An asset that is expected to appreciate significantly before the death of its owner can present a potential future estate tax problem for the heirs of the owner, especially if the asset is not liquid.
One way to combat this problem is to “freeze” the value of the asset as of a certain date before it has appreciated.One popular technique for “freezing” an asset is “selling” the asset to a trust established by the owner of the asset (the grantor) in return for an installment promissory note. The value of the note will equal the value of the asset on the date of transfer (pre-appreciation). The note must provide for interest at a minimum rate set by the IRS.
The trust which is used for this purpose is called a “Grantor Trust”. It is used because it is not considered a separate trust for income tax purposes (so there is no capital gains tax on the sale), but it is a separate trust for estate tax purposes (so its assets are not included in the seller’s estate). The trust makes payments on the promissory note, which can provide an income stream to the grantor, while the asset which is sold to the trust appreciates within the trust.
When the grantor passes away, his estate will have as an asset the promissory note, plus any accrued and unpaid interest. However, the asset that was sold to the trust will not be included, which can be very important if it is an asset which has appreciated significantly. The asset will then pass to the beneficiaries established in the trust.
As with all techniques, there are advantages and disadvantages to the installment sale to a defective Grantor Trust. Care must be used in valuing the asset to be sold because a hard-to-value asset which is under-valued may result in an IRS challenge. The appraised value of the asset must be as accurate as possible, to ensure that the value of the promissory note equals the value of the asset at the time of the transfer, and avoid gift tax treatment.
Further, the trust to be used must be an irrevocable trust if the asset is to be removed from the grantor’s estate. This fact means that the trust is not flexible if the grantor’s wishes should change. Accordingly, the grantor should be comfortable with the designated remaindermen in the trust.
In summary, a properly done installment sale to a grantor trust can be an effective tool to transfer an asset from a senior generation to a junior generation at a reduced estate tax cost while providing an income stream to the senior generation.