable evidence that the net cash flow preference for a preferred interest in a
securities preferred partnership with a widely diversified portfolio and with the prospect
of using long-term capital gains to satisfy a large part of the preference should be
materially less than the average preferred yield for a single corporate issuer, even if the
rating of the preferred stock of that single corporate issuer is the same as the average
rating of all of the stocks in the partnership's portfolio. Both the materially reduced risk
resulting from diversification and the likely tax-advantaged satisfaction of the preference
should materially lessen the appropriate "fair" yield.
Each partnership's relative credit worthiness will
obviously turn on its own unique facts and circumstances. The preferred net cash flow
preference should be determined, when the preferred interests are initially issued, by a
professional business appraiser who analyzes the respective partnership's unique facts
and circumstances.
(b) Preferred Return Coverage. Dividend coverage
is the ability to pay the stated preferred return in a timely manner. "Coverage of the
dividend is measured by the ratio of the sum of the pre-tax and pre-interest earnings to
the sum of the total interest to be paid and the pre-tax earnings needed to pay the after-tax
dividends." Rev. Rul. 83-120, supra, at Sec. 4.03. The ruling goes on to state that actual
payment of dividends, and not just the ability to pay, will be taken into account in
evaluating dividend coverage.
Because partnerships do not pay income taxes, they
have a built-in advantage over corporations. Presumably, coverage of a preferred
partnership's preferred return ("preferred return coverage") should be measured by the
ratio of the partnership's pre-interest net cash flow to the sum of the preferred return and
interest to be paid by the partnership.
A major coverage issue for preferred partnerships,
and especially securities preferred partnerships, is whether the limited partnership
agreement permits or even requires the preference (but not other distributions) to be
satisfied in cash or in kind, without regard to realized or unrealized gains or other
income, or with realized or unrealized capital gains. Expanding the permissible sources
for the pay-out of the preferred returns will improve coverage, perhaps dramatically.
AT-1152260v1 61

EXAMPLE: Mother and Son are the only partners of a FLP which is in
the process of recapitalizing. It is anticipated that Mother will receive a
preferred interest with a dissolution preference of $1,400,000, the prerecapitalization
value of Mother's FLP interests. The partnership holds
assets with a $3,000,000 value. These assets are expected to yield 1.5%
per annum, or $45,000, which is slightly more than the average yield of
the S&P 500.
At issue is the appropriate net cash flow preference rate to support a
$1,400,000 value for the preferred interest.
If the only source of net cash flow preference payments is the $45,000 of
annual dividends, minus partnership expenses, then any reasonable net
cash flow preference will clearly not be covered in the foreseeable future,
even if the dividends are expected to increase at a rate of 7% per annum.
At a minimum, the net cash flow preference would have to be fixed at
such a high rate (for example, 9% or more) that any freeze objective which
Mother may have would be jeopardized, especially if the projected total
return on the partnership's assets is expected to be less than that rate.
If the partnership calls for annual distributions equal to 3.2% of the net
asset value as of the last day of the calendar year, however, and if the
assets are expected to generate an annually compounded total return of
10% per year, then the $105,600 projected distribution for even the first
year ($3,000,000 total assets x 110% projected value at the end of the first
year x 3.2% distribution) should cover a 7.25%, or $101,500, cumulative
annual net cash flow preference on the $1,400,000 preferred interest, and
the preferred return coverage should further improve with the passage of
time. If 7.25% would otherwise be the appropriate net cash flow
preference rate, a slight increase in the net cash flow preference rate may
be in order because of the comparatively tight preferred return coverage.
Alternatively, the payout rate may be increased from 3.2% of the year-end
value to 3.5% (possibly with a cap when the cumulative net cash flow
preference is satisfied in full).
(c) Dissolution Protection. The focus in evaluating
the protection of the liquidation preference (the "dissolution protection") is the likelihood
of the preferred partnership having enough assets at the time of dissolution to satisfy the
stated dissolution preference. Dissolution protection is quantitatively reviewed by taking
the ratio of the preferred partnership's net asset value to the dissolution preference. See
Rev. Rul. 83-120, supra, at Sec. 4.04.
A greater weighting of a partnership's capitalization
toward preferred interests reduces the dissolution protection. For example, if 80% of a
securities preferred partnership's contributions are for preferred interests and only 20%
are for nonpreferred interests, the preferred interests of that preferred partnership will be
materially riskier than a securities preferred partnership with an initial contributions
AT-1152260v1 62

allocation of 50% for preferred interests and 50% for nonpreferred interests. Market
corrections in the 20% range are unusual, but do occur from time to time, whereas a 50%
decline is truly extraordinary. In contrast, a 90%-10% partnership (that is, a partnership
with an initial contributions allocation of 90% for preferred interests and 10% for
nonpreferred interests) would at first offer little dissolution protection. It may not be
possible to structure a 90%-10% preferred partnership because of this dissolution
protection component, at least without a usurious net cash flow preference rate. A
"garden variety" 10% correction would wipe out the nonpreferred interests' underlying
asset base and would then leave the preferred interests with no downside protection, at
least pending a market recovery. Historically, 10% corrections occur on average every
three years or thereabouts. Several such corrections have occurred since July of 1998.
Similar principles should apply in analyzing the
dissolution protection of a recapitalized partnership. A heavier weighting toward the
preferred interests will reduce the dissolution protection, at least to some degree.
(d) Voting Rights. Although voting rights and
possible voting control are less important valuation factors than yield, preferred return
coverage, and dissolution protection, voting rights, and especially voting control, may
buttress the value of the preferred interests to a significant degree. Id., at §§ 4.05 and
5.02. Rev. Rul. 83-120 downplays the significance of even voting control if that voting
control does not enable the controlling preferred interest holders to convert their preferred
interests into nonpreferred interests. Control in a preferred partnership context may
therefore be a positive factor in avoiding the possibility of a transfer and a potential gift,
whereas it may be a negative factor in a FLP context where increasing the allowable
discount is an objective.
Even more importantly, a senior family member
who is willing to give up some rights to potential appreciation for net cash flow and
dissolution preferences may insist upon control, at least with respect to partnership
distributions, to safeguard payment of the preferred return to the maximum extent
reasonably possible.
(e) Lack of Marketability. Lack of marketability
seems to be assigned approximately the same weighting by the IRS as voting rights and
possibly voting control. Both lack of marketability and voting rights should be
considered for valuation purposes, but they are much less important than yield, preferred
return coverage, and dissolution protection. See Rev. Rul. 83-120, supra, at Secs. 4.01
and 4.06. This is consistent with the assumed investment objective of most preferred
equity holders; preferred interests are usually acquired for their income streams, not as
trading vehicles. Furthermore, the lack of marketability discount is typically much less in
regard to assets, such as the preferred interests, which generate substantial income.
Because the IRS seems to weight both voting rights
and lack of marketability as secondary valuation factors, voting control by holders of
preferred interests may substantially, if not completely, offset any lack of marketability
discount.
AT-1152260v1 63

(2) Application of Subtraction Method. After the value
of the preferred interest is determined, the six steps of the subtraction method are then
applied. See Reg. § 25.2701-3. Although Reg. § 25.2701-3(b) expressly adopts a four
step approach, two other steps are effectively required by Reg. § 25.2701-3(b)(4)(iv) and
(c).
The subtraction method is not applied in a universal
manner, however. There are subtle, or not so subtle, differences, depending on whether
the subtraction method is being applied upon the initial formation of the partnership,
upon a conversion of a FLP to a preferred partnership by reason of a recapitalization, or
upon a transfer of a nonpreferred interest in a preferred partnership. See Reg. § 25.2701-
3(b). The rules may differ materially if any nonfamily members are partners, especially
in the context of a recapitalization or a subsequent transfer of a nonpreferred interest.
The only consistent feature of the subtraction method
Regulations is that they are consistently ambiguous, internally inconsistent, and almost
impossible to construe. There is also a very good possibility that they are based on
family attribution principles which have now been rejected first by the courts and then by
the IRS itself. In certain other respects, provisions of the Regulations appear to have
little, if any, foundation in the statute and legislative history. Overall, the Regulations
establish a Byzantine labyrinth which unnecessarily complicates use of a statutorily
sanctioned preferred equity structure.
(a) Recapitalization. Under IRC § 2701(e)(5) and
Reg. §§ 25.2701-1(a)(3) and (b)(2)(i)(B)(1) and 25.2701-3, the recapitalization of an
interest in a FLP into a preferred interest will convert the FLP to a preferred partnership,
assuming that the FLP has no preferred interests prior to the recapitalization, and will
trigger application of the following version of the subtraction method:
• Step 1: Determine the value of all family-held interests in the limited
partnership as though all such interests are held by one individual.
Reg. § 25.2701-3(b)(1)(i).
• Step 2: The value of all preferred interests issued as part of the
recapitalization, which value should be determined by using IRC
§ 2701 principles, is then to be subtracted. Step 2, as set forth in Reg.
§ 25.2701-3(b)(2)(i), does not apply to any preferred interests received
by the transferor as consideration for the transfer. Nonetheless, the
last sentence of Reg. § 25.2701-3(b)(4)(iv) requires the value of the
preferred interests received in the recapitalization to be subtracted, and
Step 2 would seem to be the logical place for such subtraction.
• Step 3: The difference between the value of all family-held interests
(as determined under Step 1) and the value of the preferred interests
(as determined under Step 2) is then to be allocated proportionately
among all nonpreferred partner interests which continue to be
outstanding after the recapitalization, including the nonpreferred
AT-1152260v1 64

partner interests which continue to be held by partners receiving
preferred interests in the recapitalization. See Reg. § 25.2701-3(b)(3).
• Step 4: Each partner's nonpreferred interests are then reduced by
appropriate minority interest and lack of marketability discounts.
These discounts are based on the difference between the discounts
appropriate for the nonpreferred interests actually owned by the
respective partner and the discounts which would be allowable with
respect those nonpreferred interests, assuming that all family voting
rights were attributed to those nonpreferred interests. See Reg.
§ 25.2701-3(b)(4)(ii).
• Step 5: If the total value of all nonpreferred interests is less than 10%
of the sum of the total value of all partner interests and the total
indebtedness owed by the partnership to family members (the "ten
percent minimum value threshold"), the 10% minimum value rule will
cause the discounted values of all nonpreferred interests after Step 4 to
be increased proportionately until the discounted values for the
nonpreferred interests, including the proportionate increases, equal the
10% minimum value threshold. See IRC § 2701(a)(4) and Reg.
§ 25.2701-3(b)(4)(ii) and (c).
• Step 6: Under normal gift tax concepts, a taxable gift to a partner
generally results if and to the extent that value passes from the donor
partner and the value of all preferred and nonpreferred interests held
by the respective donee partner immediately after the recapitalization
exceeds the value of the FLP interests held by that donee partner
immediately prior to the recapitalization. See Reg. § 25.2511-2(a).
Under the Regulations' approach, however, a gift to a partner may
result if and to the extent that the value of the respective partner's
nonpreferred interests, determined by applying the first five steps of
the subtraction method formula, exceeds the value (without regard to
IRC § 2701 principles) of that partner's nonpreferred interests
immediately after the recapitalization. See Reg. § 25.2701-3(b)(4)(iv).
The application of the subtraction method in the
recapitalization context is confusing at best. Especially confusing is the application of
Step 1, which raises more questions than it answers.
Under Step 1, the value of all family-held interests
in the limited partnership is determined as though all such interests are held by one
individual. Does this mean that if all of the partners are family members, the interests are
to be valued on a liquidation basis since the limited partnership can be dissolved by a
partner holding all of the partner interests Alternatively, if all partners are family
members, does the assumed 100% ownership by one individual mean that interests are to
be valued on a going concern basis, as a result of which lack of marketability discounts,
but not minority interest discounts, will be allowed, but any right which a fictional single
AT-1152260v1 65

partner may have to dissolve the limited partnership will be disregarded This question
of whether liquidation value or going concern value is appropriate is absolutely central to
the feasibility of the conversion of a FLP to a preferred partnership. If Step 1 requires
use of liquidation value, the preferred interests will effectively have to be structured
without taking into account any discounts, even though 30% to 40% discounts would
have applied to the FLP interests if there had been no recapitalization. Otherwise, a
substantial gift will result.
EXAMPLE: Mother and Son are the only two partners of a FLP. In
1996, Mother contributed $1,000,000 for controlling partner interests
entitled to 66 b% of all economic benefits, and Son contributed $500,000
for noncontrolling partner interests entitled to 33 a% of all economic
benefits. As of January 1, 2001, the underlying partnership assets are
worth $3,000,000. Mother's controlling interests are valued at $1,400,000,
taking into account a 30% lack of marketability discount. In turn, Son's
noncontrolling interests are valued at $600,000, taking into account a 40%
combined lack of marketability and lack of control discount.
Mother is approaching retirement. She wants more income and is
becoming more risk averse. A conversion of Mother's partner interests in
the FLP to a preferred interest is proposed.
Option 1: Liquidation Value. If liquidation value has to be used in the
recapitalization, Mother's receipt of preferred interests in the preferred
partnership with a $1,400,000 value (that is, the pre-recapitalization value
of Mother's partner interests in the FLP surrendered in the conversion) will
result in a potential $600,000 gift by Mother to the holders of the
nonpreferred interests. This potential $600,000 gift is the excess of the
undiscounted $2,000,000 allocable underlying asset value and the
$1,400,000 discounted value of the Mother's partner interests prior to the
recapitalization. The entire potential $600,000 will be treated as a transfer
to Son's retained nonpreferred partner interests since Mother retains no
nonpreferred interests. This $600,000 transfer will be in addition to the
$1,000,000 allocable to Son by reason of his retention of his
noncontrolling nonpreferred partner interests. Thus, the total allocation to
Son under Step 3 will be $1,600,000. In applying Step 4, the net cash
flow and dissolution preferences accorded to the preferred interests should
materially increase the allowable lack of marketability and lack of control
discounts for Son's nonpreferred interests, for the cash flow likely to be
distributed to the nonpreferred interests will be eliminated, at least for a
number of years, and the nonpreferred interests will bear the first risk of
loss. Instead of the 40% combined lack of marketability and lack of
control discount allowable for Son's FLP interests, a 45% discount is
appropriate for his nonpreferred partner interests. As a result, Son's
nonpreferred partner interests will be deemed to have a value of $880,000
([1-.45] x the $1,600,000 value allocated to Son under Step 3), compared
with a value of $600,000 before the conversion. In turn, Mother's
AT-1152260v1 66

preferred interest will be deemed to have a value of $1,400,000, which
equals the value of her pre-conversion FLP interests. Even though the
value of Mother's partner interests is the same both before and after the
recapitalization, Mother will be treated as having made a very substantial
gift. The question under Step 6 is then whether the amount of the gift will
be (1) $330,000 (that is the $600,000 deemed transferred to Son under
Step 3, reduced by a 45% discount under Step 4), (2) the $280,000 excess
of Son's $880,000 post-recapitalization value of his nonpreferred interests
over his $600,000 pre-recapitalization value, or (3) zero (on the grounds
that no value has passed from the potential donor partner, Mother).
If liquidation value has to be used in the recapitalization, and if the only
partners are family members, a potential gift by Mother can be clearly
avoided only by converting Mother's limited partner interests with a prerecapitalization
value of $1,400,000 into a preferred interest with a value
of $2,000,000, thus effectively negating any discounts that would have
been allowable under the FLP prior to the conversion. Using this
approach, the recapitalization will cause the value of Mother's interests to
increase from $1,400,000 before the recapitalization to $2,000,000
immediately after it. In contrast, if Mother receives a preferred interest
with a value of $2,000,000 in the recapitalization, the recapitalization will
cause the value of Son's partner interests to decline from $600,000 to
$580,000. Thus, if the regulations require use of liquidation value,
compliance with those regulations to avoid a potential gift by Mother will
clearly shift value to Mother, the partner whose FLP partner interests are
converted into preferred interests. Under traditional gift tax principles,
such a shift in value may itself be a gift, not by Mother but by Son, the
partner not receiving the preferred interests.
Option 2: Going Concern Value. Alternatively, if going concern value is
used instead of liquidation value, it is not clear whether prerecapitalization
or post-recapitalization partner interest values will serve as
the starting point under Step 1, for the regulations themselves are
inconsistent. Compare Reg. § 25.2701-1(a)(3) with Reg. § 25.2701-
3(b)(1)(i). Irrespective of which values are used, however, only lack of
marketability, and not lack of control, discounts will be allowable under
Step 1.
If pre-recapitalization values are appropriate, and if a 30% lack of
marketability discount is allowable, the Step 1 value will be $2,100,000,
representing 70% of the $3,000,000 underlying asset value. If the
preferred interest received by Mother in the recapitalization has a value
equal to the $1,400,000 value of the FLP partner interests converted into
the preferred interest, the $700,000 excess of the $2,100,000 Step 1 value
over the $1,400,000 value of the preferred interest will be allocated under
Step 3 to Son's nonpreferred interests since Mother retains no
nonpreferred interests. If $700,000 is allocable to Son under Step 3,
AT-1152260v1 67

which represents a 30% discount (so the undiscounted value allocated to
Son is $1,000,000), and if a total discount of 45% is appropriate, the value
of Son's nonpreferred interests in the partnership will be $550,000 ([1-.45]
x the $1,000,000 undiscounted value allocated to Son above), slightly less
than the $600,000 pre-recapitalization value of his FLP partner interests,
and no gift will have been made by Mother to Son.
If post-recapitalization values are appropriate, and if the allowable lack of
marketability discount is 35% immediately after the recapitalization (as
opposed to 30% before the recapitalization), the Step 1 value of all partner
interests immediately after the recapitalization will be $2,440,000, (the
$1,400,000 value of the preferred interests + 65% [$3,000,000 -
$1,400,000]). After subtracting the $1,400,000 value of the preferred
interest received by Mother in the conversion, the remaining $1,040,000
will be allocated under Step 3 to Son since Mother retains no nonpreferred
interests. If $1,040,000 is allocable to Son under Step 3, which represents
a 35% discount (so that the undiscounted value allocated to Son under this
approach is $1,600,000), and if a total discount of 45% is appropriate, the
post-recapitalization value of Son's nonpreferred interests in the preferred
partnership will be $880,000 ([1-45%] x the $1,600,000 undiscounted
value allocated to Son under this approach), $280,000 more than the
$600,000 pre-recapitalization value of his FLP partner interests, and a
$280,000 gift will have been made by Mother to Son.
The regulations themselves seem to indicate that
going concern value, not liquidation value, should be used. The regulations state that the
property interests to be valued in Step 1 are the partner "interests," not the value of the
underlying partnership assets. See Reg. § 25.2701-1(a)(1) and (2). See also Reg.
§ 25.2701-3(b)(1) for the general rule that "interests" are valued. Only in the special rule
applicable to contributions to capital are the values of the underlying assets valued. See
Reg. § 25.2701-3(b)(i)(ii).
If persons other than family members are partners,
and if the family members who are partners do not have the right to dissolve the
partnership without the consent of one or more family members (either under the terms of
the partnership agreement or under the default provisions of state law), going concern
value should control, for only the values of all family held interests will be treated as held
by one individual for purposes of applying Step 1. See Reg. § 25.2701-3(b)(1)(i). It
seems illogical that the results should be so different when the only partners are family
members, on one hand, and when one or more partners are not family members, on the
other hand.
The above discussion assumes that the IRC § 2701
regulations relating to recapitalizations (and to transfers) are valid, but there is a serious
question as to whether this is a proper assumption. Step 1's requirement that all familyheld
interests be valued as though they are "held by one individual" probably represents a
position which was once taken by the IRS but which has subsequently been reversed. For
AT-1152260v1 68

