Taxes: EGGTRA in 2005 (revision of 2001 Seminar Notes)


By James H. Beauchamp 2005

A. Lifetime Gifts (Non-Charitable) in General

When Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”), many changes were made to the Gift and Estate Tax statutes, the most significant of which was the repeal of estate taxes for persons dying in the year of 2010.  If a wealthy person dies in 2011, however, estate taxes must again be considered.  The “Sunset Rule” is the culprit in the legislation, and before we consider other topics, we must first understand what the Sunset Rule is. Under a procedure enacted in 1974, rules were established which dealt with Congressional Budgets.  One of the rules, known as the Byrd Rule (Senator Byrd from West Virginia), made part of the Budget Act of 1990, permits any member of Congress to raise a point of order against extraneous provisions being included in a budget reconciliation bill. If reducing taxes might increase the deficit for a fiscal year beyond the years covered by the reconciliation matter, the law requires 60 Senators to vote in favor of the tax legislation. Failing to attain such a vote means the tax legislation can last no longer than 10 years.  

Less than 60 Senators voted in favor of EGTRRA, so EGTTRA will expire on December 31, 2010 (unless Congress changes the law again).  So in considering gift and estate taxes, we must remember that the rules have changed, but not forever.

Basic Math:  Estate Taxes.  With this introduction, let’s begin with an explanation of how estate and gift taxes are computed To compute Federal Estate Taxes, the taxable estate is computed using the tax table reproduced below1.  Excluded from the taxable estate is property interests passing to a surviving spouse which qualify for the marital deduction.  

Let’s take an example.  Suppose Uncle Fred died in 2005, and left his nephew as his sole heir, and that Uncle Fred’s taxable estate was $1,500,000.  Using the tax table below, one can determine the tax to be $555,800.  Let’s also assume Uncle Fred’s estate is entitled to take the entire estate tax credit of $555,800.  Based on these assumptions, the net tax due to the IRS is zero.  Had Uncle Fred’s taxable estate been $2,000,000, the tax would be $780,800, the credit $555,800, and his estate would owe the difference between the two, or, $225,000 ($780,800 less $555,800).  IRC §2001

EGTRRA increases the amount of the estate tax credit over time.  Using the same example, if Uncle Fred died in 2006 with a taxable estate of $2,000,000, the tax is $780,800, but the estate tax credit increases to $780,800.  Thus, the nephew will inherit $2,000,000 without paying any estate taxes.  Here is the new estate tax credit table applicable to decedents (the gift tax side of the equation is dealt with later in the outline):

YearTax RateEstate (and GST) ExemptionEstate Credit
200448%  1,500,000.$555,800
200547%  1,500,000.$555,800
200646%  2,000,000.$780,800
200745%  2,000,000.$780,800
200845%  2,000,000.$780,800
200945%   3,500,000. $1,455,800
201155%  $1,000,000.     $345,000.

Here are the tax tables themselves:

Gift and Estate Tax Rates 2005 (top rate in 2005 is 47%)

       Of The
   % on Amount
OverNot OverPay+ExcessOver
2,000,000 780,800472,000,000

When Congress passed EGTRRA, the concept of the “unified credit” was modified.  A credit against gift and estate taxes is available, but since Congress did not repeal the gift taxes, changes were made relating to the credit available for gifts. 

Basic Concepts:  Inter vivos Gifts. For tax purposes, there are only two means of making lifetime transfers: gifts and sales.  Although these categories seem airtight, as with most things in life, these classifications are not always treated as they seem.  So let’s begin with a refresher course on gifts, then we’ll turn to sales.


There are three elements to a gift, which are, a donor intends to make a gift, he completes the gift by delivery to or for the donee, and the donee accepts the gift.  All three elements are required in order to effectuate a completed gift (incomplete gifts are not gifts). 