many years prior to the issuance of the IRC § 2701 regulations, the IRS contended that all
family-held interests should be aggregated for valuation purposes. This so-called "family
attribution" argument was still being actively pushed by the IRS when the IRC § 2701
regulations were issued in 1992. However, courts repeatedly rejected this "family
attribution" argument by the IRS. See Estate of Lee v. Commissioner, 69 T.C. 860
(1978); Estate of Bright v. United States, 658 F.2d 999 (5th Cir. 1981) (en banc.); Estate
of Andrews v. Commissioner, 79 T.C. 938 (1982); Minahan v. Commissioner, 88 T.C.
492 (1987) (costs assessed against the IRS for its continued litigation of family
attribution); and LeFrak v. Commissioner, supra. Finally, the IRS relented and
acknowledged in Rev. Rul. 93-12, 1993-1 C.B. 202, that "family attribution" is
inappropriate, although this concession has not stopped the I.R.S. from resurrecting this
argument from time to time, only to lose again (and again). See FSA 1999844; Estate of
Bonner v. United States, 84 F.3d 196 (5th Cir. 1996); Estate of Nowell v. Commissioner,
supra; and Estate of Mellinger v. Commissioner, 112 T.C. 26 (1999). The "family
attribution" approach taken in Step 1 thus appears to be an historical vestige which
reflects a position which is no longer being taken by the IRS and which has consistently
been rejected by the courts. Unfortunately, the IRC § 2701 regulations have never been
revised, even though validity of the "family attribution" approach taken in those
regulations is highly suspect.
To cut through the confusion caused by the
Regulations, the basic purpose of the subtraction method needs to be kept in mind. The
underlying premise of the subtraction method, as applied by the IRS long before the
adoption of IRC § 2701, is that a potential gift should occur by reason of a
recapitalization only if the value of the preferred interests received in the recapitalization
is less than the value of the FLP interests given up in exchange for those preferred
interests. If the value of the preferred interests received in the recapitalization, applying
IRC § 2701 principles, equals the value of the FLP interests surrendered for those
preferred interests, and if the 10% minimum value rule does not apply, there should be no
taxable gift. See Reg. § 25.2701-3(a). Supporting this position is Estate of James W.
Anderson, 56 TCM 553, 557 (1988), which describes the subtraction method, as in effect
prior to Chapter 14, as follows: "In general, Revenue Ruling 83-120 focuses solely on
valuing the preferred stock issued in a recapitalization and only derivatively determines
the value of the common stock issued. The derivative value is a matter of arithmetic: it
is calculated by subtracting the preferred stock's determined value from the value of
stock contributed in exchange for the preferred." (Emphasis added) The confusing and
suspect language of the regulations, especially in regard to Step 1 and the
interrelationship of allowable discounts under Steps 1 and 4, should not alter that result.
(b) Transfer of Nonpreferred Interest. A gift, sale,
or other transfer of nonpreferred interests (especially from a senior family member to
junior family members) subsequent to the recapitalization will also cause the subtraction
method to be applied. See Reg. §§ 25.2701-1(a)(1) and 25.2701-1(b)(2)(i)(B)(3). In the
context of a transfer of nonpreferred interests, the subtraction method operates in the
following manner:
AT-1152260v1 69

• Step 1: Determine the value of all family-held interests in the
partnership immediately after the transfer as though such interests
were held by one individual. Reg. § 25.2701-3(b)(1)(i).
• Step 2: Subtract the value of all family-held preferred interests, using
IRC § 2701 principles. Reg. § 25.2701-3(b)(2)(i)(B).
• Step 3: Allocate the balance remaining after applying Steps 1 and 2
proportionately among all nonpreferred interests. See Reg. § 25.2701-
3(b)(3).
• Step 4: Reduce the allocations under Step 3 to each partner holding
nonpreferred interests by applicable "minority or similar discounts."
See Reg. § 25.2701-3(b)(4)(ii). This is done in the same general
manner as described in Step 4 of the subtraction method, as applied to
recapitalizations.
• Step 5: If the total value of all nonpreferred interests (after applying
Steps 1 through 4) is less than 10% of the sum of the total value of all
partner interests and the total indebtedness owed by the partnership to
family members, the discounted value of all nonpreferred interests
after Step 4 will be increased proportionately under the 10% minimum
value rule until the discounted values of the nonpreferred interests,
including the proportionate increases, equal the 10% minimum value
threshold. See IRC § 2701(a)(4) and Reg. § 25.2701-3(b)(4)(ii) and
(c).
• Step 6: Under normal gift tax concepts, a taxable gift to a partner
generally results if and to the extent that value passes from a donor
partner and the value of the partner interests held by the respective
donee partner immediately after the transfer exceeds the sum of the
value of the partner interests held by that donee partner immediately
before the transfer and any consideration paid by that donee partner for
the transferred partner interests. See Treas. Reg. § 25.2511-2(a).
Again, however, the Regulations may use a different approach. Under
the Regulations, a gift may result if and to the extent that the value of
the respective partner's nonpreferred interests, determined by applying
the first five steps of the subtraction method formula, exceeds the
value (without regard to IRC § 2701 principles) of that partner's
nonpreferred interests immediately after the transfer. See Reg.
§ 25.2701-3(b)(4)(iv). The position taken by the Regulations is
probably more supportable in a transfer context. In the transfer
context, the value of what is given up is expected to equal the value of
what is received, or a gift is a distinct possibility.
The application of the subtraction method to a transfer situation can result in a
taxable gift in a number of ways that vary materially from traditional gift tax concepts.
AT-1152260v1 70

Whether these potential "phantom" taxable gifts will be upheld, if challenged, remains to
be seen.
One potential "phantom" gift is clearly contemplated by the statute. A "phantom"
taxable gift remains a distinct possibility if IRC § 2701's special valuation rules assign a
zero value to a noncumulative preferred interest or cause important liquidation, put, call,
and conversion rights to be ignored for transfer tax purposes.
The other causes of "phantom" taxable gifts are much more suspect. To illustrate
one analogous position taken by the Regulations, a phantom gift may occur under the
literal terms of the regulations if a partner holding a preferred interest transfers a
noncontrolling, nonpreferred interest to another partner and if that other partner acquires
a controlling interest in the preferred partnership as a result of the transfer. See Reg.
§ 25.2701-3(b)(4)(ii). This result is at odds with the normal rule that a gifted minority
interest should be valued as a minority interest, even if the transferor has a controlling
interest prior to the transfer and even if the transferee has a controlling interest after the
transfer. See Rev. Rul. 93-12, supra.
Most importantly, if a FLP has been recapitalized, and if a partner receiving a
preferred interest in the recapitalization also retains substantial nonpreferred interests, a
subsequent gift or other transfer of part or all of the nonpreferred interests will bring into
play many of the same confusing issues discussed in regard to recapitalizations, including
the highly questionable application of "family attribution" principles in Step 1.
EXAMPLE: Mother initially contributes $1,485,000 to a securities FLP for 99%
general and limited partner interests, and Son initially contributes $15,000 for 1%
general and limited partner interests. Several years later, the partnership assets
have doubled in value to $3,000,000, and a decision is made to convert a 50%
limited partner interest held by Mother into a preferred interest. Prior to the
conversion, this 50% limited partner interest has a value of $975,000, using a 35%
combined lack of marketability and lack of control discount. As a result, the
dissolution preference of the preferred interest received by Mother in the
recapitalization is fixed at $975,000, and the 7.25% cumulative annual net cash
flow preference is deemed sufficient to support a $975,000 value for the preferred
interest.
To simplify the example, assume that Step 1 of the IRC § 2701 Regulations
dealing with the application of the subtraction method requires use of a
liquidation approach. See the "Recapitalization" discussion and example for a
description and comparison of the liquidation approach and the going concern
approach. The author continues to believe that the going concern approach, or a
variation of it, should be the appropriate valuation methodology. See Newhouse
v. Commissioner, 94 T.C. 193 (1990). Nonetheless, an example using the
liquidation approach should illustrate the potential downside risk. Therefore, the
value of all partner interests under Step 1 is $3,000,000, the net value of all
partnership assets on a liquidation basis. When the $975,000 value of the
preferred interest is then subtracted from this $3,000,000 net asset value pursuant
AT-1152260v1 71

to Step 2, the $2,025,000 difference is a potential gift. After the recapitalization,
however, Mother will still hold 98% of all nonpreferred interests, with Son
holding the remaining 2%. Therefore, $1,984,500 (98% of $2,025,000) will be
allocable to Mother, and a transfer to oneself will not be treated as a gift. See
Step 3. Only the remaining $40,500 (2% of $2,025,000) will be allocable to Son.
After applying a 45% discount under Step 4, Son's 2% nonpreferred interest will
have a post-recapitalization value of $22,275 ([1-.45] x $40,500), compared with
a pre-capitalization value of $18,000 (applying a 40% combined lack of
marketability and lack of control discount to a $3,000,000 1% allocable share of
the FLP assets). Therefore, assuming arguendo that a liquidation approach is
appropriate, a gift of at least $4,275 will be deemed to have occurred.
If Mother gives Son a 50% nonpreferred limited partner interest shortly after the
recapitalization, the Regulations again require application of the subtraction
method. The Step 1 and Step 2 analysis will be the same, again assuming for the
sake of simplicity that Step 1 requires use of a liquidation approach. As a result,
the amount to be allocated under Step 3 will still be $2,025,000 ($3,000,000 under
Step 1 - $975,000 under Step 2). Of this $2,025,000, only $972,000 ([1-.52] x
$2,025,000), representing Mother's retained 48% nonpreferred interest, will be
allocable under Step 3 to Mother and will not be taken into account in
determining the amount of the taxable gift. The remaining $1,053,000 ([1-.48] x
$2,025,000) will be allocable to Son. After applying a 45% discount under
Step 4, the value of Son's interest after the gift will be $579,150 ([1-.45] x
$1,053,000), compared with a $22,275 value before the gift. As a result, Mother
will be deemed to have made a gift of $579,150.
Again, unless one of IRC § 2701's special valuation rules applies, a gift should
generally occur only to the extent that the value of all interests retained by the transferor
partner and all consideration received by that partner is exceeded by the value of all
partner interests held by that partner before the transfer. A further adjustment may be
required (a) if the gift consists of a minority interest and the transferor partner holds a
controlling interest before the gift or (b) if the gift consists of a controlling interest and
the transferor partner retains only a minority interest. If the result under the Regulations
differs from this historic application of the subtraction valuation method, then the validity
of the provisions of the Regulations that cause the difference is, at best, highly
questionable.
(3) Mitigation of Recapitalization and Post-
Recapitalization Transfer Problems. The subtraction method Regulations are a real,
albeit probably unwarranted, obstacle to a recapitalization of a FLP or a transfer of
nonpreferred interests after a recapitalization. Whether many of the provisions of these
Regulations will be upheld, if they are ultimately challenged, is a legitimate question.
Since discretion is the better part of valor, however, it may be more prudent to "dodge
and weave" rather than engage in a frontal assault on the Regulations.
(a) Addition of Non-Family Member. The addition
of a non-family member as a partner before recapitalization will not totally circumvent
AT-1152260v1 72

the obstacles posed by the subtraction method Regulations but it may mitigate the
downside risks. If the non-family member partner can block the liquidation of the
partnership both under the terms of the partnership agreement and under the default
provision of applicable state law, a liquidation valuation approach under the subtraction
method Regulations, if otherwise appropriate, should give way to a going concern
approach. As shown in the recapitalization example which appears above, use of the
going concern approach will at least materially reduce the potential taxable gift, and may
even eliminate it.
(b) Post-Installment Sale Recapitalizations.
Probably the most effective means of circumventing the subtraction method Regulations
involves multiple possible steps. First, a partner will transfer an interest in the
partnership to a grantor trust for an installment note. Next, at some point prior to the due
date of the installment note, the partnership will be recapitalized. Each partner will
receive preferred interests proportionate to that partner's interests in the partnership
before the recapitalization. Finally, the installment note will be satisfied by transferring
the grantor trust's preferred interests to the grantor.
EXAMPLE: Assume that Mother contributes $2,970,000 for a .99%
general partner interest and a 98.01% limited partner interest. A dynasty
grantor trust, of which Mother is the grantor, contributes $30,000 for a
.01% general partner interest and a .99% limited partner interest. The trust
includes spraying and sprinkling powers for children and more remote
descendants and possibly for the grantor's spouse (as discussed below).
Following the formation of the limited partnership, Mother gifts to the
grantor trust a 31.34% limited partner interest with an independently
appraised value of $564,120, after taking into account a 40% combined
lack of marketability and lack of control discount. Shortly after the gift,
Mother sells to the grantor trust on an installment basis the remainder of
her limited partner interest. This 66.67% limited partner interest is sold
for its independently appraised fair market value of $1,200,000, again
taking into account a 40% combined lack of marketability and lack of
control discount. In exchange for this sale, the grantor trust issues its
$1,200,000 note, payable interest only for the first eight years and with a
balloon payment of principal and interest on the ninth anniversary of the
sale. The interest rate is 5.12%, the mid-term AFR in effect as of the sale.
Seven years after the sale, the underlying partnership assets have doubled
in value to $6,000,000. The partners agree to a recapitalization. Preferred
interests with an aggregate dissolution preference of $1,200,000, a 7.25%
cumulative annual net cash flow preference, and a total value of
$1,200,000 are issued to the partners in proportion to their FLP interests
(based on economic interests and disregarding the non-lapsing differences
in the management rights of the general partner and limited partner
interests, as sanctioned by Reg. § 25.2701-1(c)(3)). Therefore, Mother, as
the owner of a .99% general partner interest, will receive an $11,880
AT-1152260v1 73

preferred partner interest, representing a proportionate .99% of all of the
newly issued preferred interests, and the grantor trust, as owner of 99.01%
of all general and limited partner interests, will receive $1,188,120 of
preferred interests, representing a proportionate 99.01% of all newly
issued preferred interests.
As of the ninth anniversary of the note, and the grantor trust transfers its
preferred interest with a value of $1,188,120 and $11,880 of cash
(generated by the trust's preferred interest) in satisfaction of the trust's
principal obligation to Mother. The trust's accrued interest obligation is
satisfied with cash and investment returns attributable to distributions
from the partnership during the nine-year note term. After this transfer,
Mother will own a $1,200,000 preferred interest and a .99% nonpreferred
general partner interest. The grantor trust will continue to hold a .01%
nonpreferred general partner interest and a 99% nonpreferred limited
partner interest.
Option 1: Special Grantor Trust Provisions Are Valid. At first blush, the
recapitalization appears to be proportionate, and proportionate
recapitalizations are generally excepted from adverse IRC § 2701 gift tax
consequences. See IRC § 2701(a)(2)(C) and Reg. § 25.2701-1(c)(3). The
IRC § 2701 Regulations, however, include a number of special rules for a
preferred partnership with a grantor trust as a partner. Under Reg.
§ 25.2701-6(a)(4)(i), (4)(ii)(C), and (5)(i)(A), the grantor of a grantor trust
will be treated as the owner of the preferred interests received by the
grantor trust in the recapitalization in year 7. The grantor's spouse,
children, and more remote descendants will be treated as owning all
nonpreferred interests held by the grantor trust on a pro rata basis. See
Reg. § 25.2701-6(a)(4)(i) and (5)(ii)(B). Therefore, even though the
recapitalization will in fact be proportionate, the Regulations will treat the
recapitalization as not being proportionate, and the subtraction method
gauntlet will need to be run as of the date of the recapitalization in year 7.
See also PLR 9321046.
In applying the subtraction method to the recapitalization, first assume the
worst case. Start with a $6,000,000 liquidation value. After subtracting
the $1,200,000 value of the preferred interests, the remaining $4,800,000
will be allocated proportionately among the nonpreferred partners. The
grantor trust's $4,752,480 share (.9901 x $4,800,000) before discounts will
equate to a $2,613,864 share ([1-.45] x $4,752,480) after allowing for 45%
combined lack of marketability and lack of control discounts. This
$2,613,864 share allocable to the grantor trust's nonpreferred interests
after the recapitalization compares with the $3,564,360 value ([1-.4] x
.9901 x $6,000,000) of the grantor trust's partner interests before the
recapitalization. Since the post-recapitalization value of the grantor trust's
nonpreferred interests is approximately $950,000 less than the pre-
AT-1152260v1 74

ecapitalization value of its partner interests, there should be no taxable
gift by reason of the recapitalization.
Alternatively, the $2,613,864 post-recapitalization value of the grantor
trust's nonpreferred interests, applying IRC § 2701 principles, will exactly
equal the $2,613,864 value of such nonpreferred interests, determined
without regard to IRC § 2701 principles. Again no gift is indicated as a
result of the recapitalization. See Reg. § 25.2701-3(b)(4)(ii) and
PLR 9447004.
When the grantor trust distributes its $1,188,120 of preferred interests to
Mother in year 9 in satisfaction of the installment note, no taxable gift
should occur. Instead, Mother, the deemed owner, will become the actual
owner, and the value of the grantor trust's nonpreferred interests,
determined under the subtraction method, should be the same both before
and after the transfer.
The Regulations also call for the termination of grantor trust status to be
regarded as a deemed transfer. See Reg. § 25.2701-1(b)(2)(i)(C)(1).
Again, applying the subtraction method, the value of the trust's
nonpreferred interests after the termination should equal the value of those
interests immediately before the termination, and no taxable gift should
result.
Option 2: Special Grantor Trust Provisions Are Invalid. The special
grantor trust Regulations relating to both attribution and deemed transfer
have no apparent basis in the statute or legislative history. Arbitrarily,
income tax provisions are superimposed over gift tax provisions, even
though transfer taxes are normally separate and distinct from income
taxes. Given these circumstances, the validity of these special grantor
trust provisions is highly suspect.
If these Regulations are ultimately found to be invalid, the results could
even be worse than if they are held to be valid, but only if the grantor's
spouse, an ancestor of the grantor or the grantor's spouse, or a spouse of
such an ancestor is a trust beneficiary. Under these circumstances, all of
the preferred interests received in the recapitalization will be attributed to
the family members who are at or above the grantor's generation level, and
all of the trust's nonpreferred interests will be allocated pro rata among the
grantor's spouse, children, and more remote descendants who are
beneficiaries. See Reg. § 25.2701-6(a)(4)(i), 5(i)(C) or (D), and 5(ii)(B).
The proportionate allocation of preferred interests exception of IRC
§ 2701(a)(2)(C) and Reg. § 25.2701-1(c)(3) will generally not apply,
according to the IRS, since the attribution rules will cause the preferred
interests to be constructively owned by family members at or above the
grantor's generation level and the nonpreferred interests to be
constructively owned pro rata by the grantor's spouse, children and more
AT-1152260v1 75

emote descendants. See PLR 9321046. The post-recapitalization
allocation of $2,613,864 to the grantor trust's nonpreferred interests will
be the same. However, if the $1,188,120 post-recapitalization value of the
preferred interests is subtracted from the $3,564,360 pre-recapitalization
value of the preferred interests, the net pre-recapitalization value will be
$2,376,240, resulting in a potential net gift of $237,624. See Reg.
§ 25.2701-3(b)(4)(iv). Ironically, the grantor may fare better if the grantor
trust attribution Regulations are upheld. It should be noted, however, that
use of a liquidation approach to Step 1 of the subtraction method is being
used here to illustrate maximum downside potential gift risks. Alternative
approaches, such as the use of going concern values in Step 1, may
mitigate or eliminate the potential gift.
If none of the trust beneficiaries are family members at or above the
grantor's generation level (e.g., the grantor's spouse is not a beneficiary),
both the preferred and nonpreferred interests will apparently be allocated
pro rata among the children and more remote descendants who are
beneficiaries. See Reg. § 25.2701-6(a)(4)(i). Since both the constructive
and actual allocations will be proportionate among the partners, no taxable
gift should result under IRC § 2701. See IRC § 2701(a)(2)(C) and Reg.
§ 25.2701-1(c)(3).
Irrespective of whether the grantor's spouse or another family
member/beneficiary is at or above the grantor's generation level, the
transfer of the preferred interests to the grantor in year 9 in satisfaction of
the installment note should not trigger a taxable gift. Applying the
subtraction method, the same amount should be allocated to the grantor
trust's nonpreferred interests both before and after the transfer, and
irrespective of whether IRC § 2701 principles are or are not applied to
post-transfer values of such nonpreferred interests.
(c) Drop-Down Preferred Partnership. A third
technique which can be used effectively to avoid, at least in large part, the potential
adverse impact of the subtraction method Regulations is a so-called "drop-down"
preferred partnership. Under this technique, the existing FLP is not recapitalized, and all
FLP partner interests remain nonpreferred. Instead, a partner, generally a senior family
member, will form a new preferred partnership with one or more other persons and
contribute his or her FLP partner interests and possibly other assets to the preferred
partnership for preferred, or both preferred and nonpreferred, partner interests in the
preferred partnership.
EXAMPLE: Assume that Mother holds 66.67% of all partner interests in
an existing FLP. The underlying assets of the FLP consist of $3,000,000
of widely diversified marketable securities. Since Mother owns only
noncontrolling limited partner interests in the FLP, her FLP partner
interests have an independently appraised value of $1,200,000 after
AT-1152260v1 76

allowance is made for a 40% combined lack of marketability and lack of
control discount.
Mother is concerned about the volatility of the markets. She and Son
agree to form a new preferred partnership. Mother contributes her FLP
limited partner interests with a value of $1,200,000 for (1) a preferred
interest with a $1,000,000 dissolution preference, a 7.25% cumulative
annual net cash flow preference, and a $1,000,000 appraised value, and
(2) controlling nonpreferred interests representing 25% of all nonpreferred
interests. Son contributes a widely diversified stock portfolio with a value
of $600,000 for noncontrolling non-preferred interests representing 75%
of all nonpreferred interests.
In the context of the formation of a new preferred
partnership, as opposed to a recapitalization, the subtraction method is applied as follows:
• Step 1: Determine the fair market value of all contributions. Reg.
§ 25.2701-3(b)(1)(ii).
• Step 2: Subtract the value of the preferred interests, applying IRC
§ 2701 principles. Reg. § 25.2701-3(b)(2)(ii).
• Step 3: The difference between the fair market value of all
contributions and the value of the preferred interests is then allocated
proportionately among all non-preferred interests, including those
owned by partners holding preferred interests. Reg. § 25.2701-3(b)(3).
• Step 4: The amount allocated to each partner's non-preferred interests
in Step 3 is then reduced by appropriate "minority or similar
discounts," including otherwise allowable lack of marketability
discounts. See Reg. § 25.2701-3(b)(4)(ii) and PLR 9447004.
• Step 5: The 10% minimum value rule is applied by increasing the
values of the non-preferred interests proportionately until the total
value of all of the non-preferred interests, as thus adjusted, equals 10%
of the sum of the total value of all partner interests and the total
indebtedness owed by the partnership to all family members. This step
may be skipped if the total value of all non-preferred interests prior to
any such adjustment equals or exceeds such 10% minimum value
threshold. See IRC § 2701(a)(4) and Reg. § 25.2701-3(b)(4)(ii) and
(c).
• Step 6: A gift will occur to the extent that the value of a partner's
non-preferred interests, determined after the first five steps, exceeds
either (1) the capital contributions by that partner for non-preferred
interests, which is a common measure of a gift, or (2) the fair market
value of the non-preferred interests (without regard to IRC § 2701
AT-1152260v1 77

principles) which are received in exchange for such capital
contributions, which may be the position taken by the Regulations.
See Reg. § 25.2701-3(b)(4)(iv). The Regulations literally may call for
a gift to be constructively received whenever the value of the
respective partner's non-preferred interests, calculated through the first
five steps, exceeds the actual value of those non-preferred interests,
calculated without regard to IRC § 2701. However, it is difficult to
conceive of a gift having occurred in an economic loss situation where
the consideration exchanged for the non-preferred interests, as
opposed to the value of the non-preferred interests received therefor,
exceeds the value of these non-preferred interests, as determined under
the first five steps of the subtraction method.
Under this application of the subtraction method
upon the formation of the partnership, a potential gift will occur if the partner's preferred
interests have a value, using IRC § 2701 principles, that is significantly less than the
value of the capital contributions for such preferred interests. However, this shortfall in
the value of the preferred interests will be regarded as a transfer by the partner holding
the preferred interests to himself or herself, and thus will not be a taxable gift, to the
extent that the shortfall is allocable to that partners' own non-preferred interests. Also,
the allowance of minority and "similar" discounts, including lack of marketability
discounts, will go a long way toward insulating the partner receiving the preferred
interests from having made a taxable gift, although the extent of insulation by reason of
discounting is not free from doubt. Therefore, it should not be automatically assumed
that a taxable gift will occur if and to the extent that the value of the preferred interests is
less than their dissolution preference.
EXAMPLE: Assume, as in the immediately preceding example, that
Mother contributes FLP partner interests with a value of $1,200,000 to a
newly formed preferred partnership in exchange for (1) a preferred interest
with a $1,000,000 dissolution preference, a 7.25% cumulative annual net
cash flow preference, and a $1,000,000 appraised value and (2) controlling
nonpreferred interests representing 25% of all nonpreferred interests. Son
contributes marketable securities with a value of $600,000 for
noncontrolling nonpreferred interests representing 75% of all nonpreferred
interests.
Under Steps 1 and 2 of the subtraction method applicable to newly formed
preferred partnerships, the $1,000,000 of preferred interests will be
subtracted from the $1,800,000 of total contributions, leaving $800,000 as
a potential gift. Under Step 3, 25% of this $800,000 potential gift is
allocated to Mother and is thus not a gift. The remaining $600,000 is
allocated to Son. Under Step 4, the $600,000 allocated to Son is reduced
by an appropriate discount for lack of control and lack of marketability,
which is determined to be only 30% since the $1,200,000 FLP partner
interests already take into account a substantial first-tier discount. The
value of Son's nonpreferred interests, then, is appraised at $420,000. This
AT-1152260v1 78

does not result in a gift under Step 6. Not only is the $420,000 value of
Son's nonpreferred interests less than the $600,000 value of Son's
contributions, but it also equals the fair market value that would have been
determined without regard to IRC § 2701 principles.
Assume now that the IRS successfully challenges the value of the
preferred interests on the grounds that the 7.25% cumulative annual net
cash flow preference is too low under the circumstances. Instead of a
$1,000,000 value, the preferred interests are found to be worth only
$900,000, $100,000 less than the initial appraisal (the "$100,000
shortfall").
Under the first three steps of the subtraction method, this $100,000
shortfall will be regarded as having been transferred to the holders of the
non-preferred interests, but that does not mean that a $100,000 taxable gift
will have occurred. Of this $100,000, $25,000 will be regarded as a
transfer by Mother to herself by reason of her 25% ownership of all of the
non-preferred interests. A transfer to oneself is not a taxable gift.
The other $75,000 will be regarded as a transfer to Son and will be added
to the $600,000 which Son contributes for his non-preferred interests.
However, this $675,000 allocation to Son's non-preferred interests under
the first three steps of the subtraction method should then be reduced
under Step 4 by appropriate minority interest and lack of marketability
discounts. Again, a 30% combined minority interest and lack of
marketability discount for the non-preferred interests is ultimately
determined to be appropriate. The value of Son's non-preferred interests,
using IRC § 2701 principles, is thus $472,500 after the allowable
discounts.
Son contributed $600,000 for his nonpreferred interests, which is
$127,500 more than their value, using IRC § 2701 principles. Therefore,
there may be no taxable gift to Son where the value of the non-preferred
interests received by that partner is less than the value of the property
contributed for those non-preferred interests.
If taken literally, however, the Regulations may treat what is actually a
short-term economic loss as a taxable gift to the extent that the value
determined under the first five steps of the subtraction method formula
exceeds the value (without regard to IRC § 2701 principles) of Son's nonpreferred
interests received for his $600,000 capital contribution . Thus,
the taxable gift could be as much as the $52,500 difference between the
$472,500 value ([1-.3] x $675,000) determined under the first five steps of
the subtraction method formula and the $420,000 economic value of Son's
non-preferred interest, assuming a 30% discount with respect to a
$600,000 contribution.
AT-1152260v1 79

C. Comparison of Advantages and Disadvantages of Preferred Partnerships. In
many respects, preferred partnerships can be extremely user friendly when compared
with other freeze options, but preferred partnerships also have their drawbacks. Clearly,
neither the preferred partnership nor any other freeze option will be the universal freeze
option of choice. There are too many variables which may be accorded different degrees
of importance by different people.
1. Advantages of Preferred Partnerships. Among the principal
advantages of preferred partnerships are (1) the facilitation of a desire to control, (2) a
permissible retention of a disproportionately larger and more predictable share of
partnership net cash flow and income, (3) maximization of backloading, (4) minimization
of the potential adverse tax consequences of death, (5) higher potential discounts for
nonpreferred interests, and (6) the leveraging potential of tandem use with other freeze
techniques.
a. Retention of Control. Senior family members may realize the
valuation advantages of surrendering control over a FLP, but may or may not be willing
to give up control. Noncontrolling retained partner interests will have a materially lesser
value because of combined lack of marketability and lack of control discounts. In
contrast, if the senior family member is unwilling to relinquish control, a lack of
marketability discount should be allowable, but a lack of control discount will not usually
be available.
A preferred partnership structure should enable the senior family
member who places a high premium on control to maintain control with comparatively
little, if any, adverse impact on the allowable discount. In particular, either the postinstallment
sale recapitalization technique or the drop-down preferred partnership
technique should be available to freeze values at least at the FLP partner interests' values,
based only on a lack of marketability discount, and should permit a freeze based on both
lack of marketability and lack of control discounts.
EXAMPLE: Mother and Son establish a FLP. Mother contributes
$2,970,000 for a .99% general partner interest and a 98.01% limited
partner interest. Son contributes $30,000 for a .01% general partner
interest and a .99% limited partner interest.
If Mother makes no transfers, her retained interests will be entitled to a
lack of marketability discount, which an independent appraiser determines
to be 30%.
Mother gifts part of her limited partner interests and then sells the balance
of her limited partner interests, on an installment basis, to a grantor trust.
An independent appraiser determines that a 40% combined lack of
marketability discount and lack of control discount should be allowable
for purposes of determining the amount of the taxable gift, $564,120, and
the installment sale price, $1,200,000. A subsequent proportionate
recapitalization and in kind satisfaction of the installment note with a
AT-1152260v1 80

$1,200,000 preferred interest will have the effect of locking in the 40%
discount.
b. Disproportionate Retention of More Predictable Net Cash
Flow. A preferred partnership is an excellent vehicle for an individual, especially a
senior family member, who is concerned about net cash flow. The preferred partnership
structure may legitimately permit a shifting to the preferred interests of a
disproportionately large share of not only the current net cash flow of the partnership but
also the likely net cash flow for the near future. Once a reasonably comfortable and
secure level of net cash flow is assured, the senior family member may then be willing to
make substantial gifts of nonpreferred interests, especially noncontrolling nonpreferred
limited partner interests, which generate no current net cash flow and may be unlikely to
generate net cash flow in the near future.
EXAMPLE: Mother and her existing grantor trust form a new FLP by
contributing a total of $5,000,000. Mother contributes $4,950,000 of
assets for a .99% general partner interest and a 98.01% limited partner
interest. The grantor trust contributes $50,000 of assets for a .01% general
partner interest and a .99% limited partner interest. Mother would like to
gift a substantial limited partner interest. However, she contemplates that
the partnership will make annual distributions equal to 3% of the value of
the partnership assets as of the first day of each year, and she believes that
she cannot afford to lose any significant portion of the annual
distributions.
Mother agrees to sell her 98.01% limited partner interest to the grantor
trust for its $3,000,000 appraised value. After several years, during which
the underlying assets increase in value from $5,000,000 to $7,500,000, the
partnership is recapitalized. Each partner receives a proportionate share of
a newly issued class of preferred interest with an aggregate $3,000,000
dissolution preference, a 7.25%, or $217,500, cumulative annual net cash
flow preference, and an aggregate $3,000,000 appraised value. Mother
receives $29,700 in value of these preferred interests, and the grantor trust
receives $2,970,300 in value of these interests. At some time thereafter,
the grantor trust satisfies its $3,000,000 installment note by transferring to
Mother its preferred interests worth $2,970,300 and $29,700 of cash
(generated by the excess of the net cash flow preference of the preferred
interest held by the grantor trust over its interest obligations under the
installment note). In the aftermath of these transfers, Mother will hold
preferred interests with a value of $3,000,000 and a .99% nonpreferred
general partner interest. As the holder of the preferred interests, Mother
will be entitled to $217,500 (.0725 x $3,000,000) cumulative annual net
cash flow preferences, which will be fully covered by the distributions of
3% of the then value of the partnership's underlying assets. Thus, almost
all of the distributions will, initially following the satisfaction of the
installment note with the preferred interests, go to Mother as the holder of
the preferred interests. In turn, the grantor trust will hold a .01%
AT-1152260v1 81

nonpreferred general partner interest and a 99% nonpreferred limited
partner interest, but will receive only minimal partnership distributions, at
least initially.
The net cash flow after income taxes is also more predictable
under a preferred trust structure than will be the case under either grantor trust freeze
alternative, either an installment sale to a grantor trust or a GRAT. Under either of the
grantor trust freeze alternatives, the grantor may be hit with a very substantial income tax
liability on "phantom income" (that is, income on which the grantor is taxed but which is
not distributable to him or her). Tax reimbursement provisions may be used to mitigate
or even eliminate these "phantom income" concerns, but such reimbursements may lessen
some of the estate planning advantages, as will be discussed in more detail below.
A preferred partnership (other than a drop-down preferred
partnership funded almost entirely with FLP partner interests) also permits a focusing of
all of the net cash flow of the partnership to satisfy the net cash flow preference. In
contrast, unless substantially all of a FLP's partner interests are sold on an installment
basis to a grantor trust or are contributed to a GRAT, the full net cash flow of the
partnership will not be available to satisfy the obligations owed to the grantor. Instead,
the partnership distributions will be allocated among the partners, including the grantor
trust or GRAT, in proportion to their respective percentage interests, and only the grantor
trust's or GRAT's share of these partnership distributions will be available to satisfy, at
least in part, the trust's obligations to the grantor.
EXAMPLE: Mother and a grantor trust previously established by Mother
are the only two partners of a FLP with $5,000,000 of underlying assets.
Historically, the partnership has distributed 3% of its underlying net asset
value, calculated as of the first day of the year, to the partners in
proportion to their respective percentage interests. Thus the expected
distributions for the year are $150,000. Mother holds a 60% partner
interest which is valued at $1,800,000 ([1-.4] x $3,000,000) and is
expecting $90,000 of distributions for the year.
If Mother sells her partnership interest to a grantor trust for a $1,800,000
10-year installment note yielding 5.82% per annum, the grantor trust's
$90,000 allocable share of partnership distributions for the year will not
fully cover its $104,760 annual interest obligation. If the note does not
permit deferral of interest at the same 5.82% rate, with annual
compounding, in kind payments of partner interests will need to be made
to Mother, or the note will be in default.
In contrast, if Mother's 60% FLP partner interest is converted into a
preferred interest with a $1,800,000 dissolution preference, a 7.25% (or
$130,500) cumulative annual net cash flow preference, and a $1,800,000
value, the first $130,500 of distributions from the partnership for the year
will go to Mother in full satisfaction of that year's annual net cash flow
AT-1152260v1 82

preference. The remaining $19,500 of distributions for the year will go to
the other partner, the grantor trust, which holds all nonpreferred interests.
Because a preferred partnership structure can be used to retain a
disproportionately large, more predictable share of partnership net cash flow, such a
preferred partnership structure is especially likely to appeal to an individual who has
fewer "discretionary assets" (that is, assets which the individual can give away without
undue hardship). Thus, as a rule of thumb, a preferred partnership structure may very
well be the freeze vehicle of choice for an individual with a net worth of under
$5,000,000, and possibly under $10,000,000.
c. Permissible Backloading. If the total return on the
partnership's underlying assets exceeds the interest factor or its equivalent built into the
freeze structure, value will be shifted to the nonfrozen interests, most of which will be
held by or for the benefit of children or other junior generations. That shift in value will
be greater with each additional year for which repayment of the freeze technique's
principal component or its equivalent can be postponed.
(1) Dissolution Preference. Of all of the freeze
techniques, a preferred partnership structure maximizes the deferral of the principal
component or its equivalent. The dissolution preference of the preferred interest will not
need to be satisfied until the partnership is ultimately dissolved. It is not unusual for the
scheduled dissolution date of a partnership to be 30, 40, or even 50 years in the future.
In contrast, a zeroed-out GRAT will generally only run for
a very short term, such as 2 or 3 years. An installment sale to a grantor trust provides
much more flexibility than a GRAT, but rarely will the term of the installment note
extend beyond 20 to 25 years. Any longer term will invite close scrutiny as to whether
the note represents debt or equity.
(2) Net Cash Flow Preference. A preferred interest
must include a cumulative annual net cash flow preference to be tax effective. To the
extent that a partnership has available net cash flow for a particular year, that net cash
flow should be applied against the amounts payable as the cumulative annual net cash
flow preference of the preferred interests. To the extent that the partnership's net cash
flow for a particular year is insufficient to satisfy that year's cumulative net cash flow
preference, the shortfall will be carried over to later years. If the shortfall cannot be
satisfied within four years after the year of accrual, the unsatisfied annual net cash flow
preference will be increased, retroactively to the initial date of accrual, at an annually
compounded rate corresponding to the net cash flow preference rate. Effectively, then, a
preferred partnership potentially permits substantial backloading of the net cash flow
preference if the partnership generates little net cash flow, but the trade-off may be a
higher net cash flow preference rate if the inability to satisfy the cumulative annual net
cash flow preference when it accrues or shortly thereafter is foreseeable at the time the
preferred interests are issued.
AT-1152260v1 83