Basic Concepts: Gift taxes.  Once a gift has been completed, one must consider the tax ramifications.  In Oklahoma, there are no gift taxes.  However, there are gift taxes at the federal level, and have been since the Revenue Act of 1924.  Although gift taxes have been repealed and reenacted over the course of time, the federal government imposes the tax as an excise tax upon the privilege of making a transfer by gift.  This tax applies to transfers made in trust or otherwise, and to transfers, direct or indirect, of property, be it real or personal, tangible or intangible (IRC § 2511). 

For tax purposes, only completed gifts are taxed, and control of the property is a key issue.  If a “gift” is made to a revocable trust, the grantor still has control of the trust, so the gift is considered as being incomplete, and there are no gift tax ramifications.

Let us assume a completed gift has been made, and gift taxes must be paid.  The gift tax rates are the same as shown below; the effective exemption amount is different from estate taxes, beginning in 2004.  After the repeal of estate taxes in 2010, we still have gift taxes to pay (the rates will be the highest income tax rate, currently scheduled to be 35%).  In the year 2010, the estate tax “step-up” in basis is repealed, which means, the heirs of an estate will have the same tax basis as the decedent (for capital gains purposes).  There are two exceptions – spouses leaving property to widows or widowers are entitled for a step-up in basis, up to $4.3 million ($3 million, plus using the other $1.3 million), and if the spouse doesn’t use the other $1.3 million, then $1.3 in assets transferred to others.  Here are the new gift tax rates, exemptions and credits:

YearTax RateGift Tax ExemptionGift Credit
200547% 1,000,000.$345,000
200646% 1,000,000.$345,000
200745%  1,000,000.$345,000
200845%  1,000,000.$345,000
200945%  1,000,000.$345,000

In addition to the lifetime gift tax exemptions, donors may deduct the annual exclusion.  The gift tax annual exclusion – $11,000 per donee, for the year 2005 – is not allowed for gifts of future interests in property.  A future interest is an interest in property, where the right to use, possess, or enjoy the property is postponed until a future date. Although a future interest may vest immediately in the donee, it will be deemed a future interest for gift tax purposes, if the donee cannot enjoy or use it presently. IRC § 2503(b)(1); Reg § 25.2503-2. Future interests include reversions, remainders, and other interests or estates, whether vested or contingent, which do not commence in use, possession, or enjoyment until some future time. Future interests must be reported at their full value for gift tax purposes, but the annual exclusion may not be used.


The only other means of effecting of a conveyance, if it is not a gift, is by a sale.  The difficulty with a sale is the seller will be subject to capital gains taxes, and may be subject to recapture of depreciation taken on the property (which is treated as ordinary income).  If the sale is made for inadequate consideration, the IRS might contend that it is a gift. 

Other Types Of Conveyances

As a freshman in law school, I was taught that property had many attributes, and that each attribute should be considered as a stick – and that the characteristics of property could be analyzed as if property were simply a bundle of sticks. With that analogy fixed in my mind, the professor then began delineating different types of conveyances, each having different characteristics. 

We will use that analogy at this point in the outline, because we are going to consider conveyances of property which are not absolute conveyances; specifically, we will discuss life estates, term of years, GRITS, QPRTs, GRATS and GRUTS.  In each instance, the conveyance made by the grantor splits the ownership interests into something less than what the grantor originally owned.

Life Estates

A life estate is created by a conveyance, typically a deed, in which the grantee is given an interest in property for the term of the grantee’s life; when the grantee dies, the remainder interest, which is a vested interest, is no longer subject to the life estate.  A variation of a life estate may be accomplished in a trust:  the trustee is directed to retain title to the property for the life of a person, and upon that person’s death, to convey the remainder interest to another person (or persons).

What are the attributes of ownership, in a life estate?  Until the death of the life tenant, the life tenant owns the property to the exclusion of anyone else. Take this example. The grantor conveys the real estate to himself, for his life or some other life.  The life tenant has possession or enjoyment, or the right to income, during his lifetime.  Upon the death of the life tenant, title to the property then belongs to whomever is named as the remainderman.  If this type of conveyance is made by deed (not by a trust instrument), the life tenant can sell his or her interest to someone else.  The buyer in such a case will enjoy the property so long as the seller is alive.  When the seller (the life tenant) dies, the buyer’s interest in the property ends.