Again, the "zeroed-out" GRAT is highly inflexible and does not
allow any material backloading of the interest component, as well as the principal
component. Annuity payments, including an interest factor, must be made at scheduled
annual or more frequent dates during the comparatively short term of the GRAT, which
will generally not extend for more than 2 or 3 years.
An installment sale to a grantor trust, however, does allow
backloading of interest. If the installment note provides for a deferral of all interest, no
interest or principal may be payable until the end of the note term. If substantial interest
is deferred, debt versus equity considerations may warrant a shorter note term. Instead of
a balloon payment at the end of 20 or 25 years, a 15 to 18 year term may be advisable to
minimize the risk that the IRS may challenge the classification of the note as debt, as
opposed to equity.
d. Post-Death Income Tax Considerations. Income tax
considerations also play a very significant role in freeze planning if the assets of the
partnership have appreciated considerably and have a value materially above the income
tax basis of those assets in the hands of the partnership. To the extent that the value of a
deceased partner's interests in the partnership are includible in his or her gross estate and
are not income in respect of a decedent within the meaning of IRC §691, an IRC §754
election by the partnership will enable an effective step-up in basis of an allocable share
of the basis of the underlying partnership assets. See IRC §§ 754, 743(b), and 755. This
step-up of the "inside basis" (that is, the basis of the decedent's allocable share of the
basis of the underlying partnership assets) will be in addition to a step-up in basis of the
decedent's partner interests (the "outside basis") to their value, as finally determined for
federal estate tax purposes. See IRC § 1014.
If the deceased partner owns a preferred interest at of the date of
his or her death, both the inside and outside basis of that preferred interest will be
increased to correspond to the estate tax value of that preferred interest, excluding any
income in respect of a decedent attributable to the preferred interest.
A FLP partner interest held by a GRAT will also receive a step-up
in both its inside and outside basis. In fact, if the FLP partner interests have appreciated
in value subsequent to their contribution to the GRAT, the step-up in basis for income tax
purposes will be even greater, but only because the appreciation will be reflected in a
higher estate tax value. Since estate tax rates are typically higher than income tax rates,
the higher current or ultimate estate tax liability will, in all likelihood, more than offset
the lower income tax liability.
One of the potential principal disadvantages of an installment sale
to a grantor trust involves the grantor's death before the note is repaid. The deceased
grantor will hold only the installment note at death. Therefore, only the installment note
will be includible in the grantor's gross estate for estate tax purposes and will be entitled
to a step-up in basis for income tax purposes to its estate tax value, excluding any noterelated
income in respect of a decedent. The FLP partner interests held by the grantor
trust may support the value of the installment note, but these FLP partner interests
AT-1152260v1 84

themselves will not be includible in the decedent's gross estate for estate tax purposes.
Consequently, the outside basis of these grantor trust-owned FLP partner interests will
not be entitled to a step-up under IRC §1014, and the inside basis will not be entitled to
an IRC § 1014-related step-up by reason of the partnership's IRC §754 election. If any
step-up in basis is available, it will be attributable to a deemed sale resulting from the
termination of grantor trust status upon the grantor's death, which may result in an
income tax liability in the deceased grantor's final income tax return. See Reg. §1.1001-
2(c), Example 5, Madorin v. Commissioner, supra, and Rev. Rul. 77-402, supra. Any
step-up in income tax basis, then, will be accompanied by a material risk of a
corresponding income tax liability, which is clearly not the desired result.
EXAMPLE: Assume that Mother is a limited partner of a FLP, holding a
60% noncontrolling partner interest. The underlying FLP asset consists of
a single stock with a $5,000,000 value and a zero basis. Mother
implements a freeze when the value of her 60% noncontrolling partner
interest is $1,800,000 ([1-.4] x $3,000,000). Subsequently, the FLP's
underlying asset doubles in value on takeover speculation. Mother then
dies. The FLP's underlying stock is purchased after her death for
$10,000,000 in cash.
If the freeze technique used is a preferred partnership structure, Mother
will hold a preferred interest with a $1,800,000 date of death value,
resulting in a $990,000 estate tax liability. Her inside and outside basis
will be $1,800,000. The gain realized by all partners upon the post-death
sale will be $8,200,000, resulting in a $1,640,000 income tax liability.
The combined estate and gift tax liability will be $2,630,000.
If a GRAT is used, the $3,600,000 value of the 60% partner interests held
by the GRAT will be includible in Mother's gross estate, triggering a
$1,980,000 estate tax liability. As some consolation, the gain realized by
all partners from the post-death sale will be reduced to $6,400,000, with a
resulting $1,280,000 income tax liability. The total tax liability will be
$3,260,000, $630,000 more than under the preferred partnership option.
If an installment note to a grantor trust is used, the $1,800,000 installment
note will be includible in Mother's gross estate for estate tax purposes,
resulting in a $990,000 estate tax liability. However, there is a very
distinct possibility that no step-up in basis of the 60% limited partner
interest held by the grantor trust will be allowable. If that proves to be the
case, the gain realized by all partners upon the post-death sale will be
$10,000,000, causing a $2,000,000 income tax liability. The combined
estate and gift tax liability will be $2,990,000, $360,000 more than under
the preferred partnership option.
e. Higher Discounting of Nonpreferred Interests. Assuming that
a 30% lack of marketability discount or 40% combined lack of marketability and lack of
control discount is properly allowable for purposes of valuing a FLP partner interest, a
AT-1152260v1 85

discount which is at least 5 to 10 percentage points higher seems logically appropriate to
reflect the subordinate positions of the nonpreferred interests to the dissolution and net
cash flow preferences of the preferred interests. Thus the lack of marketability discount
for a controlling nonpreferred interest should be at least 35%, and the combined lack of
marketability and lack of control discount for a noncontrolling nonpreferred interest
should be at least 45%.
In contrast, neither of the other freeze techniques will increase the
allowable discounts for partner interests.
f. Double Leverage from Tandem Use of Freeze Techniques. For
extremely high net worth individuals, a preferred partnership structure is generally
combined with a GRAT, an installment sale to a grantor trust, or both. The double
leverage resulting from tandem use of a preferred partnership structure with one or more
of the other freeze techniques will accentuate the shift of value to the transferred nonpreferred
interests in the event that the total return on the underlying partnership assets
meets or exceeds expectations. Such double leverage will also increase the risk of
economic underperformance.
EXAMPLE: A partnership holds $100,000,000 of underlying assets. A
10% annually compounded total return is expected
First assume that the partnership includes no preferred feature. Mother
sells a noncontrolling 60% limited partner interest to a grantor trust for a
$36,000,000 installment note ([1-.4] x $60,000,000), payable interest only
for the first year at a 5.12% rate. The underlying partnership assets in fact
increase in value at the expected 10% rate. The value of the
noncontrolling 60% limited partner interest held by the grantor trust will
increase at the same 10% rate to $39,600,000 at the end of the first year.
When the $37,843,200 balance owed under the note is then subtracted, the
net value of the grantor trust's holdings after one year is $1,756,800.
Alternatively, assume that the partnership is a drop-down preferred
partnership. The controlling preferred interest has a $40,000,000
dissolution preference, a 7.25% cumulative annual net cash flow
preference, and a $40,000,000 value. The noncontrolling nonpreferred
interests, which have a $33,000,000 value after taking into account a 45%
combined lack of marketability and lack of control discount, are sold to a
grantor trust for a $33,000,000 installment note, again payable interest
only for the first year at a 5.12% rate. If the first year's total return for the
partnership is 10%, as anticipated, the net value of the grantor trust's
holdings will be $2,215,400, the difference between the $36,905,000 value
of the grantor trust's nonpreferred interest ([1-.45] x [$110,000,000-
$42,900,000]) and the $34,689,600 note balance ([1+.0512] x
$33,000,000). This net value of $2,215,400 is $458,500, or over 25%,
more than the net value under the nonpreferred structure.
AT-1152260v1 86

g. Lesser Need for Seed Gifts or Guarantees. An installment sale
to a grantor trust is generally assumed to need a prior "seed" gift to the trust with a value
of at least 10% (or 11.1%) of the initial installment note principal balance at the time of
the installment sale. Alternatively, a guarantee of at least 10% (or 11.1%) of the initial
installment note principal balance by the beneficiaries of the grantor trust may suffice,
but only if the guarantors have the net worth to back up the guarantee. For larger
transfers, satisfaction of this 10% (or 11.1%) "seed" gift or guarantee guideline may
cause the donor to incur a very substantial gift tax liability or may involve very
substantial guarantees by the beneficiaries. The donor or guarantors may shy away from
the installment sale because of their reluctance to pay the gift tax or incur the risk of the
guarantee being called, even though the installment sale to a grantor trust may otherwise
be the best freeze vehicle from a tax and estate planning perspective.
A preferred partnership structure, coupled with an installment sale
of the nonpreferred interests to a grantor trust, can be used as a vehicle to minimize the
amount of a "seed" gift or guarantee.
EXAMPLE: Assume that a partnership holds $100,000,000 of
underlying assets.
Mother would like to sell a noncontrolling 99% limited partner interest to
a grantor trust on an installment basis. The value of this limited partner
interest is $59,400,000 ([1-.4] x $99,000,000). At a minimum, Mother
will have to gift at least $5,400,000 ($59,400,000 ) 11) and incur a 2001
gift tax liability of $2,970,000, assuming that prior taxable gifts already
place Mother in the highest gift tax bracket. Alternatively, the
beneficiaries of the grantor trust will have to guarantee at least $5,950,000
of the indebtedness, representing 10% of the $59,400,000 note, and will
have to have at least $5,940,000 of net worth to legitimize the guarantees.
In contrast, if a preferred structure is used and the controlling preferred
interest has a $40,000,000 value, the noncontrolling nonpreferred interest
that remains will have a value of $33,000,000, taking into account a 45%
combined lack of marketability and lack of control discount. A "seed" gift
of only $3,000,000 ($33,000,000 )11) will be needed to support an
installment sale to a grantor trust, and the resulting 2001 gift tax liability
will be $1,650,000. Alternatively, the beneficiaries will need to guarantee
at least $3,300,000 of the $33,000,000 installment note. If even lesser
"seed" gifts or guarantees are preferred, more value can be shifted to the
preferred interest, which will reduce the value of the nonpreferred interests
and the seed gifts or guarantees.
2. Disadvantages of Preferred Interests. A preferred partnership has very
significant potential drawbacks which must be overcome to be the preferable freeze
technique. These potential drawbacks include (1) higher rates, (2) either the loss of at
least part of the otherwise allowable discounts for a FLP or a much more complicated
AT-1152260v1 87

structure to preserve the discounts, and (3) the reduced ability to convert "phantom
income" from the partnership into an estate planning advantage.
a. Higher Rates. No freeze vehicle can compete with the interest
factor available under an installment sale to a grantor trust. For the month of July, 2001,
the applicable federal rates payable by a grantor trust, assuming annual payment dates,
will range from 4.07% to 5.82%. Effectively, the grantor trust is permitted to borrow at
the same rates as the United States Treasury, irrespective of the credit-worthiness of the
grantor trust.
It is generally thought that a GRAT's interest factor, 120% of the
mid-term applicable federal rate (which is 6.2% for July, 2001), will also beat the rate for
a preferred partnership. As shown previously, however, if mortality and possible
exhaustion factors are also taken into account, the effective interest factor for a GRAT is
likely to be much higher than this stated interest factor. In many instances, especially
with an elderly grantor and a longer GRAT term, the GRAT will have the highest
effective rates.
Unlike the statutorily prescribed rates for an installment sale to a
grantor trust or GRAT, there is no safe harbor rate for preferred partnerships.
Furthermore, the preferred rates are likely to be higher than at least the stated rates for the
other freeze vehicles. For example, for credit-worthy preferred partnerships, such as
securities partnerships which hold high quality, widely diversified stocks and which are
not leveraged, a preferred rate of from 7.0% to 7.5% would seem reasonable for July,
2001. If the net cash flow preference is likely to be satisfied with income that enjoys
preferential income tax rates, such as long-term capital gains and tax-exempt income, an
even lower preferred rate may be justifiable. Conversely, if the lesser quality of the
underlying partnership assets, high leverage at the partnership level, poor net cash flow or
dissolution preference coverage, or similar considerations make the partnership or the
preferred interests riskier, the preferred rates may be higher, and possibly materially
higher, than the 7.0% to 7.5% range for more credit-worthy partnerships.
Even this rate differential may be converted from a preferred
partnership drawback to an advantage if one of the senior family member's objectives is
to shift current cash flow to his or her children or more remote descendants.
EXAMPLE: Mother is concerned about her two children in their
twenties, both of whom are beginning their working careers and have
young children of their own. Mother has set up a preferred partnership
and gifted one-half of her non-preferred interests with a $675,000 value to
a grantor trust, thus exhausting her current applicable exclusion amount.
She has retained both a preferred interest, which has a $2,000,000
dissolution preference and a 7.5% per annum, or $150,000 per year, net
cash flow preference, and the other half of her non-preferred interests.
Mother ultimately wants the net cash flow generated by her preferred
interest, but is willing to shift as much of that net cash flow as she can
without adverse gift tax consequences until she retires in 9 years. Mother
AT-1152260v1 88

may want to consider an installment sale of her preferred interest to the
grantor trust for $2,000,000, with annual interest payments of $102,400
(the 5.12% mid-term applicable federal rate for a July, 2001 sale) being
due as of each of the first through ninth anniversaries of the sale and with
the full principal balance also being payable on the ninth anniversary of
the sale. After the $150,000 annual net cash flow preference payment is
received by the grantor trust and is then used to pay the $102,400 annual
interest expense, the trust will net $47,600 per year for 9 years. This
$47,600 annual net amount can be used, in part or in full, by the grantor
trust to make distributions to the children. Some of this $47,600 annual
net amount can also be accumulated in the trust to provide a sinking fund
for at least part of the grantor trust's principal obligation due at the end of
the 9-year note term.
b. Discounting. A recapitalization of a FLP into a preferred
partnership runs a material risk that the lack of marketability discount, or combined lack
of marketability and lack of control discount, allowable for the respective FLP partner
interests will be lost or substantially reduced to the extent that the FLP interests are
converted into preferred interests. The Regulations clearly raise this specter, although
these Regulations are so ambiguous and inconsistent, both internally and with other IRS
rulings, that their meaning and validity are questionable. It is probably safe to say that
the confusion caused by these Regulations is one of the biggest deterrents to preferred
partnership recapitalizations.
Various techniques, such as post-installment sale recapitalizations
and drop-down preferred partnerships, may circumvent the potential loss or reduction of
allowable discounting, but these techniques only add to the inherent legal complexities of
a recapitalized preferred partnership.
c. Phantom Income. An installment sale to a grantor trust
involves an inherent income tax consideration, which may be regarded by the seller of the
FLP interest as a drawback but actually represents an additional estate planning benefit.
So long as the trust to which the FLP interest is sold on an installment basis continues to
be classified as a grantor trust, all taxable income of that trust will be taxable for income
tax purposes to the grantor, the seller of the FLP interest on an installment basis. See IRC
§§ 671 et seq. and Rev. Rul. 85-13, 1985-1 C.B. 184. This will not be a disadvantage if
the seller's primary objective is to maximize the trust's holdings, for the principal and
undistributed net income of the trust can continue to build without being burdened with
any income tax liability unless the trust instrument directs or permits that the grantor be
reimbursed for his or her trust-related income tax liability. See PLR 199922062 and
PLR 200120021. Not only will the build-up in value of the trust be free from any income
tax liability, as well as any gift or estate tax liability (assuming that the FLP interest is
sold for its fair market value), but the seller's personal obligation to pay the income tax
liability attributable to the taxable income generated by the trust (absent a tax
reimbursement provision in the trust) will reduce the seller's retained assets and will thus
reduce his or her ultimate estate tax liability. The potential hazard is that the seller may
be hit with an unexpected, or unexpectedly large, income tax liability on income which
AT-1152260v1 89

he or she does not actually receive. It is conceivable that the income tax liability on this
"phantom income" may even exceed the proceeds received by the seller from the sale of
the FLP interest on an installment basis.
EXAMPLE: Mother sells her FLP interest on an installment basis for
$1,000,000, the interest's appraised fair market value. The installment note
is payable interest only for 20 years, with a balloon payment at the end of
that 20-year term. In year 15, the FLP sells its only asset for a very
favorable price. The grantor trust's allocable share of the gain is
$6,000,000. Mother's resulting personal income tax liability is
$1,200,000. This liability is significantly more than the $1,000,000
principal balance plus the pro rated interest for the year of sale which the
seller receives when the note is satisfied in full. This assumes that the
installment note is prepaid in the year of sale. If the note is not prepaid,
only the annual interest payment, and not the $1,000,000 of principal, will
be available to Mother at the end of the year of sale to help defray her
$1,200,000 income tax liability.
A preferred partnership, or at least the preferred interest, is much
less likely to throw off "phantom income." To the extent that a preferred interest in a
preferred partnership offers the potential for "phantom income," that phantom income,
especially if accompanied by a deferred payment of the cumulative annual net cash flow
preference, will probably increase the ultimate estate tax liability attributable to the
preferred interest. The "phantom income" will thus not present the same estate planning
opportunities.
VI.
SELF-CANCELLING INSTALLMENT NOTES
A. Overview. A self-cancelling installment note ("SCIN") is a debt obligation
that contains a provision which calls for the cancellation of the liability upon the death of
the holder during the term of the note. If the holder dies prior to the expiration of the
term of the SCIN, the automatic cancellation feature may operate to remove a significant
amount of assets from what would otherwise be includible in the estate of the holder.
EXAMPLE (INSTALLMENT SALE): Assume Father, who is age 75, is
in the 55% estate tax bracket and owns a business worth $10,000,000. He
sells the business to Son in exchange for a ten-year installment note
calling for equal principal and interest payments of $1,340,713 per year
based on the 5.72% August, 2001 long-term applicable federal rate
("AFR"). If Father dies immediately after Son makes the second
installment payment, the $8,418,603 remaining principal balance on the
note, plus the two payments of $1,340,713 received (and an assumed 10%
total return on the first year's payment), totaling $11,234,100, would be
includible in Father's estate and would result in approximately $6,178,755
in federal estate taxes.
AT-1152260v1 90

EXAMPLE (SCIN): Assume the same facts as in the preceding example,
except that Father and Son negotiate an arm's length increase of
$3,009,919 in the purchase price (resulting in equal annual installments of
principal and interest of $1,744,257) in exchange for Father's agreement to
cancel the note in the event he dies prior to the end of the term. Upon
Father's death after two years, only the two payments of $1,744,257
received (and an assumed 10% total return on the first year's payment),
totaling $3,662,940, would be includible in Father's estate, resulting in an
estate tax of $2,014,617. This self-cancelling feature would thus save
Father's estate approximately $4,164,138 in federal estate taxes as
compared to the regular installment sale.
The calculations in all SCIN examples are from NumberCruncher v. 2000.01,
Illustrations Courtesy NumberCruncher Software: 610 924 0515/leimberg.com.
As discussed below, the SCIN transaction works best when the seller/client dies
prior to, and "preferably" materially prior to, his or her actuarial life expectancy. The
ideal candidate is someone in poor health, but whose death is not imminent, or someone
with a very poor family health history. As with all sophisticated tax planning strategies,
the SCIN is not for all clients or all situations, especially since clients' actual life
expectancies are never truly known in advance.
There are also numerous issues concerning the technique which have not yet been
fully resolved. In addition to the obvious mortality issue, there are questions as to what
base rates should be used (the IRC § 7520 rate or the AFR), what life expectancies
should be used (the tables used under IRC § 7520, the tables used under IRC § 72, or the
seller's actual life expectancy), how the payments should be allocated for income tax
purposes (what amounts are return of basis, interest, and gain) and the effect of the
cancellation of the note upon the seller's death for income tax purposes (is the
cancellation a taxable event for the debtor).
B. Structure of a SCIN Transaction.
1. Overview. Apart from the self-cancelling feature, a SCIN transaction
closely resembles an installment sale.
2. SCIN Structure.
a. Interest. Two different issues must be considered when setting
the stated interest rate on a SCIN: (1) the lowest rate allowed under the "original issue
discount" (OID) rules which does not result in imputed interest (assuming that the
purchaser is not a grantor trust) and (2) the lowest rate which does not result in a taxable
gift.
(1) OID Rate. A normal installment note which is not
issued by a grantor trust must have a rate at least equal to the "applicable federal rate"
(AFR) determined under IRC § 1274(d) in order to avoid the imputed interest rules.
Because the SCIN transaction is a sale or exchange, the rate to be used is the lowest of
AT-1152260v1 91

the AFRs in effect for any month in the 3 month period including and ending with the
first calendar month in which there is a binding, written contract for the sale of the
property. See IRC § 1274(d)(2). While the AFR must be compounded semiannually, the
IRS issues AFRs each month which take the semiannual compounding requirement into
account. See, e.g., Rev. Rul. 2001-36, 2001-32 I.R.B. 1, which sets forth the August,
2001 rates.
(2) Gift Tax Rate. In order to prevent an installment
sale from being a part gift/part sale, the value of the installment note received must be
equal to the value of the property sold. In a normal installment sale, having a rate at least
equal to the AFR in effect for the month of the sale should prevent the value of the note
from being worth less than the value of the property sold, for the note will not be a "gift
loan" under IRC § 7872(b)(1). See IRC §§ 7872(c)(1)(A), (e)(1)(B), (f)(1)(B) and (f)(3).
In theory, the same rationale should apply to a SCIN. The
value of the SCIN must equal the value of the property sold to avoid part sale/part gift
treatment. In fact, the IRS has indicated that the value of the SCIN need only be
"substantially equal" to the value of the property sold. G.C.M. 39503, June 28, 1985,
Issue (2)(B). Notwithstanding what might be an easier standard to meet, taxpayers are
well advised to structure the SCIN so that the value of the SCIN is at least equal to the
value of the property sold.
In order to have the value of the SCIN equal the value of
the property sold, however, the seller of the property must be compensated for the risk
that the seller may die during the term of the note, and thus not receive the full purchase
price. Since such a feature must be bargained for at arm's length to be respected, the
seller must be compensated for the risk associated with the potential cancellation either
by an increase in the purchase price or by a higher interest rate. See Banoff and Hartz,
"Self-Cancelling Installment Notes: New IRS Rules Expand Opportunities," 65 J. Tax'n
146 (1986) (hereinafter, "Banoff and Hartz 1986"). In order to calculate the premium, an
advisor must determine what stream of payments are required, taking into consideration
the possible death of the seller, to have the same present value as the principal amount of
the promissory note. See Covey, et al. "Q&A Session I of the Twenty-Seventh Annual
Institute on Estate Planning," 27 U. Miami Inst. on Est. Plan. 216 (1993). There is not
universal agreement on how payments under a SCIN are properly valued, for there is no
clear answer concerning which mortality tables should be used and which discount rate
should be applied to value the payments. Some commentators use the life expectancies
in Table 90CM (Reg. § 20.2031-7(d)(7) and Aleph Volume (Pub. 1457)) and a rate equal
to the greater of 120% of the mid-term AFR, assuming annual payments, as prescribed by
IRC § 7520, or the AFR for the actual term of the note, as prescribed by IRC § 7872. See
Covey, et al. "Q&A Session I of the Twenty-Seventh Annual Institute on Estate
Planning," 27 U. Miami Inst. on Est. Plan. 216 (1993). Others use the annuity tables
(Reg. § 1.72-9, Table V) and the AFR as prescribed by IRC § 7872. See Hesch and
Manning, "Beyond the Basic Freeze: Further Uses of Deferred Payment Sales," 34 U. of
Miami Inst. on Est. Plan. 1601.3(B)(1) and (2) (2000) (hereinafter "Hesch and Manning
2000"). One Seventh Circuit decision supports use of the IRC § 1274 rate (which is the
underlying basis for the IRC § 7872 rate); that decision of the Seventh Circuit ruled that
AT-1152260v1 92

the use of the IRC § 483 rate, and thus the IRC § 1274 rate, is a safe harbor for all
purposes, including for the valuation of a note for gift tax purposes. Ballard v.
Commissioner, 854 F.2d 185 (7 th Cir. 1988). The Tax Court has refused to follow this
reasoning in cases outside of the Seventh Circuit, however. Krabbenhoft v.
Commissioner, 94 T.C. 887, 890 (1990), aff'd 939 F.2d 529 (8 th Cir. 1991). Additionally,
the Service has indicated that an individual's actual life expectancy may be used (G.C.M.
39503, supra), and other commentators have recommend that the actual life expectancy
be used. See Banoff and Hartz, "Sales of Property: Will Self-Cancelling Installment
Notes Make Private Annuities Obsolete," 59 Taxes 499, 515 (1981) (hereinafter "Banoff
and Hartz 1981").
While an advisor could determine these payment streams and
resulting rates manually, or by use of a computer program, some commentators
recommend that an actuary be employed. See Covey, et al. "Q&A Session I of the
Twenty-Seventh Annual Institute on Estate Planning," 27 U. Miami Inst. on Est. Plan.
216 (1993), and Smith and Olsen, "Fractionalized Equity Valuation Planning:
Preservation of Post-Mortem Valuation Discounts," 34 U. Miami Inst. on Est. Plan.
1103.3(F)(2) (2000).
Although the matter is by no means free from doubt, the author
personally is persuaded by the well-reasoned approach of Hesch and Manning. The IRC
§ 7872 AFRs are, more likely than not, appropriate, and the examples used in regard to
SCINs will generally use AFRs, not IRC § 7520 rates. Nonetheless, AFRs should not be
used by the faint of heart. A conservative planner probably should use the higher of the
IRC § 7520 rate or the AFR for the actual term of the note, as recommended by Covey.
Clearly, most practitioners are using the higher of the IRC § 7520 rate or the AFR for the
actual term of the note, for the gift, and possibly the estate, tax risk of using a rate which
is too low is simply too great.
b. Term. The term of the SCIN should not equal or exceed the
individual's life expectancy, or the SCIN might be recharacterized as a private annuity.
G.C.M. 39503, supra, Issue 1. Even this conclusion is not universally accepted. See
Hesch and Manning 2000, at 1601.3(A). As noted above, however, there is a difference
of opinion as to how life expectancy is to be determined. Are the 90CM estate tax tables
under Reg. § 20.2031-7(d)(7) and Aleph Volume (Pub. 1457), the income tax annuity
tables under Reg. § 1.72-9, Table V, or the Seller's actual life expectancy to be used
While a conservative approach would be to structure the SCIN to have a term which is
shorter than the shortest of all of these possible life expectancies, such a structure would
virtually eliminate the primary advantage of the SCIN -- the likelihood that a would-be
seller with health problems or a poor family health history will die before he or she is
"supposed to." If the seller has a "terminal illness," however, the actuarial tables should
not be used. Reg. § 20.7520-3(b)(3). "Terminal illness" means that the individual has an
"incurable illness or other deteriorating physical condition" which results in at least a
50% probability that he or she will die within one year. Reg. § 1.7520-3(b)(3). If the
individual lives for 18 months or longer after the relevant valuation date, he or she will be
presumed not to have been terminally ill at the time of the transaction, unless the
existence of a terminal illness can be established by clear and convincing evidence. Reg.
AT-1152260v1 93

§ 1.7520-3(b)(3). As Hesch and Manning point out, SCINs may not technically be
subject to this regulation, but it is wise not to use any standard actuarial tables when an
individual is gravely ill. Hesch and Manning 2000, at 1601.3(c).
Also, as discussed above in the context of an installment sale to an
IDGT, a SCIN term which is too long may raise debt/equity concerns, especially when
the sale is to a trust with comparatively few other assets.
The mortality component of the SCIN increases as the term of the
SCIN increases, for a greater risk premium must be added to the SCIN to compensate the
seller for the higher probability that the seller will die prior to the expiration of the longer
term. The parties might be tempted to create a short term SCIN with the hopes that the
seller would allow the purchaser to extend the term of the SCIN serially in a manner
which would be similar to "rolling GRATs." Such a structure, however, would have to
be carefully structured, probably as a unilateral option of extension within the instrument
to be held by the issuer, so that the extension would not be a modification, and thus an
exchange, of the SCIN under Reg. § 1.1001-3. There would still be a material risk that,
at some future extension date, the seller would be terminally ill, thus materially
increasing the risk of estate tax exposure.
EXAMPLE (" ROLLING SCINs"): Assume that a 64 old client
desires to sell a piece of property worth $10,000,000 to a family
member. Based upon Table V under Reg. § 1.72-9, the seller's life
expectancy is just over 20 years. Therefore, the client sells the
property to the family member for an interest-only SCIN with a
term of twenty years, using the purchase price premium method.
Alternatively, the client could sell the property to the family
member for an interest-only SCIN with a 4 year term and balloon
payment, again using the purchase price premium method.
Assume that the interest payments are made during the term of the
SCIN. At the expiration of the initial 4 year term the SCIN is
extended for another 4 years, and is subsequently extended for
successive four year terms, until the expiration of 20 years. What
are the estate tax results
As shown on the following chart, assuming a 10% total return on
interest paid to the seller, the "rolling SCINs" result in a lower
value of assets being included in the seller's estate at each point.
AT-1152260v1 94

Long Term SCIN vs. "Rolling SCINs"
$18,000,000
$16,000,000
$14,000,000
$12,000,000
Estate Tax Savings
$10,000,000
$8,000,000
Interest Premium
Purchase Premium
Rolling Interest
Rolling Premium
$6,000,000
$4,000,000
$2,000,000
$0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Years
However, the use of "rolling SCINs" materially increases the risk
of a "terminal illness" posing a problem at the time that the SCIN
is scheduled to mature and is proposed to be extended for another 4
years. A death within the first 18 months of any 4 year extension
is likely to arouse suspicions that the seller may have been
terminally ill at the time of the extension.
c. Premium on Principal. If the risk premium is not reflected in a
higher interest rate, then it must be added to the sales price and reflected in a higher face
AT-1152260v1 95

amount of the SCIN. As is discussed below, a principal risk premium should be treated
as a capital gain to the seller and increase the basis of the property in the hands of the
purchaser.
d. Comparison of Interest and Principal Premiums. If a selfamortizing
note with equal principal and interest payments is used, there should be no
difference for estate tax purposes between choosing an interest risk premium and a
principal risk premium, as the annual payments under either structure would be the same.
If, however, an interest-only SCIN or a level principal payment SCIN is used, then for
estate tax purposes, the relative merits of choosing the principal premium or interest rate
premium to compensate the seller for the risk of death occurring during the term of the
SCIN should be analyzed, as the benefits depend upon the type of note used.
EXAMPLE (SELF-AMORTIZING SCIN): Assume Father,
who is age 75 and is in the 55% estate tax bracket, wants to sell a
business with a $10,000,000 value to Son. The sale is to be
structured as a 10-year SCIN in which Father and Son negotiate an
increase of $3,009,919 to the $10,000,000 purchase price in
exchange for Father's agreement to cancel the note in the event he
dies prior to the end of the term. This increased purchase price
results in equal annual installments of principal and interest of
$1,744,257 under a self-amortizing installment note. Upon
Father's death after two years, only the two payments of
$1,744,257 received (and an assumed 10% total return on the first
year's payment), totaling $3,662,940, would be includible in
Father's estate, resulting in an estate tax of $2,014,617. This selfcancelling
feature would thus save Father's estate approximately
$4,164,138 in federal estate taxes as compared to the regular
installment sale.
If Father and Son choose to use the interest premium method
instead of the principal premium method, the purchase price would
remain $10,000,000, but the interest rate would increase from
5.72% to 11.6458%, with the same resulting self-amortizing
annual payments of $1,744,257. Therefore, Father's death after
two years would have the same estate tax results as under the
principal premium method.
EXAMPLE (INTEREST ONLY SCIN): Assume again the same
facts as in the preceding self-amortizing note example. Instead of
structuring the SCIN to have equal annual installments of principal
and interest over the 10-year note term, however, Father and Son
decide to structure the SCIN so that it requires annual payments of
interest only and a balloon payment of principal at the end of 10
years.
AT-1152260v1 96

Principal Premium. If Father and Son opt for a principal premium
instead of an interest premium, the $10,000,000 purchase price of
the business would be increased by a $5,833,061 mortality factor,
resulting in an initial principal balance of $15,833,061. Son would
be obligated to make annual interest payments of $918,317, with a
balloon principal payment of $15,833,061 at the end of 10 years.
If Father dies immediately after Son makes the second interest
payment, only the two interest payments of $918,317 received (and
an assumed 10% total return on the first year's payment), totaling
$1,928,465, would be includible in Father's estate, resulting in an
estate tax of $1,060,656. This self-cancelling feature would thus
save Father's estate approximately $5,118,099 in federal estate
taxes when compared to a regular installment sale, and a savings of
$953,961 over a self-amortizing note with the same 10-year term.
Interest Rate Premium. If Father and Son choose not to increase
the purchase price but instead opt to increase the 5.72% interest
rate by 6.506% to 12.226%, Son would be obligated to make
annual interest payments of $1,222,602 and a principal balloon
payment of $10,000,000 at the end of 10 years. If Father dies
immediately after Son makes the second interest payment, again,
the two interest payments of $1,222,602 received (and an assumed
10% total return on the first year's payment), totaling $2,567,464,
would be includible in Father's estate, resulting in an estate tax of
$1,412,105. While the interest premium self-cancelling feature
would thus save Father's estate approximately $4,766,650 in estate
taxes when compared to a regular installment sale, it would result
in additional estate taxes of $351,449 when compared to the
principal premium method on an interest-only note, and a savings
of $602,512 when compared to a self-amortizing note with the
same 10-year term.
EXAMPLE (EQUAL PRINCIPAL PAYMENT SCIN):
Assume again the same facts as in the self-amortizing note
example ($10,000,000 value of property, 5.72% AFR and 75 year
old seller). Instead of structuring the SCIN to have self-amortizing
annual installments of principal and interest over the 10-year note
term, Father and Son decide to structure the SCIN so that it
requires level annual principal payments over the 10 year term.
Principal Premium. If Father and Son opt for a principal premium
instead of an interest premium, the $10,000,000 purchase price of
the business would be increased by a $2,731,556 mortality factor,
resulting in an initial principal balance of $12,731,556. Son would
be obligated to make level annual principal payments of
$1,273,156, with varying interest amounts over the 10 year term,
the first two total payments being $2,001,401 and $1,928,576
AT-1152260v1 97

espectively. If Father dies immediately after Son makes the
second payment, only these two payments received (and an
assumed 10% total return on the first year's payment), totaling
$4,130,117, would be includible in Father's estate, resulting in an
estate tax of $2,271,564. This self-cancelling feature would thus
save Father's estate approximately $3,907,191 in federal estate
taxes when compared to a regular installment sale.
Interest Rate Premium. If Father and Son choose not to increase
the purchase price but instead opt to increase the 5.72% interest
rate by 5.785% to 11.505%, Son would be obligated to make level
annual principal payments of $1,000,000, with varying interest
amounts over the 10 year term, the first two total payments being
$2,150,500 and $2,035,450 respectively. If Father dies
immediately after Son makes the second interest payment, again,
these two payments received (and an assumed 10% total return
growth on the first year's payment), totaling $4,401,000, would be
includible in Father's estate, resulting in an estate tax of
$2,420,550. While the interest premium self-cancelling feature
would thus save Father's estate approximately $3,758,205 in
federal estate taxes when compared to a regular installment sale, it
would result in $148,986 less of savings when compared to the
principal premium method on a level principal payment note.
(Note that NumberCruncher uses the IRC § 7520 rate as the
discount rate for valuing SCIN payment streams, and as such, the
program will not allow discount rates to be entered in percentages
other than rounded to the nearest 0.2%. Therefore the 5.72% AFR
for August is automatically rounded to 5.80% by the program, so
that the annual interest payment is slightly higher in the examples.)
For income tax purposes, choosing to increase the principal
balance of the purchase price will generally result in higher capital gains taxes and lower
interest income being reported by the seller, with the buyer receiving a higher basis in the
purchased asset and a lower current deduction, if any, for the payment of interest.
Conversely, if the purchase price remains equal to the fair market value of the property
sold and the interest rate is instead increased, then the seller will report more interest and
less capital gains income. In turn, purchaser will take a lower cost basis in the acquired
property, but may have a higher current deduction for the increased interest payments.
Hesch and Manning, "Family Deferred Payment Sales, Installment Sales, SCINs, Private
Annuity Sales, OID and Other Enigmas," 26 U. of Miami Inst. on Est. Plan. 310.3(B)
(1992) (hereinafter "Hesch and Manning 1992").
e. Collateral and Credit Enhancements. As in a normal
installment sale to an IDGT, if the property is sold to a trust for a SCIN, the SCIN should
be secured by all trust assets, and not just the assets sold. Such other trust assets,
including any "seed" gifts, presumably should be of sufficient value so that the value of
AT-1152260v1 98

the trust assets after the sale would be at least 10% (or possibly 11.1%) more than the
principal amount of the SCIN, including any principal premium. Bona fide guarantees
resulting in corresponding coverage should also work. It should be emphasized,
however, that if a principal premium approach is used, the required "seed" funding for a
SCIN will materially exceed the required "seed" funding for a normal installment sale to
an IDGT (i.e., 10%, or possibly 11.1%, of the sales price without any principal premium
adjustment).
C. Tax Analysis.
1. Income Tax Consequences to Seller.
a. Sale to Family Member or Non-Grantor Trust.
(1) Availability of Installment Method. A sale of
property to a family member or a non-grantor trust in exchange for a properly structured
SCIN is a taxable event and, unless the seller elects otherwise, should generally result in
installment sale treatment for the seller. Temp. Reg. § 15A.453-1(c)(1).
Although the installment method will generally be
available, there are significant exceptions. In particular, the installment sale method is
not available for a sale of marketable securities and other property regularly traded on an
established market. IRC § 453(k)(2). It is also not available to the extent that the gain in
question is depreciation recapture and may not be available at all if the sale consists of
depreciable property and is to a controlled entity. IRC § 453(i) and IRC § 453(g).
Finally, sales of inventory or dealer property will not generally qualify for installment
treatment. IRC § 453(b)(2).
Even if the installment method is available, there may be
limits on its use. First, interest may be charged on the deferred tax liability if the
aggregate face amount of all of the seller's installment obligations from sales during the
year exceeds $5,000,000. IRC § 453A. Also, a pledge of the installment note will trigger
gain recognition. IRC § 453A(d). Third, a gift or other disposition of the installment
note, or the sale of the purchased property by a related purchaser within two years of the
installment sale, may cause the balance of the deferred gain to be recognized. IRC
§ 453B and IRC § 453(e).
(2) Gain or Loss. Under the installment method, it is
assumed that the seller will outlive the term of the SCIN, and the maximum principal
amount to be received by the seller in the SCIN transaction, including any principal
premium, is the "selling price." Temp. Reg. § 15A.453-1(c)(2)(i)(A). The seller's
adjusted basis is then subtracted from this selling price to determine the gross profit, if
the selling price exceeds the basis. Temp. Reg. § 15A.453-1(b)(2)(v). If the selling price
is less than the seller's basis, a loss would be realized, but would most likely be
disallowed under IRC § 267(a) because the purchaser would likely be a member of the
seller's family to whom IRC § 267(b)(1) would apply, or a trust created by the grantor to
which IRC § 267(b)(4) would apply.
AT-1152260v1 99