Now let’s explore a technique using life estates. During the past few years, many children are concerned about whether they will receive an inheritance when their parents die. Their primary fear is that the inheritance will be lost if the parent is placed in a nursing home, when DHS pays for nursing home bills.  When the parent dies, DHS will demand reimbursement from the estate of the decedent, dollar for dollar, for all expenses paid for by DHS. 

One technique that has been used, with limited success, is the creation of a life estate in the parent, with a remainder interest in the children.  Using actuarial tables, it is possible to compute the value of the life estate.  Suppose a 70 year old parent who is in a nursing home conveys his $100,000 home to himself in November of 2004 (assume an applicable Section 7520 rate of 4.2%), for life, and on his death, the remainder goes to his son.  The value of his life estate can be computed, and for your information, is worth $40,758. 

If the donor is in the nursing home, and owns a life estate in real estate worth $40,758, DHS will not pay for nursing home benefits, to the extent of the value of the life estate – so if a nursing home charges $3,000 a month, DHS will not pay for benefits for 14 months ($3,000 x 14 = $42,000).  After the parent pays the bill for 14 months in a nursing home, it would appear that DHS would begin to pay for nursing home benefits in the 15th month, if we assume the parent had less than $2,000 in cash assets at that time.  When the parent dies, there is no probate of the remainder interest, since it is a vested interest in the son.  Under this scenario, however, the question must be asked, who will live in the home and take care of it while the parent is in the nursing home?  If the home is rented, then the rental income might disqualify the parent from DHS assistance, if the parent’s income is too much (i.e., more than DHS permits).

Let’s not forget gift taxes: if the life estate is worth $40,758, then the remainder interest is worth $59,242 ($100,000 less $40,758).  This gift is a future interest, and will not qualify for any annual exclusion.  Presumably, the parent will use part of the lifetime gift tax credit, so the parent will not have to pay the gift tax (which would be $12,818).

Nor should we overlook federal estate taxes: under Section 2036 of the Internal Revenue Code, all property transferred by a decedent, in which he retained an interest for life, is included in his gross estate.  Thus, there are no particular estate tax benefits in creating a life estate.

Transfers which are to take effect only at death are included in the grantor’s taxable estate, under IRC Section 2037, if the decedent retains a reversionary interest worth 5% or more of the value of the property.  In addition, transfers made for insufficient consideration are taxable and are included in the estate under Section 2043, and as well as revocable transfers, which are included under Section 2038. 

Term of Years

Although term of years conveyances are not the sorts of things people think of, when they are planning their estates, the concept is very similar to a lease of real estate – however, the owner for the term of years actually owns the property during that time.  The primary application I’ve used in creating a term of years is in a pre-nuptial agreement, where the prospective husband will grant the prospective wife a term of years (not to exceed her life-time), for his home (where they both will live).  The normal provision in the ante-nuptial agreement is that if the husband dies, and the wife then remarries or co-habits with another person of the opposite sex, the term of years will terminate and the property will then belong to the remaindermen.

The other applications for terms of years are things that were once very popular, but have now slipped into some disfavor, viz., grantor retained annuity trusts, grantor retained income trusts, and grantor retained unitrusts.  In these trusts, the grantor retains an interest in irrevocably transferred property.  The remainder interest passes to the designated beneficiaries at the end of a specified term, or the grantor’s death.  Each of these types of conveyances deserves a bit more explanation.


GRITS.  A Grantor Retained Income Trust (GRIT) or a Qualified Personal Residence Trust (QPRT), is an irrevocable trust, where the grantor retains an income interest in property for a term of years.  After the term of years, the trustee conveys the remainder interest to named beneficiaries.  Although there is a “future interest” involved, viz., the portion which will be conveyed to the remainder beneficiaries, we must nonetheless consider the gift tax aspects of a GRIT.