Assuming that the sale results in a gain, the gross profit is
then divided by the selling price (less any "qualifying indebtedness" assumed or taken
subject to by the buyer) to arrive at the "gross profit ratio." Temp. Reg. § 15A.453-
1(b)(2)(1) through (iii). Each payment of principal received by the seller is then
multiplied by the gross profit ratio to determine the amount of each payment allocable to
the gain and to nontaxable return of basis. Temp. Reg. § 15A.453-1(b)(2)(i).
A portion of each payment will also consist of interest,
which may be calculated under one of two methods, depending upon whether the SCIN is
treated as a maximum selling price installment sale, or as a contingent payment
installment sale. Hesch and Manning 1992, at 310.3(B)(4). By treating the payment
stream as a maximum selling price installment sale, the interest paid will be front-loaded.
In contrast, if the payment stream is treated as a contingent payment installment sale, the
interest paid will be back-loaded.
EXAMPLE (MAXIMUM SELLING PRICE): Assume Father,
who is age 75, is in the 55% estate tax bracket and owns a business
worth $10,000,000. He sells the business to Son in exchange for a
ten-year SCIN with an arm's length increase of $3,009,919 in the
purchase price (resulting in equal annual installments of principal
and interest of $1,744,257) in exchange for Father's agreement to
cancel the note in the event he dies prior to the end of the term.
The adjusted purchase price of $13,009,919 should equal the
present value of the payments, and assuming that the basis in the
property sold is $1,000,000, the gross profit ratio would be 92.31%
[($13,009,919 - $1,000,000)/$13,009,919].
Under the maximum selling price installment sale approach, the
first year's payment of $1,744,257 would consist of $1,000,090 of
principal and $744,167 of interest. Of this principal payment,
92.31% (or $923,183) would be gain, and the remaining $76,907
would be a nontaxable return of basis. Under this treatment, the
$1,000,090 of principal deemed paid would reduce the outstanding
principal for the following year. Id.
EXAMPLE (CONTINGENT PAYMENT): If, instead, each
payment of $1,744,257 is treated as a separate OID obligation
under the contingent payment regulations, then the amount of
interest is drastically reduced in the initial years. Reg. § 15.453-
1(c)(2)(ii).
The present value factor at 5.72% for a payment to be received in a
year would be 0.94589. Therefore, the principal amount of the
first year's payment of $1,744,257 would be $1,649,875 (of which
$1,522,999 would be gain and $126,875 would be a nontaxable
return of basis, using the same 92.31% gross profit ratio). The
AT-1152260v1 100

emaining $94,382 would be allocated to interest. Hesch and
Manning 1992, at 310.3(B)(4).
(3) Death of Seller During the Term of the SCIN. If the
SCIN is cancelled by reason of the death of the seller during the note term, any deferred
gain will be recognized as income. The primary question is whether the deferred gain is
properly includible (a) on the deceased seller's final return, in which event the resulting
income tax liability should be deductible as an IRC § 2053 claim against the estate for
estate tax purposes, or (b) in the initial return of the deceased seller's estate as an item of
income in respect of a decedent ("IRD") under IRC § 691. See Banoff and Hartz 1986, at
150-51, and Hesch and Manning 1992, at 306.1(F).
When the issue arose in Estate of Frane, the Tax Court
agreed that gain should be recognized upon the death of the seller prior to the expiration
of the term of the SCIN, but held that the gain was properly reportable by the seller on
the seller's final return, not by the seller's estate. Estate of Frane v. Commissioner, 98
T.C. 341, 354 (1992). The Tax Court held that the income tax consequences of the
cancellation were governed by IRC § 453B(f), which had been enacted, in part, to
overrule the outcome of Miller v. Usury, 160 F. Supp. 368 (W.D. La. 1958), so that the
cancellation of a SCIN would be treated as a disposition. IRC § 453B(f)(1). Because the
cancellation was in favor of a related party, the fair market value of the obligation would
be no less than the face amount of the obligation. IRC § 453B(f)(2). Since the Tax Court
held that the gain was properly reportable on the seller's final income tax return, it also
held that the Seller's estate was not taxable under the IRD rules of IRC § 691(a).
The Eighth Circuit Court of Appeals overturned the Tax
Court in favor of the Service's alternate position that the decedent's estate recognizes the
deferred gain on its initial income tax return as an item of IRD. Estate of Frane v.
Commissioner, 998 F.2d 567 (8 th Cir. 1993). The Eighth Circuit held that the
cancellation of a SCIN is not a "disposition" which is taxed to the seller under IRC §
453B pursuant to IRC § 453B(f), but is rather a "transmission" which is taxable as IRD to
the estate under IRC § 691 pursuant to IRC § 453B(c). The Eighth Circuit based this
decision on the language in IRC § 691(a)(5)(iii) that "cancellation occurring at the death
of obligee shall be treated as a transfer by the estate, taxable under section 691(a)(2)."
Estate of Frane v. Commissioner, 998 F.2d at 572. This holding is in accord with the IRS
position in Rev. Rul. 86-72, 1986-1 C.B. 253.
The Eighth Circuit decision in Estate of Frane may very
well not be the final word on the issue of whether the deferred gain is includible in
income by the deceased seller on his or her final return or by the estate of the deceased
seller on its initial return. A very strong argument can be made that the gain should be
recognized by the seller on his or her final income tax return in accordance with the Tax
Court decision and IRC § 453B(f). See Hesch and Manning 2000, at 1601.3 and
Warnick, 805 T.M., Private Annuities, at A-14.
b. Sale to Grantor Trust. As in the case of a normal installment
sale to an IDGT, if the property is sold to a grantor trust, and if the grantor is the only
AT-1152260v1 101

person who is treated as an owner, then the grantor's sale of assets to the IDGT, the
IDGT's payment of interest on the SCIN to the grantor, and any satisfaction of the
installment note by an in kind distribution from the IDGT to the grantor should be
nontaxable events for income tax purposes, at least as long as the IDGT continues to be a
grantor trust.
(1) Cessation of Grantor Trust Status During Grantor's
Lifetime. If the IDGT ceases to be a grantor trust during the grantor's lifetime, and if the
SCIN is still outstanding at the time of such cessation, a taxable event is likely to be
deemed to have occurred at the time the trust ceases to be a grantor trust. See Reg. §
1.1001-2(c), Example (5), Madorin v. Commissioner, supra, Rev. Rul. 77-402, 1977-2
C.B. 222, and PLR 200010010. Presumably, any gain will be based on the excess of the
amount then due under the SCIN over the adjusted basis of the IDGT's assets.
(2) Grantor's Death During Installment Note Term.
The grantor's death before the end of the term of the SCIN results in the cancellation of
the remaining payments otherwise due under the SCIN. Because of the cancellation
feature, and because the sale never took place for income tax purposes during the life of
the seller, the deferred gain that would normally be recognized upon the death of the
seller under Frane arguably should not be recognized by the seller or the seller's estate,
although the matter is not free from doubt. See Hesch and Manning 2000, at 1601.4.
See also the discussion of what happens when a seller in a normal installment sale to an
IDGT dies before the installment note is satisfied in full.
2. Income Tax Consequences to Purchaser.
a. Sale to Family Member or Non-Grantor Trust.
(1) Basis. If the sale is to a family member or a nongrantor
trust, the first income tax consideration for the buyer-debtor is the calculation of
the basis in the property received. Unfortunately, the manner in which basis is
determined is not completely settled. G.C.M. 39503 concludes that the buyer-debtor
acquires a basis equal to the maximum purchase price of the property. This result would
be symmetrical to the treatment of cancellation at death in favor of a related party as a
disposition under IRC § 453B(f) and is arguably supported by what might be dicta in the
Eighth Circuit's decision in Frane Estate. Hesch and Manning 2000, at 1601.3(F) and
Frane Estate v. Commissioner, 998 F.2d 567 (8 th Cir. 1993), n.5. G.C.M. 39503, and the
appellate decision in Frane Estate, however, both predate the final versions of Reg. §§
1.483-4 and 1.1275-4(c)(5), which provide that a purchaser only receives basis when
payments are made on a contingent payment instrument, not when the contingent
payment obligation is issued. Although it is not clear that a SCIN is a contingent
payment instrument subject to these regulations, a conservative purchaser may choose to
increase basis only to the extent that payments are made, especially because of the
potential penalties under IRC §§ 6662(e)(1)(A) and (h)(2) if the adjusted basis claimed
exceeds 200% of the amount determined to be correct. See Hesch and Manning 2000, at
1601.3(F), in which the authors contend that a SCIN should not be treated as a
contingent payment obligation for these purposes.
AT-1152260v1 102

(2) Interest Deduction. The second income tax
consideration for the purchaser is the amount and deductibility of interest. The amount of
the interest component of each payment should be computed under one of the two
methods discussed above in regard to the seller. As for the buyer's ability to deduct the
interest, while G.C.M. 39503 states that "[in] the installment sale situation, …interest is
fully deductible by the buyer", the purchaser will be subject to the typical limitations
placed on the deductibility of interest, depending upon the nature of the assets purchased.
Although the default classification of interest for an individual is non-deductible personal
interest (IRC § 163(h)(1) and (2)), interest payments under a SCIN, unless issued in
regard to the purchase of a personal use asset other than a primary or secondary
residence, should generally be deductible as investment interest under IRC §
163(h)(2)(B) (subject to the limitations of IRC § 163(d)), as qualified residence interest
with respect to a primary or secondary residence under IRC § 163(h)(2)(D) and (h)(3), as
passive activity interest under IRC §§ 163(h)(2)(C) and 469, or as business interest under
IRC § 163(h)(2)(A).
(3) Cancellation of SCIN. Finally, although the death
of the seller during the term of the SCIN arguably may represent cancellation of
indebtedness, resulting in a reduction of the buyer's basis under IRC § 108(e) (and
possibly taxable income to the buyer to the extent that the cancellation of indebtedness
exceeds basis), this result does not seem to comport with the intent of IRC § 108(e).
Compare Raby and Raby, "Self-Cancelling Installment Notes and Private Annuities,"
2001 TNT 115-54 (2001), which takes the position that IRC § 108(e) applies, with Hesch
and Manning 2000, at 1601.3(F), and Hesch, "The SCINs Game Continues" 2001 TNT
136-96 (2001), which make a persuasive argument that IRC § 108(e) does not apply.
b. Sale to Grantor Trust. As in the case of a typical installment
sale to an IDGT, the IDGT's purchase of the seller's property in exchange for a SCIN
should not be a taxable event, at least as long as the IDGT remains a grantor trust.
(1) Cessation of Grantor Trust Status During Grantor's
Lifetime. If the IDGT ceases to be a grantor trust during the grantor's lifetime, if the
SCIN is still outstanding at the time of such cessation, and if a taxable event is deemed to
have occurred at the time the trust ceases to be a grantor trust, then the IDGT will take
either a cost basis for the purchased property, which presumably will equal the
outstanding balance under the SCIN at the time the IDGT ceases to be a grantor trust, or
possibly will take a basis for such property equal to the payments under the SCIN, as
provided under Reg. §§ 1.483-4 and 1.1275-4(c)(5) for a contingent payment instrument.
(2) Grantor's Death During Installment Note Term.
The grantor's death before the end of the term of the SCIN results in the cancellation of
the remaining payments otherwise due under the SCIN. As in the case of a typical
installment sale to a grantor trust, the outcome is certainly not free from doubt, but
because of the cancellation feature, and because the IDGT would not be obligated to
make any payments under the SCIN after the seller's death, the IDGT should take a basis
under IRC § 1015(b), which would typically be a carryover basis as opposed to a cost
basis. See Hesch and Manning 2000, at 1601.4.
AT-1152260v1 103