Stated differently, when the trust is funded, a future gift is made.  The value of the gift is the excess of the FMV of the transferred property, less the value of the term of years (i.e., that which is retained by the grantor).  To make such a computation, we simply multiply the fair market value of an annuity factor times the term of years.

Assume a 7.6 discount rate (i.e., the §7520 rate), and a term of years of 10 years.  Also assume the grantor places property having an initial value of $100,000 into the trust.  If the grantor is 65 year old, his interest is worth $63,458.  Subtract this amount from $100,000, to determine the portion of the gift subject to gift tax:  $36,542.  Because this gift is a future interest, it will not qualify for the annual exclusion.  The grantor will have to use all or part of his remaining gift tax credit, or pay gift tax.  If the grantor is a bit younger, then the value of the grantor’s retained interest might actuarially be 100%.  This would eliminate any gift tax liability.

The advantage of a GRIT is that an individual can transfer a significant value property to others, but pay little or no gift tax. 

A GRIT is, of course, subject to the grantor trust rules, which means that all income, deductions and credits are treated as if there is no trust and these items are attributable directly to the grantor.

Should the Grantor die during the term of years, the entire trust principal will be included in the Grantor’s estate, because he owns an interest which does not end before his death.  If gift tax were paid at the outset, then the total estate taxes would be reduced.  If the gift tax credit were used at the outset, to “pay for the gift tax”, then upon the death of the Grantor, the portion used would be restored to the estate. As a means of purchasing discount dollars to pay for estate taxes, a remainderman beneficiary might purchase life insurance on the life of the grantor, for a term of years.

Under Chapter 14 (special valuation rules), the Internal Revenue Code (§2702) limits the benefits of GRITs, where family members are remainder beneficiaries. The Treasury tables ordinarily used to value trust interests are disregarded, and retained interests are valued at zero. Thus, a grantor will have 100% gift tax liability, if, after the term of years, the trust corpus is transferred to family members. A “member of the family” means (1) the individual’s spouse, (2) any ancestor or lineal descendant of the individual or the individual’s spouse, (3) any brother or sister of the individual, and (4) any spouse of any individual described in (2) or (3).  Family members do not include nieces and nephews.

One exception to the Chapter 14 rules is an incomplete gift.  If the gift is incomplete, then the property is included in the donor’s estate.  Another exception to the Chapter 14 rules might be the Grantor’s home. A Qualified Personal Residence Trust, or QPRT (sometimes called a ‘residence or house GRIT’), is a safe harbor from the Chapter 14 rules. Suppose a grantor creates a QPRT by transferring his personal residence to a trust and retains the right to use the residence without the payment of rent for a specified period of time. At the end of that period, the residence either passes outright to beneficiaries designated by the grantor (usually members of his family) or the trust is continued for their benefit. If the grantor continues to occupy the residence after his retained interest terminates, he must pay fair market value rent to the remaindermen.

When the grantor transfers his residence to the trust, he is treated as having made a gift to the family members who will receive the residence when his retained interest terminates. The value of the gift is the fair market value of the residence, reduced by the present value of the grantor’s retained interest (the right to live in the residence rent free for the specified period of time). The present value of the retained interest is computed under IRC §7520, which calls for the use of IRS valuation tables and the §7520 interest rate for the month of the transfer. The value of the retained interest is usually more than the rental value of the residence based on market conditions, which, if combined with a nominal growth in the FMV of the residence, results in an a good discount for gift tax purposes.

When the grantor’s retained interest terminates, the residence passes to the remaindermen free of additional gift tax, even though the property may have appreciated in value since the trust was created. Thus, use of a QPRT ‘freezes’ the value of the residence at its market value when the trust is created. If the real estate market is low when the trust is created, the discount in gifting will be even greater.

If the grantor is still living when his retained interest terminates, the residence won’t be includible in his gross estate for estate tax purposes (unless he continues to live in the residence without paying fair market value rent, in which case it will be includible under the retained life estate rule of §2036(a)). If the grantor dies during the term of his retained interest, the residence will be includible in his gross estate under the retained life estate rule. But he won’t be any worse off than he would have been if he hadn’t created the trust in the first place.

There are some drawbacks to QPRTs: 

  • Loss of ownership during the grantor’s life.
  • No step-up in basis. When the residence passes to the remaindermen at the end of the trust term, they don’t get a stepped-up basis. Instead, the grantor’s basis carries over to them, so if they sell the residence they will have to pay capital gains tax on any gains made over what the grantor originally paid for the property (plus or minus adjustments to basis). This problem can’t be avoided by having the grantor buy back the residence from the trust before the trust term ends, because the governing instrument of a QPRT must include a provision prohibiting the sale of the residence to the grantor, the grantor’s spouse, or an entity controlled by either of them. 
  • Loss of property tax exemption. The transfer of the residence to a QPRT results in the loss of a homestead property tax exemption in Oklahoma.
  • Inability to mortgage the residence after the QPRT is created. If the grantor needs to raise cash for any reason after creating a QPRT, he can’t do so by mortgaging the residence, because he’s no longer the owner of the residence.

How do we compute values for QPRTs?  The easiest method is to purchase a computer program, such as Number Cruncher (  If you believe in doing your own math, here’s how it works:

SMART MAN, age 55, transfers his personal residence to a QPRT and retains the right to live in the residence rent-free for 15 years. If Smart Man dies before the end of the 15 years, the trust property is counted as part of his taxable estate. The fair market value of the residence at the time the trust is funded is $2,000,000. Assume a §7520 interest rate of 6.4%. The value of Smart Man’s retained interest is $1,372,298, computed as follows:

(1) Find the required life

    expectancy factors from

    Table 90CM.

       Initial age = 55

       Term of years = 15

       Terminal age = 70

1 minus – value, Table 90CM, age 55 = 89658

1 minus value, Table 90CM, age 70 = 71357

(2) Divide the factor for age 70

    (71357) by the factor for age 55


       71357 / 89658 = .79588

(3) Take the §7520

    rate for the month the trust is

    created (6.4%, or .064), and add it

    to the number 1.

       1 + .064 = 1.064

(4) Take the figure computed in step

    (3) (1.064) and calculate it to

    the 15th power (because the term

    of the trust is 15 years; if the term

    of the trust were 10 years, you

    would calculate 1.064 to the 10th


1.06415 = 2.535855

(the calculator that comes with Windows operating system is shifted to the scientific view; enter 1.064, then X^Y, then 15, then =; X^Y function is the same as X to the Y power)

(5) Divide the result in step (2)

    (.79588) by the result in step

    (4) (2.535855).

.79588 / 2.535855  = .313851

(6) Subtract the result in step (5)

    (.313851) from the number 1.

        1 – .313851 = .686149

(7) Multiply the result in step (6)

    (.686149) by the fair market

    value of the residence


        .686149 X $2,000,000 =  $1,372,298

Thus, the term of years value of Smart Man’s retained interest in his home is $1,372,298. The value of the remainder interest is the difference between the FMV and the retained interest, i.e., $627,702 ($2,000,000 – $1,372,298). Thus, the amount of the taxable gift made by Smart Man on the transfer of the residence to the trust is $627,702.

In this example, Smart Man retained a contingent principal interest (the right to have the trust property distributed to his estate if he dies before the end of the 15 years).  If he did not retain such an interest, the value of his retained interest would be $1,211,312. That amount is determined by multiplying the fair market value of the residence ($2,000,000) by .605656 (the factor from Table B of the IRS valuation tables for valuing an income interest payable for a term certain of 15 years, using a §7520  interest rate of 6.4%). The value of the taxable gift made by Smart Man on the transfer of the residence to the trust would therefore have been $788,688 ($2,000,000 – $1,211,312).

Thus, by not retaining a contingent principal interest in the trust, Smart Man can reduce the amount of his taxable gift by $160,986 ($788,688 – $627,702).