3. Gift Tax Considerations. There are several gift tax considerations in
regard to a SCIN transaction which are substantially the same as those in regard to a
typical installment sale to an IDGT. First, there is the normal valuation issue with respect
to the assets sold in the transaction. Second, if the value of the SCIN received is found to
be worth less than the value of the property sold (or not "substantially equal" to the value
under the standard set forth in G.C.M. 39503), then the transaction will be treated as a
part sale/part gift. The potential negative implications of such a bargain sale are very
similar to those discussed above with respect to a typical installment sale to an IDGT.
Not only would a taxable gift result, but if the property is sold to a trust, the gift may
even cause the assets in the trust to be ultimately includible in the grantor's gross estate,
for estate tax purposes, at their date of death or alternate valuation date values, including
any appreciation after the initial transfer of the assets to the trust.
If a trust is the purchaser in a SCIN transaction in which a principal
premium approach is used, substantially greater "seed" funding may be required to insure
that the SCIN will be regarded as bona fide debt. In all probability, the total trust assets,
or access to assets (taking into account bona fide guarantees), should be at least 10% (or
possibly 11.1%) more than the principal obligation under the SCIN, including the
principal premium. Otherwise, the transfer to the trust may be treated as an equity
contribution, which almost inevitably would result in a significant taxable gift. See
PLR 9535026.
A SCIN may also encounter a materially greater gift tax risk if scheduled
payments are missed or possibly even if they are consistently late. In Estate of Constanza
v. Commissioner, T.C. Memo. 2001-128, missed SCIN payments were held to evidence
the absence of a bona fide debt. As a result, a taxable gift, measured by the difference
between the value of the transferred property as of the date of the transfer and the total
payments made under the SCIN, was deemed to have been made. See IRC § 2512(b).
4. Estate Tax Considerations. If the SCIN is properly structured, and if
there are no other retained interests in the SCIN or in a purchasing trust which would
result in inclusion, the seller's death prior to the expiration of the SCIN term should result
in the inclusion in the seller's gross estate, for federal estate tax purposes, of only the
payments made or due under the SCIN during the seller's life (and any income or
appreciation attributable to such payments). The balance due under the SCIN, exclusive
of any payments due but not made during the seller's life, will be cancelled and will
escape inclusion in the seller's gross estate. Estate of Moss v. Commissioner, 74 T.C.
1239 (1980), acq. in result only 1981-1 C.B. 2. In this regard, G.C.M. 39503 states that
"in the case of an installment sale, when a death-extinguishing provision is expressly
included in the sales agreement and any attendant installment notes, the notes will not be
included in the transferor's gross estate for Federal estate tax purposes." This removal of
assets from the seller's gross estate is the primary motivation for using a SCIN.
If the sale is made to a family trust, the seller/grantor runs the risk of being
deemed to have retained an income interest in the trust within the meaning of IRC §
2036. In particular, a bargain sale may result in total inclusion of the trust's assets. See
PLR 9251004. Under the clear terms of the statute, a properly structured sale for a SCIN
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in which the value of the SCIN equals the value of the property sold should not be subject
to IRC § 2036 because the transfer should be "a bona fide sale for an adequate and full
consideration in money or money's worth" under IRC § 2036(a)(1). If, however, the
assets in the trust are not sufficient for the transaction to be considered to be arm's length,
the IRS might argue that the transaction is not a sale, and is really a contribution to the
trust, similar to the thin capitalization concept in a debt/equity analysis. See PLR
9535026, where the IRS provided a caveat to its generally favorable IDGT ruling by
stating that such ruling would be void if the promissory notes were subsequently
determined to be equity, as opposed to debt. If the seller were found to have retained an
income interest, and if the "adequate and full consideration" exception does not apply, the
entire value of the trust's assets could be includible in the seller's gross estate for estate
tax purposes.
In structuring a sale to a trust for a SCIN so as to avoid estate tax
inclusion under IRC § 2036(a)(1) in a "bootstrap" sale situation, the advisor should make
sure that he or she satisfies the following three tests provided by Fidelity-Philadelphia
Trust Co. v. Smith, 356 U.S. 274 (1958), and Rev. Rul. 77-193, 1977-1 C.B. 273:
a. The size of the payments to the seller should not be based upon
the actual income of the assets sold to the trust;
repayment; and
transferee/purchaser.
b. The assets sold should not be the sole source of the debt
c. The liability incurred should be a personal obligation of
The use of an "old and cold" gift or bona fide guarantees to
provide "seed" funding so that the trust assets immediately after the transfer have a value
that is at least 10% (and possibly 11.1%) more than the principal obligation under the
SCIN, including any principal premium, should satisfy these tests by providing a source
of funding above and beyond the assets sold, as long as the SCIN provides for full
recourse against the assets of the trust, including the assets traceable to the "old and cold"
gifts as well as those traceable to the sale. See Rev. Rul. 77-193, 1977-1 C.B. 273.
The obvious tradeoff of a SCIN, of course, is that if the seller lives
longer than he or she is "supposed to" and thus survives the end of the SCIN term, the
assets included in the seller's gross estate will be greater, and possibly much greater, than
if the seller had sold the property in a typical installment sale. Because of the risk
premium, the SCIN payments will be materially higher than typical installment
payments, and unless the payments are consumed or otherwise insulated from estate tax
inclusion, they will be includible in the decedent's taxable estate. Depending upon the
total return on the assets sold and interest rates, the estate tax inclusion could be even
worse than if the seller had done nothing.
5. Generation-skipping Tax Considerations. If the SCIN is properly
structured, there should be no taxable gift upon the sale and no estate tax inclusion at the
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time of the seller's death. Therefore, a properly structured SCIN should not have direct
GST implications. If the property is sold to an IDGT with generation-skipping "dynasty"
trust provisions, however, a "seed" or other gift transfer to the IDGT could occur, in
which event a seller may need to allocate, or to have allocated, sufficient GST exemption
so as to make the IDGT exempt from GST taxes.
If the SCIN is not structured properly, there may be a gift at the time of
the sale. If the property is sold to a family member or to a grantor or non-grantor trust,
the gift may also be a taxable GST transfer, depending upon the generation assignment of
the purchaser and any GST exemption allocations. Additionally, if the SCIN is
includible in the seller's estate, there could be a taxable GST event upon the seller's death
or thereafter if a trust is involved, again depending upon the transferee's generation
assignment and any GST exemption allocations.
D. Advantages and Disadvantages of SCINs.
1. Advantages.
a. Estate Tax Savings Upon Early Death. A SCIN should be used
only when the seller is expected to die prior to his or her actuarial life expectancy. If the
seller obliges by passing away prior to, and "preferably" materially prior to, his or her
actuarial life expectancy, the estate tax savings can be quite substantial. In so many
words, the seller in a SCIN transaction is gambling on his or her premature death. If he
or she wins that bet in what can only be termed a Pyrrhic victory, the jackpot is likely to
be a bonanza of federal estate tax savings.
b. Interest Deductibility by Purchaser. Unless the purchased
property consists of personal use property (other than a primary or secondary residence),
the interest paid by the purchaser under the SCIN should generally be deductible,
whereas interest is not deductible under a private annuity. This assumes that the
purchaser in the SCIN transaction is not a grantor trust.
c. Purchaser's Basis. Although the issue is not free from doubt,
the basis of a purchaser (other than a grantor trust) in a SCIN transaction should be the
initial principal obligation under the SCIN, including any principal premium. In contrast,
the purchaser's basis for property purchased in a private annuity transaction may be
limited to the aggregate annuity payments, which could result in a lower basis, especially
if the seller dies prematurely (as anticipated).
d. Backloading of Payments. A payment deferred under either a
SCIN or a private annuity is a payment that may never have to be made. Backloading of
payments is much more easily structured under a SCIN, as opposed to a private annuity.
Conceptually, either interest or principal should be deferrable to a date within the seller's
actuarial life expectancy, but an appropriate principal premium or interest premium
would have to be calculated and ultimately paid (unless the seller dies before the due
date). But see Estate of Musgrove v. United States, 33 Fed. Cl. 657 (Fed. Cl. 1995), in
which a demand SCIN transaction was held to be a gift because of the absence of a real
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expectation of repayment (since the seller was in poor health and the purchaser did not
have other funds). This permissible backloading is a distinct SCIN advantage.
e. Collateralization of Payment Obligation. The property sold in
exchange for the SCIN can be used as security, thus better assuring the stream of
payments if the seller is otherwise concerned that payments will not be made. In
contrast, a private annuity should not be secured or guaranteed. See Banoff and Hartz
1986, at 146.
f. Interest Rate. Although the issue is by no means free from
doubt, there is a distinct possibility that the interest rate under the SCIN can be based on
the generally lower AFR for the particular note pursuant to IRC § 7872, as opposed to
120% of the mid-term AFR under IRC § 7520. Whether use of the IRC § 7872 AFR is
worth the gift tax risk and possibly the estate tax risk, however, is questionable at best. In
contrast, a private annuity must use the generally higher IRC § 7520 rate.
2. Disadvantages of SCINs.
a. Risk of Lengthy Life. As noted previously, both a SCIN and a
private annuity represent a bet that the seller will die prematurely. If the seller does not
oblige and lives until a ripe old age, the SCIN or private annuity may not prove to be
advantageous from a tax-oriented estate planning perspective, but the seller, and
hopefully the purchaser, can find considerable consolation.
b. Tax Uncertainties. A SCIN is replete with tax uncertainties.
What interest rate should be used How should the seller's life expectancy at the time of
the sale be determined How are payments properly allocable among return of capital,
gain, and interest Does the purchaser realize income under cancellation of indebtedness
principles upon the seller's death What is the purchaser's basis for the property acquired
in the SCIN transaction
c. Income Tax Consequences for Seller or His or Her Estate. If
the seller dies before the SCIN matures, the deferred gain will be recognized for income
tax purposes, upon cancellation of the note as of the seller's death, either in the deceased
seller's final return or the first return of the decedent's estate. It is considerably less clear
whether the same, or similar, income tax results will follow if the purchaser is a grantor
trust.
If the SCIN matures during the seller's life, not only will the
proceeds from the satisfaction of the SCIN generally be includible in the seller's estate for
estate tax purposes, but the satisfaction will also trigger the recognition of gain by the
seller unless the purchaser is a grantor trust.
d. Limits on Availability of Installment Sale Treatment.
Installment sale treatment is not available for the sale of certain assets, including
marketable securities, inventory and dealer property, and possibly depreciable property.
The installment note cannot be used to collateralize any loan to the seller without
jeopardizing continuing deferral of the gain, and a gift or other disposition of the SCIN or
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a sale of the purchased property by the related purchaser within two years of the sale may
also trigger gain recognition. In addition, an interest surcharge on the deferred gain under
large SCINs (e.g., those with a principal balance in excess of $5,000,000) may negate
part, if not all, of the benefits of deferral under the installment method. Although it may
be possible to circumvent all of these installment sale limits by structuring the transaction
as a sale to a grantor trust, no similar limits apply to a private annuity.
e. Additional Trust "Seed" Funding. If the purchaser is a trust
and a principal premium approach is used, substantially greater "seed" funding is likely to
be required than under a normal installment sale to an IDGT. In all probability, the value
of the property in the trust, or the value of the property accessible by the trust, after the
sale should be at least 10% (or possibly 11.1%) more than the principal obligation under
the SCIN, including the principal premium.
VII.
PRIVATE ANNUITIES
A. Overview. A private annuity is an annuity which is issued by a purchaser who
or which is not in the business of selling annuities, usually a family member or trust for
family members, as payment for the purchase of an asset, usually from a senior family
member. The annuity is structured to have a fair market value equal to the fair market
value of the property sold, taking into consideration the life expectancy of the
seller/annuitant. Although private annuities are normally structured so that the annuity
payments end on the death of the seller (a so-called "conventional private annuity"), they
may also be structured to end on the earlier of the death of the seller/annuitant or the
expiration of a stated term (the so-called "private annuity subject to a term" or "private
annuity for a term of years"). See Warnick, 805 T.M., Private Annuities, at A-1. This
discussion will focus on the more common conventional private annuity.
Like the SCIN, the advantage of a private annuity is that if the seller dies
materially earlier than his or her actuarial life expectancy, then the property sold for the
private annuity should not be includible in his or her estate, and only the annuity
payments received, and the total return attributable to such annuity payments, should be
subject to estate taxation. Effectively, then, the private annuity is a niche technique
designed to take estate planning advantage of a client's poor health or poor family health
history.
The following examples compare the normal installment sale, the SCIN and then
the private annuity.
EXAMPLE (NORMAL INSTALLMENT SALE): Assume Father, who is
age 75, is in the 55% estate tax bracket and owns a business worth
$10,000,000. He sells the business to Son in exchange for a ten-year
installment note calling for equal payments of principal and interest of
$1,340,713 per year, based on the 5.72% August, 2001 long-term
applicable federal rate ("AFR"). If Father dies immediately after Son
makes the second installment payment, the $8,418,603 remaining
principal balance on the note, plus the two payments of $1,340,713
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eceived (and an assumed 10% total return on the first year's payment),
totaling $11,234,100, would be includible in Father's estate and would
result in approximately $6,178,755 in estate taxes.
EXAMPLE (SCIN): Assume the same facts as above, except that Father
and Son negotiate an arm's length increase of $3,009,919 in the purchase
price (resulting in equal annual installments of principal and interest of
$1,744,257) in exchange for Father's agreement to cancel the note in the
event that he dies prior to the end of the term. Upon Father's death after
two years, only the two payments of $1,744,257 received (and an assumed
10% total return on the first year's payment), totaling $3,662,940, would
be includible in Father's estate, resulting in an estate tax of $2,014,617.
This self-cancelling feature would thus save Father's estate approximately
$4,164,138 in estate taxes as compared to a regular installment sale.
EXAMPLE (PRIVATE ANNUITY): Assume the same facts as above,
except that Father and Son negotiate a private annuity paying Father
$1,382,189 each year for his lifetime in payment of the purchase price,
based upon the August, 2001 IRC § 7520 rate of 6.0%. Upon Father's
death after two years, only the two payments of $1,382,189 received (and
an assumed 10% total return on the first year's payment), totaling
$2,902,597, would be includible in Father's estate, resulting in an estate
tax of $1,596,428. This private annuity would thus save Father's estate
approximately $4,582,327 in estate taxes as compared to a regular
installment sale, and would save $418,189 more than the sale in exchange
for a SCIN.
As with the SCIN examples, the calculations in all examples are from
NumberCruncher v. 2000.01, Illustrations Courtesy NumberCruncher
Software: 610 924 0515/leimberg.com.
B. Structure of a Private Annuity Transaction.
1. Private Annuity Overview. The structure of a private annuity, or at
least a conventional private annuity, is relatively straightforward. The seller/annuitant
will transfer property to a purchasing family member or family trust in exchange for the
purchaser's contractual obligation to make equal annual (or more frequent) annuity
payments to the seller/annuitant for the remainder of the seller/annuitant's life. To avoid
a bargain sale, the value of the annuity payments under the private annuity should equal
the value of the property transferred. Fortunately, the value of the annuity payments
under a private annuity can be calculated with much greater certainty than the payments
under a SCIN. Unless the seller/annuitant has a terminal illness at the time of the
transfer, the annuity payments under a private annuity are valued by using the IRC
§ 7520 rate in effect for the month of transfer (i.e., 120% of the mid-term AFR, assuming
annual payments, which is 6.0% for August, 2001) and the Table 90CM estate tax life
expectancies set forth in Reg. § 20.2031-7(d)(7) and Aleph Volume (Pub. 1457). See
Estate of Gribauskas v. Commissioner, 116 T.C. 142 (2001) (citing Estate of Cullison v.
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Commissioner, T.C. Memo. 1998-216, aff'd without published opinion, 221 F.3d 1347
(9 th Cir. 2000)).
2. Structural Differences from SCIN. Both a private annuity and a SCIN
are used in similar situations, where the seller's actual life expectancy, based on the
seller's personal health history or his or her family health history, is likely to be less than
his or her actuarial life expectancy. There may also be certain structural similarities. In
several important respects, however, the structure of a private annuity may vary
materially from that of a SCIN. Among the primary differences are the following:
a. Backloading. It is not clear whether IRC § 2702 special
valuation rules for a retained interest in a trust or a term interest apply to a private
annuity. A persuasive argument can be made that IRC § 2702 should not apply, for the
private annuity represents an obligation of the purchaser of the property and is not a
transfer of an interest in a trust or a term interest in a deemed trust, as required under IRC
§ 2702. See Warnick, 805 T.M., Private Annuities, at A-50-51. See also Reg. § 25.2702-
4(b), which distinguishes a contractual obligation for full and adequate consideration, at
least in the case of a lease. The matter is not free from doubt, however, even if the
purchaser is not an actual trust, for a transfer with a retained life estate may be treated as
a transfer in trust. IRC § 2702(c)(1) and (c)(3)(A) and Reg. § 25.2702-4(a). See also
PLR 9253031, which indicates that a private annuity should comply with IRC § 2702,
although the ruling request was made in a manner which basically assumed the
applicability of IRC § 2702. The downside consequences of running afoul of IRC § 2702
can be devastating. Potentially, the full value of the transferred property may be treated
as a gift. To avoid such a horrific outcome, the private annuity should provide for equal
annual payments, which is the norm for a conventional private annuity, or possibly for
annual payments which are never more than 120% of the prior year's payments. See Reg.
§ 25.2702-3(b). The terms of the private annuity agreement, and the terms of the trust if
the sale is made to a trust, should also comply with the other requirements for a qualified
interest, including the prohibition on prepayment of the annuity amounts and the
prohibition on additional transfers to the trust. See Reg. §§ 25.2702-3(b) and (d). See
PLR 9253031.
As a result of this possible applicability of IRC § 2702, it is
probably prudent to limit the extent to which the annuity payments under a private
annuity should be backloaded.
In contrast, payments under a SCIN can be backloaded. For
example, such payments can be interest only for the term of the SCIN, and principal
payments can be postponed until they balloon as of the maturity date of the SCIN. This
distinction can be quite significant. If the seller dies prematurely, which is the underlying
bet that is almost always being made when a SCIN or a private annuity is used, the
payments to the seller will be materially less under a backloaded SCIN, resulting in a
materially lesser estate tax inclusion in the seller's gross estate and the shifting of more
residual value to the purchaser.
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It should be noted, however, that there is a clear limit on the
backloading under a SCIN. The SCIN must provide for a term which ends within the
seller's life expectancy, whereas the conventional private annuity will continue for the
seller's lifetime.
b. Security for Obligation. To be assured of deferred income tax
treatment, the obligation of the purchaser under a private annuity should not be secured.
Hesch and Manning 2000, at 1601.6. See Estate of Bell v. Commissioner, 60 T.C. 469
(1973); 212 Corp. v. Commissioner, 70 T.C. 788 (1978) and Benson v. Commissioner, 80
T.C. 789 (1983). The inability to secure a private annuity is enough to cause almost any
seller to pause. If the seller is planning to live off of the annuity payments and has few
other sources of support, or if the purchaser has a history of creditor problems or is
involved in high risk ventures, this hurdle may prove to be insurmountable.
c. Funding for Purchasing Trust. If the purchaser is a trust,
substantially greater funding in the form of "seed" gifts or guarantees may be required if
the trust is structured as a private annuity, as opposed to a SCIN. This additional funding
requirement for a trust entering into a private annuity is attributable to the position of the
IRS in Rev. Rul. 77-454, 1977-2 C.B. 351, that a possible exhaustion factor must be
taken into account. In Rev. Rul. 77-454, the IRS held that, because an annuitant may live
beyond his or her life expectancy and, using IRC § 7520 return rates, may consume the
entire trust principal and income, such annuities should be treated as extending not for the
life of the seller but instead for the lesser of the life expectancy of the seller or the life of
the seller. Any difference between the value of the recharacterized annuity and the fair
market value of the property sold will be considered a taxable gift. In order for the
annuity to have a fair market value equal to the value of the property sold, the trust must
be funded with sufficient assets to pay the annuity through age 110. Hesch and Manning
2000, at 1601.6(B). But see Estate of Shapiro v. Commissioner, T.C. Memo. 1993-483,
which rejected a similar possible exhaustion factor argument by the IRS. Bona fide
personal guarantees may also suffice. See PLR 9515039; Rev. Rul. 77-193, 1977-1 C.B.
273, and Hatcher and Manigault, "Using Beneficiary Guarantees in Defective Grantor
Trusts," 92 J. Tax'n 152 (March 2000).
EXAMPLE: Father, who is age 75, sells property with a value of
$10,000,000 to an irrevocable family trust which is a grantor trust
for federal income tax purposes. This sale is in exchange for a
private annuity paying $1,382,189 annually. Using the normal
10% (or 11.1%) "seed" gift or guarantee guidelines applicable to
normal installment sales to a grantor trust, the purchasing trust
should be funded with a "seed" gift of at least 10% (or 11.1%) of
the $10,000,000 purchase price, or at least $1,000,000 (or
$1,111,111), or should negotiate pro rata guarantees from the
beneficiaries in at least that amount.
Rev. Rul. 77-454, however, requires the trust to have, or have
access to, sufficient assets to pay the private annuity for a total of
35 years (110 maximum age under Table 90CM, less Father's age
AT-1152260v1 111

of 75). The present value of an annual payment of $1,382,189 for
35 years, using the August, 2001 6.0% IRC § 7520 rate, is
$20,039,317. If Rev. Rul. 77-454 is upheld, the purchasing trust
would be required to have funding or other collateral
enhancements of more than the purchase price in order for the
private annuity not to trigger a taxable gift. See also PLR 9253031
where the IRS concluded that a private annuity sale to a trust in
which the seller was the income beneficiary would result in a
taxable gift under this possible exhaustion analysis, even though
the purchasing trust had almost four times the value of the property
sold. Guarantees should also suffice as permissible collateral
enhancements. See PLR 9515039; Rev. Rul. 77-193, 1977-1 C.B.
273; and Estate of Fabric v. Commissioner, 83 T.C. 932 (1984).
Nonetheless, the requirement that the beneficiaries have sufficient
net worth to back up the very substantial guarantees may prove to
be too much of an obstacle.
At a minimum, Rev. Rul. 77-454 will greatly complicate use of a
trust as a purchaser in a private annuity transaction and it may effectively preclude use of
a trust.
C. Tax Analysis.
1. Income Tax Consequences to Seller.
a. Sale to Family Member or Non-Grantor Trust. As in the case
of a sale of property for a SCIN, a sale of property in exchange for a private annuity is a
taxable event for income tax purposes if the purchaser is other than a grantor trust.
(1) Gain or Loss. If the value of the private annuity
equals the value of the property sold and exceeds the adjusted basis of the property sold,
then the resulting gain should be reported pro rata for each payment received by the
seller. As discussed below, if there would be a gain and the value of the annuity is less
than the value of the property sold, then there would be a part sale/part gift and the
income taxes would be determined slightly differently. If the adjusted basis of the
property sold exceeds the fair market value of the annuity, the loss would likely be
disallowed under the related party rules of IRC § 267, although it might be possible to
obtain a net operating loss under IRC § 72(b)(3). See Warnick, 805 T.M., Private
Annuities, at A-39.
The income tax treatment for each payment is broken down
into nontaxable return of basis, gain and interest components under Rev. Rul. 69-74,
1969-1 C.B. 43. First, the nontaxable return of basis portion is determined by
multiplying the exclusion ratio by the amount of each payment. The exclusion ratio is
equal to the seller's investment in the annuity (i.e., his or her adjusted basis for the
transferred property), divided by the seller's "expected return" in the annuity. The
expected return is equal to the product of the annual annuity payment multiplied by the
AT-1152260v1 112

seller's life expectancy under the Reg. § 1.72-9 tables. After the excluded portion is
determined, the capital gain component is calculated by subtracting the seller's adjusted
basis from the value of the annuity. This capital gain component is then amortized in
equal annual amounts over the seller's life expectancy. The remaining amount of the
annuity payments is treated as interest or as the annuity amount, at least until the seller
reaches his or her life expectancy under Table 90CM, after which point all of the annuity
payments will be treated as interest.
EXAMPLE: Assume that Father, age 75, and Son negotiate a
private annuity paying Father $1,382,189 each year for his lifetime
in payment of the $10,000,000 purchase price, based upon the
August, 2001 IRC § 7520 rate of 6.0%. Assume that Father's
adjusted basis for the property sold is $1,000,000.
Father is expected to live 12.5 years under the Reg. § 1.72-9 tables.
However, since the annuity is only paid annually, and not
quarterly, Father's life expectancy is adjusted by 0.5 years to 12.0
years. Reg. § 1.72-5(a)(2)(i). The expected return is $16,586,268,
which is calculated by multiplying Father's adjusted life
expectancy (12.0) by the annual annuity payment ($1,382,189).
Therefore, the exclusion ratio is 6.029%, which is determined by
dividing the adjusted basis ($1,000,000) by the expected return
($16,586,268). Thus, 6.029% of each $1,382,189 annuity
payment, or $83,333, will be a nontaxable return of Father's basis.
Father's capital gain component is then determined by subtracting
his $1,000,000 adjusted basis from the $10,000,000 value of the
annuity, resulting in a $9,000,000 capital gain. This capital gain
will be allocated in equal $750,000 amounts [$9,000,000 ÷ 12] for
each of the 12 years corresponding to Father's life expectancy.
For the balance of Father's 12-year life expectancy, the remaining
$548,856 of each annuity payment will be the interest or annuity
amount component, which will be taxed as ordinary income.
Thereafter, all $1,382,189 will be treated as the interest or annuity
amount component.
(2) Death of Seller. If the Seller dies prior to
recovering his or her entire investment in the contract, i.e., before his or her life
expectancy determined under Table V of Reg. § 1.72-9, he or she might have a loss, but
such loss would probably be disallowed under IRC § 267.
(3) Part Sale/Part Gift. If the seller makes a gift by
transferring property with a fair market value in excess of the fair market value of the
private annuity, then the capital gain portion of the annuity is equal to the present value
AT-1152260v1 113

of the private annuity, not the fair market value of the property, minus the seller's
adjusted basis. Rev. Rul. 69-74, 1969-1 C.B. 43.
b. Sale to Grantor Trust. As in the case of an installment sale to
an IDGT and a SCIN sale to a grantor trust, if the property is sold to a grantor trust, and if
the grantor is the only person who is treated as an owner, then the grantor's sale of assets
to the grantor trust and the grantor trust's payment of private annuity payments should be
nontaxable events for income tax purposes.
(1) Cessation of Grantor Trust Status During Grantor's
Lifetime. If the trust ceases to be a grantor trust during the grantor's lifetime, a taxable
event may be deemed to have occurred at the time the trust ceases to be a grantor trust.
See Reg. § 1.1001-2(c), Example (5), Madorin v. Commissioner, supra, Rev. Rul. 77-
402, supra, and PLR 200010010. Presumably, any gain will be based on the excess of
the fair market value of the annuity as of the date of cessation of grantor trust status,
which fair market value will be determined under the estate and gift tax tables and the
then current IRC § 7520 rate, over the adjusted basis of the IDGT's assets.
(2) Grantor's Death as Termination of Grantor Trust
Status. The grantor's death terminates the grantor trust's obligation under the private
annuity and results in the trust becoming a separate taxpayer. Because all private annuity
payments cease as of the grantor's death, and because the sale never took place for
income tax purposes during the life of the seller, any remaining deferred gain should not
be recognized by the seller or seller's estate. Hesch and Manning 2000, at 1601.7.
2. Income Tax Consequences to Purchaser.
a. Sale to Family Member or Non-Grantor Trust.
(1) General Basis Rules. The first income tax
consideration for the purchaser is the determination of basis, which is governed by Rev.
Rul. 55-119, 1955-1 C.B. 352.
The purchaser's basis is easiest to determine when the
purchased property is not depreciable by the purchaser and the purchaser continues to
hold the purchased property until the death of the seller. At the death of the seller, the
purchaser's basis will equal the total annuity payments paid, whether or not the seller
lives more or less than his or her life expectancy. Rev. Rul. 55-119, 1955-1 C.B. 352;
Warnick, 805 T.M., Private Annuities, at A-45.
If the purchaser buys depreciable property from the seller
and holds it until the seller's death, the purchaser's initial basis is equal to the value of the
annuity, as determined under estate and gift tax rates and tables. Once the actual
payments made to the seller exceed the value of the annuity, each additional payment
made by the purchaser is added to the depreciable basis for purposes of calculating the
new depreciation deduction until the seller dies. After the death of the seller, the
purchaser's basis in the property is equal to the total payments actually made, less all
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depreciation deductions taken. Rev. Rul. 55-119, 1955-1 C.B. 352; Warnick, 805 T.M.,
Private Annuities, at A-45 - A-46.
If instead the purchaser sells the property before the seller's
death, the purchaser will have a split basis (i.e., one basis for gain determination purposes
and another, generally lower, basis for loss determination purposes). The purchaser's
basis, for purposes of determining gain, is equal to the total payments actually made plus
the actuarial value of the remaining payments under the private annuity and, for purposes
of determining loss, is equal to the total payments actually made. Rev. Rul. 55-119,
1955-1 C.B. 352; Warnick, 805 T.M., Private Annuities, at A-45.
Finally, if the seller makes a bargain sale instead of selling
the property for an annuity equal in value to the property exchanged, the purchaser will
again have a split basis. For purposes of determining gain, the purchaser's basis should
be equal to the greater of the value of the private annuity or the seller's basis, plus the
amount of any gift taxes paid by the seller. For purposes of determining loss, the
purchaser's basis should be equal to the fair market value of the private annuity. Reg. §
1.1015-4 and IRC § 1015(d). See also Warnick, 805 T.M., Private Annuities, at A-46.
(2) Post-Sale Payments. If the purchaser continues to
make payments under the private annuity after the asset is sold, it is not clear how the
post-sale payments should be characterized. It might be argued that if the sale resulted in
the realization of a gain, any further payments would have no tax effect, at least until they
exceed the actuarial value of the remaining payments under the private annuity as of the
date of the sale which were used to compute the gain, after which the annuity payments
should be allowable as losses. See Warnick, 805 T.M., Private Annuities, at A-46,
although it should be noted that no authority is given for any conclusions reached on
these post-sale payment issues, apart from the character of such payments. If the sale
resulted in a realized loss, any additional payments made should be allowable as
additional deductible losses. Id. If the sale resulted in neither a gain nor a loss, which is
possible if the selling price is less than the basis for the gain determination but greater
than the basis for the loss determination (Id. at A-45), then further annuity payments
should be allowable as losses after all annuity payments, less any depreciation, exceed
the amount realized. If, however, the seller dies prior to reaching that point, the
difference between all annuity payments, less any depreciation, and the amount realized
could be income. Id. at A-46. The character of such income or loss will in all probability
be capital. Id. (citing Rev. Rul. 55-119 and Arrowsmith v. Commissioner, 344 U.S. 6
(1952)).
(3) Interest Deduction. Unfortunately for the
purchaser, the interest or annuity portion of the private annuity payments cannot be
deducted as interest, notwithstanding the fact that the seller must include the interest or
annuity amount as interest income or the equivalent. See Bell v. Commissioner, 76 T.C.
232 (1981), aff'd, 668 F.2d 448 (8 th Cir. 1982).
b. Sale to Grantor Trust. As in the case of a normal installment
sale or sale for a SCIN to an IDGT, the IDGT's purchase of the seller's property in
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exchange for a private annuity should not be a taxable event, at least as long as the IDGT
remains a grantor trust.
(1) Cessation of Grantor Trust Status During Grantor's
Lifetime. If the IDGT ceases to be a grantor trust during the grantor's lifetime, then a
taxable event may be deemed to have occurred at the time the trust ceases to be a grantor
trust. See Reg. § 1.1001-2(c), Example (5), Madorin v. Commissioner, supra, Rev. Rul.
77-402, supra, and PLR 200010010. Presumably, any gain will be based on the excess of
the fair market value of the annuity, based on the estate and gift tax tables and the then
current IRC § 7520 rate, over the adjusted basis of the IDGT's assets. The grantor trust's
basis in the property would be (1) a basis equal to the total annuity payments paid by the
trust after the cessation of grantor trust status, if the property is not depreciable by the
trust and is held until the seller's death; (2) an initial basis equal to the value of the
annuity, determined as of the date of the deemed sale under the estate and gift tax rates
and tables and the then current IRC § 7570 rate, if the property is depreciable by the trust
and is held until the death of the seller, and as increased when and to the extent the actual
payments made to the seller exceed the value of the annuity, and after the death of the
seller, the trust's basis in the property is equal to the total payments actually made, less all
depreciation deductions taken; (3) a split basis (i.e., one basis for gain determination
purposes and another, generally lower basis for loss determination purposes), as
described above, if the trust sells the property before the seller's death; or (4) a basis
equal to the greater of the value of the private annuity or the seller's basis, but only up to
a total equal to the fair market value of the private annuity for the purpose of determining
loss, if the trust's deemed purchase is a bargain sale. Reg. § 1.1015-4 and IRC § 1015(d).
See also Warnick, 805 T.M., Private Annuities, at A-46.
(2) Grantor's Death as Termination of Grantor Trust
Status. The grantor's death results in the cancellation of the obligation under the private
annuity. As in the case of a typical installment sale to a grantor trust or in the case of a
sale to a grantor trust for a SCIN, the outcome is certainly not free from doubt, but
because by definition the private annuity payments cease upon the death of the grantor,
and because the IDGT would not be obligated to make any payments under the private
annuity after the seller's death, the IDGT should take a basis under IRC § 1015(b), which
would typically be a carryover basis as opposed to a cost basis. See Hesch and Manning
2000, at 1601.7.
3. Gift Tax Considerations. There are several gift tax considerations in a
private annuity transaction. First, as in the case of a typical installment sale to an IDGT
and a SCIN sale, there is the normal valuation issue with respect to the assets sold in the
transaction. Second, if the value of the private annuity received is found to be worth less
than the value of the property sold, then the transaction will be treated as a part sale/part
gift. This can occur if the seller/annuitant is found to have had a terminal illness at the
time of the sale. See Estate of McClendon v. Commissioner, 135 F.3d 1017 (5 th Cir.
1998), rev'g T.C. Memo. 1996-307, decided for a transaction occurring prior to the
promulgation of current Reg. § 20.7520-3(b)(3), in which the IRS lost an argument that
the sale for a private annuity was not for fair market value because of the annuitant's
health. In addition, as discussed previously, in regard to a transfer to a trust, the IRS is
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likely to use the possible exhaustion argument set forth in Rev. Rul. 77-454, 1977-2 C.B.
351, as a basis for asserting that the value of the private annuity is less than the value of
the property sold unless the trust is very well-funded prior to the transfer. The negative
implications of such an outcome are very similar to those discussed above with respect to
a normal installment sale to an IDGT. Not only may a taxable gift result, but if the
property is sold to a trust, the gift may even cause the assets in the trust to be includible in
the grantor's gross estate at their date of death or alternate valuation date values,
including any appreciation after the initial transfer of the assets to the trust.
Although there is no case directly on point, a private annuity which is not
respected, due to late or missed payments or otherwise, might not be found to be bona
fide, perhaps by analogy to Estate of Constanza v. Commissioner, T.C. Memo. 2001-128,
discussed above, in which a SCIN was held not to be a bona fide debt.
As discussed previously, it is not clear whether IRC § 2702 applies to a
private annuity. If IRC § 2702 does apply and a seller does not structure the private
annuity agreement (and the trust in the event of a sale to a trust) to comply with Reg. §§
25.2702-3(b) and (d), then the seller would be deemed to have made a gift equal to the
entire value of the property sold to the purchaser. Advisors should therefore probably
make sure that the private annuity transaction meets the requirements of IRC § 2702,
even though the better argument is that IRC § 2702 should not apply.
4. Estate Tax Considerations. As with the SCIN, if the private annuity is
properly structured, and if there are no other retained interests with respect to the
purchased property or in the purchasing trust which would result in inclusion in the
seller's gross estate, the seller's death should leave in the seller's gross estate only the
payments made on the private annuity (and the total return thereon). See Estate of
McClendon v. Commissioner, 135 F.3d 1017 (5 th Cir. 1998), rev'g T.C. Memo. 1996-307.
But see Estate of Bianchi, T.C. Memo. 1982-389, in which a residence sold in a private
annuity transaction was held to be includible in the deceased seller's estate under IRC
§ 2036(a)(1) because of the seller's continued occupancy.
As in the case of a sale for a SCIN and a typical installment sale to an
IDGT, if the sale in exchange for a private annuity is made to a family trust, the
seller/grantor runs the risk of being deemed to have retained a right to the income of the
trust within the meaning of IRC § 2036(a)(1). See PLR 9251004. A properly structured
sale for a private annuity in which the value of the private annuity equals the value of the
property sold should not be subject to IRC § 2036 because the transfer should be "a bona
fide sale for an adequate and full consideration in money or money's worth" under IRC
2036(a)(1), again subject to a potential debt/equity issue as discussed above. See PLR
9535026. The sale to a trust for a private annuity is arguably on even firmer ground than
the sale for a SCIN or a typical installment sale to an IDGT, as the tests for structuring
those transactions are based on private annuity authority supporting the inapplicability of
IRC § 2036(a)(1) in "bootstrap" sales situations. See Fidelity-Philadelphia Trust Co. v.
Smith, 356 U.S. 274 (1958); Cain v. Commissioner, 37 T.C. 185 (1961), acq. 1961-2 C.B.
4; Estate of Bergan, 1 T.C. 543 (1943), acq. 1943 C.B. 2; Estate of Becklenberg v.
Commissioner, 273 F.2d. 297 (7th Cir. 1959); Lazarus v. Commissioner, 513 F.2d 824
AT-1152260v1 117

(9th Cir. 1975); LaFargue v. Commissioner, 689 F.2d 845 (9th Cir. 1982); Stern v.
Commissioner, 747 F.2d 555 (9th Cir. 1984); Estate of Fabric v. Commissioner, 83 T.C.
932 (1984); and Rev. Rul. 77-193, 1977-1 C.B. 273. But see Ray v. United States, 762
F.2d 1361 (9th Cir. 1985).
If the purchaser in a private annuity transaction is a trust, the following
three tests set forth in Fidelity Philadelphia Trust Co., supra, should be satisfied:
a. The size of the annuity payments to the seller should not be
based upon the actual income of the assets sold to the trust;
payments; and
b. The assets sold should not be the sole source of the annuity
c. The obligation to make the annuity payments should be a
personal obligation of the transferee purchaser.
As in the case of a typical installment sale to an IDGT, a transfer to
a trust in exchange for a private annuity should be supported by "seed" funding, including
gifts and guarantees, equal to at least 10% (or possibly 11.1%) of the value of the private
annuity obligation. If the IRS's possible exhaustion argument pursuant to Rev. Rul. 77-
454, supra, is sustained, the "seed" funding may need to equal, or even be a multiple of,
the value of the property sold to the trust in a private annuity transaction. See
PLR 9253031.
As in the case of a SCIN, the obvious tradeoff of a private annuity
is that if the seller lives longer than he or she is "supposed to," then the assets included in
the seller's gross estate will probably be greater, and possibly materially greater, than if
the seller had sold the property in a typical installment sale. Because of the mortality risk
premium, the private annuity payments will be higher than typical installment payments,
but possibly more or less than under a SCIN, and unless the private annuity payments are
consumed or otherwise protected from estate tax inclusion, the payments (and the total
return thereon) will be includible in the decedent's taxable estate. Depending upon the
total return on the assets sold and interest rates, the estate tax inclusion could be even
worse than if the seller had done nothing.
5. Generation-skipping Tax Considerations. If the private annuity is
properly structured, there should be no taxable gift upon the sale and no estate tax
inclusion at the time of the seller's death. Therefore, like a properly structured SCIN, a
properly structured private annuity should not have direct GST implications. If the
property is sold to an IDGT with generation-skipping "dynasty" trust provisions,
however, a "seed" or other gift transfer to the IDGT could occur, in which event a seller
may need to allocate, or to have allocated, sufficient GST exemption so as to make the
IDGT exempt from GST taxes.
If the private annuity is not structured properly, there may be a gift at the
time of the sale. If the property is sold to a family member or to a grantor or non-grantor
trust, the gift may also be a taxable GST transfer, depending upon the generation
AT-1152260v1 118

assignment of the purchaser and any GST exemption allocations. Additionally, if the
private annuity is includible in the seller's estate, there could be a taxable GST event
upon the seller's death or thereafter if a trust is involved, again depending upon the
transferee's generation assignment and any GST exemption allocations.
D. Advantages and Disadvantages of Private Annuities.
1. Advantages.
a. Estate Tax Savings Upon Early Death. A private annuity
shares one primary advantage with a SCIN. If the seller dies materially before his or her
life expectancy and is not terminally ill at the time of the sale, very substantial estate tax
savings may result.
b. Lesser Risk of Survivorship. Survivorship of the seller beyond
his or her actuarial life expectancy is likely to result in a much higher estate tax liability
than under one of the other freeze options under which payment obligations do not vanish
upon the seller's death. If the seller does not oblige by dying prematurely, however, a
private annuity is likely to be preferable to a SCIN which includes a principal premium
and which provides for a balloon payment of all principal shortly before the seller's life
expectancy.
c. Avoidance of Gain by Seller or His or Her Estate Upon Seller's
Early Death. If a SCIN is outstanding and has not matured immediately prior to the
seller's death, any deferred gain will be recognized for income tax purposes in the seller's
final return or in his or her estate's first return. There is no similar gain recognition
provision with respect to a private annuity; only the private annuity payments actually
made will generally be taxed to the seller/annuitant (or possibly to his or her estate if the
payments are made after the seller/annuitant's death). The unrecognized balance of the
gain component of the private annuity will escape income taxation.
d. Fewer Calculation Uncertainties. The calculation of payments
under a SCIN is replete with uncertainties, including such basic factors as the appropriate
interest rate and life expectancy determination. In contrast, the conventional private
annuity is not burdened by such open issues.
e. Absence of IRC § 453 Limits. Unlike a SCIN, deferral of
income under a private annuity is not based on installment sale treatment under IRC
§ 453. As a result, a private annuity may be the only viable option if the property to be
sold consists of marketable securities, inventory or dealer property, or depreciable
property ineligible for installment sale treatment.
2. Disadvantages.
a. Nondeductibility of Interest. The inability of a purchaser to
take any interest deduction with respect to private annuity payments, even though the
payments include an interest component, is a major drawback for a private annuity and a
plus for a SCIN.
AT-1152260v1 119

. Inability of Secure Payments. A purchaser's private annuity
obligation should be secured, whereas there are no similar restrictions on securing a
SCIN. This may prove to be a major disadvantage to structuring a transaction as a
private annuity.
c. Limits on Backloading. A SCIN can be payable interest only,
with a balloon of all principal payments as of a maturity date shortly preceding the
seller's actuarial life expectancy. Such a payment structure under a SCIN will
substantially backload the payments, thus permitting the cancellation of the deferred
payments if the seller dies before the SCIN's maturity. In contrast, although the matter is
not totally free from doubt, it is probably prudent to structure a private annuity so that the
annual annuity payments are equal, or are at least not more than 20% higher than the
prior year's payments, thus satisfying the IRC § 2702 requirements.
d. Additional Trust Funding. Both a SCIN and a private annuity
with a trust purchaser may require considerably more "seed" funding than is appropriate
for a normal installment sale to an IDGT. For a normal installment sale to an IDGT, the
guideline "seed" funding is generally believed to equal at least 10% (or possibly 11.1%)
of the initial principal amount owed under the installment note. Although the matter is
not free from doubt, the value of the property held by a trust purchaser in a SCIN
transaction immediately after the sale should be at least 10% (or possibly 11.1%) more
than the initial principal obligation under the SCIN, including any principal premium.
Thus, "seed" funding to cover the entire principal premium, plus 10% of the risk adjusted
principal obligation, will most likely be required. If the IRS prevails on its possible
exhaustion argument under Rev. Rul. 77-454, 1977-2 C.B. 351, the "seed" funding
requirement for a trust purchaser under a private annuity structure may equal or exceed
the present value of the private annuity. Effectively, the 10% "seed" funding for a normal
installment sale to an IDGT will balloon to 100% or more under a private annuity. Such
"seed" funding for a private annuity is likely to be prohibitive for most would-be trust
purchasers (e.g., if the particular trust is newly created for the express purpose of being
the purchaser).
AT-1152260v1 120

Table of Contents
I. OPERATIONAL ISSUES ..................................................................................... 1
A. Separate Entity. .......................................................................................... 1
B. Personal Pocketbook.................................................................................. 1
C. Missed Payments........................................................................................ 2
D. Retained Control. ....................................................................................... 2
E. Retained Voting Rights.............................................................................. 3
F. Economic Substance. ................................................................................. 4
G. Gift Tax Annual Exclusion. ....................................................................... 4
H. Morals......................................................................................................... 5
II. POSSIBLE TRANSFERS...................................................................................... 5
A. General Transfer Considerations................................................................ 5
B. Gifts.......................................................................................................... 10
C. Freeze Techniques.................................................................................... 12
III. INSTALLMENT SALES TO GRANTOR TRUSTS .......................................... 12
A. Overview. ................................................................................................. 12
B. Structure of Installment Sale.................................................................... 13
C. Tax Analysis............................................................................................. 14
D. Comparison of Advantages and Disadvantages of Installment Sales
to Grantor Trusts. ..................................................................................... 32
IV. GRANTOR RETAINED ANNUITY TRUSTS .................................................. 36
A. GRAT Overview. ..................................................................................... 36
B. GRAT Advantages................................................................................... 38
C. GRAT Disadvantages............................................................................... 40
V. PREFERRED PARTNERSHIP RECAPITALIZATIONS.................................. 50
A. Preferred Partnership Recapitalization Introduction................................ 50
B. Structure................................................................................................... 50
C. Comparison of Advantages and Disadvantages of Preferred
Partnerships.............................................................................................. 80
VI. SELF-CANCELLING INSTALLMENT NOTES............................................... 90
A. Overview. ................................................................................................. 90
B. Structure of a SCIN Transaction. ............................................................. 91
C. Tax Analysis............................................................................................. 99
D. Advantages and Disadvantages of SCINs.............................................. 106
VII. PRIVATE ANNUITIES..................................................................................... 108
A. Overview. ............................................................................................... 108
B. Structure of a Private Annuity Transaction............................................ 109
C. Tax Analysis........................................................................................... 112
D. Advantages and Disadvantages of Private Annuities............................. 119
AT-1152260v1
i

NOW THAT YOU HAVE ME HERE,
WHAT ARE WE GOING TO DO
MERITORIOUS AND OCCASIONALLY MERETRICIOUS
PLANNING FOR AN EXISTING FLP *
Milford B. Hatcher, Jr., Esq.
Jones, Day, Reavis & Pogue
Atlanta, Georgia
_________________________________
Mil Hatcher is a partner in the Jones Day Atlanta office. He served as Atlanta
Tax Group Coordinator from 1989 until 1998. He specializes in business-oriented estate
planning and has principal responsibility firmwide for valuation and "freeze" planning,
which is designed to shift appreciation in value to lower generations with minimal or no
current gift tax liability. Although he focuses on estate, gift, and generation-skipping tax
planning and related income taxation of individuals, trusts, and estates, his extensive
partnership and corporate tax experience and his business background give him a unique
perspective which is especially suited to business-oriented estate planning.
He graduated from Washington and Lee University (Phi Beta Kappa; B.A. magna
cum laude with exceptional honors 1970); The University of Georgia (Phi Kappa Phi;
J.D. cum laude 1973); and New York University (LL.M. in Taxation 1975).
He is a member of the State Bar of Georgia (Chairman: Tax Section, 1990-1991)
and The Florida Bar and has served as an Adjunct Professor of Income Tax and Estate
Planning at the Walter F. George School of Law at Mercer University. He is a fellow of
the American College of Trust and Estate Counsel. He has authored numerous articles on
freeze related topics which have appeared in such publications as the Journal of Taxation,
Valuation Strategies, and Estate and Personal Financial Planning. He has also spoken
extensively on freeze and other estate planning related topics before various professional
groups, including the A.B.A. Real Property, Probate and Trust Section and the University
of Miami School of Law Philip E. Heckerling Institute on Estate Planning.
*
Copyright © 2001, Milford B. Hatcher, Jr. This outline is adapted from an outline presented at the
35 th University of Miami School of Law Philip E. Heckerling Institute on Estate Planning (January, 2001).
The views set forth herein are the personal views of the author and do not necessarily reflect those
of Jones, Day, Reavis & Pogue. Mr. Hatcher thanks Edward M. Manigault, an associate with Jones, Day,
Reavis & Pogue, for his assistance in preparing this outline.
AT-1152260v1