IRS regulations permit a QPRT to be converted to an annuity trust if the trust is not a qualified personal residence trust (for example, if the personal residence were sold).  So, with that pitiful segue into annuity trusts, we will now turn to the topic of GRATs and GRUTs.

GRATS and GRUTs.  A grantor retained annuity trust (GRAT) is another irrevocable trust – the grantor retains a fixed annuity interest in the property transferred to the trust, for a term of years or for life (e.g., if the corpus is $100,000, and the annuity amount is 5%, the grantor will be paid $5,000 per year; this is the interest the grantor retains for the term of years or for his life).  The remainder interest generally passes to the grantor’s designated beneficiaries at the end of the term of years, or at the grantor’s death.  There is a gift tax due on the value of the remainder interest, which is dealt with when the trust is created and funded.

A grantor retained unitrust (GRUT) is also an irrevocable trust – the grantor retains a fixed interest in the property transferred to the trust, for a term of years or for life, but the fair market value of the trust corpus at the beginning of each year is used to determine the amount paid to the grantor (e.g., if the trust property is worth $100,000, and the payout is 5%, the grantor receives $5,000; if the corpus increases to $200,000, the grantor will receive $10,000 for that year). When the grantor’s retained interest terminates, the trust corpus passes to the remaindermen free of additional gift tax, even if it has appreciated in value. If the grantor is still living when his retained interest terminates, the trust corpus is not includible in his estate for estate tax purposes when he dies because he no longer has any interest in the property. If the grantor dies during the term of his retained interest, part or all of the trust property will be includible in his gross estate. But again, he won’t be any worse off than he would have been if he hadn’t created the trust in the first place.

Suppose a wealthy client owns high yielding and rapidly appreciating property, but wants to avoid probate, and is willing to relinquish his interest in the property in the future, as a means of avoiding estate taxes.  GRATs might provide a solution.  Gift taxes are determined when the trust is created and funded, using methods similar to computing taxes for GRITs.  The annuity interest (and in some cases, other retained interests) is subtracted from the fair market value of the assets transferred in trust.  The value of the annuity interest depends on who the remainder beneficiaries are and who retains the annuity, and other interests relative to the transfer.  There are more restrictive and less appealing sets of valuation rules when a family member is a beneficiary. 

In order to create a GRAT or a GRIT, you must either own Number Cruncher or other program, or be familiar with the IRS valuation tables.  The Tax Court determined that the retained interest is valued for the fixed term of the trust (Walton, Audrey J., (2000) 115 TC No. 41), and the IRS announced that it will follow the Tax Court’s holding (Notice 2003-72, 44 IRB 964).  Walton stands for the proposition that a GRAT can be created for a term of years with the condition that if the grantor dies during the term, the annuity will continue to be paid to his estate.  If that is the case, then the GRAT could hypothetically have a remainder value of 0 or close to 0.  The trust corpus would, in effect, pass to the remaindermen with no gift or estate taxes.  

To give you an idea of the complexity of making these computations, let’s use this example: SMART WOMAN, age 65, creates a GRAT for a term of ten years and funds the trust with property valued at $1,000,000. SMART WOMAN retains the right to receive $100,000 from the trust each year, with annual payments to be made to her at the end of the year. At the end of 10 years, the property will be transferred to her children.  The §7520 rate for the month in which the trust is created is 7.2%. The present value of the remainder interest (i.e., the gift to the remaindermen) is $370,298, determined as follows:

(1) Determine the required annuity factor as follows:

    Initial age = 65

    Term of years = 10

    Terminal age = 75

 N-factor, Table H (7.2), age 65   =   7671.994

 N-factor, Table H (7.2), age 75   =   2215.108

 Difference                                      5456.886

 D-factor, Table H (7.2), age 65   =   866.5824

 Required annuity factor

         = 5456.886 / 866.5824    =      6.29702

(2) Annuity amount                                      $100,000

(3) Present value of annuity

    interest ((1) X (2))                       $629,702

(4) Value of property

    transferred to trust                      $1,000,000

(5) Present value of

    remainder interest

    ((4) minus (3))                            $370,298

In this example, gift taxes will be paid on property worth $370,298.  If the trust corpus produces over 10% a year, SMART WOMAN will have transferred $1,000,000 worth of property to her kids but she has only paid gift taxes on $370,298.  Note:  the Chapter 14 rules apply (in part). Had the parties been unrelated, then IRC §2702 doesn’t apply, and interests are valued according to their actuarial present value using the valuation rules of IRC §7520.  These rules mandate using a discount rate of 120% of the applicable federal annual midterm rate for the month in which the trust is created and funded.  In this instance, the taxable gift would be $304,090.

Let me make a parenthetical comment on interest rates. The 120% applicable federal annual midterm rate and the §7520 rate change monthly and are reported in the IRS cumulative bulletin and various tax services, and in various financial publications, such as the Wall Street Journal.  This rate can also be obtained by visiting or

Suppose the income earned on the trust corpus is less than the annuity amount; in that case, the shortfall is made up from the principal.  All income and appreciation in excess of that required to pay the annuity accumulates for the benefit of the remainder beneficiary.  Therefore, it is possible to transfer assets to the beneficiary when the trust terminates with values which far exceed their original values.  Such a transfer is not subject to further gift tax. 

Under the Chapter 14 rules, where intra-family transfers of interests are made in trust, and the transferor retains an interest in the GRUT, the value of a qualified unitrust interest is determined as if it were an interest in a charitable remainder unitrust. I will not attempt to illustrate computations dealing with a GRUT, but will opine that they are more complicated that GRATs.  Using factors similar to those of SMART WOMAN, gift taxes would be paid of approximately $643,000 (where the remainder interest goes to a family member) or approximately $604,000 (where the remainder interest goes to a non-family member).

There are many more options available in creating a GRUT, such as, permitting the trust assets to revert to the grantor’s estate, in the event of the grantor’s premature death.  In addition, the annuity amount can be increased, but not by more than 120% of the prior year’s payout rate.  For example, the trust could provide the annuity payout rate in each subsequent year equal 120% of the prior year’s rate.  If the initial annuity payout rate is 5%, it could increase to 6% in the second year, to 7.2% in the third year, and so on. 

One final thought: GRATs and GRITs are subject to the grantor trust rules, which means, there are income tax consequences to the grantor, regardless of what amount is paid to the grantor by the GRAT or GRIT. The grantor will be taxed on income and on realized gains from the sale of assets, even if the income and gains are more than the required trust payments. 

B.  Charitable Split-Interest Gifts

Charitable Remainder Trusts

With the repeal of Estate Taxes in 2010, and the possibility of a permanent repeal of Estate taxes, it appears we might still be faced with additional income taxes, which will require us to keep more sets of records.  And our heirs will have “one more tax” to pay, which will be in the nature of additional income taxes.  Since brevity is the essence of clarity, let me cut to the chase: charitable remainder trusts may be of more value if the estate taxes are permanently repealed.

As things now stand, when a person dies, the heirs inherit the property at the fair market value at the date of death – thus, the heirs will have a new tax “cost” basis, and there are no additional estate taxes on the “step-up” in basis.  If the estate taxes are permanently repealed after year 2010, Congress may eliminate the benefit of the set-up in basis (under current legislation, there is a partial step-up in basis, for those dying in 2010:  $1.3 million for every person, and $3.0 million for property left to the spouse).  Assume, for purposes of this section of the outline, that my heirs acquire my estate, without an estate tax, but that my estate is not eligible for a step-up in basis.  My heirs’ cost basis will be the same as mine, for income and capital gains purposes.  If I paid $70,000 for commercial real estate in 1985, and depreciated it as a business property, my heirs inherit my cost basis:  after I die, and assuming the estate taxes are repealed, there will be no estate tax to be paid.  However, when the commercial real estate is sold by my children, they will have two income taxes to pay:

(a) Capital gains tax based on the difference between their sales price (let’s say $150,000) and my purchase price ($70,000).  If long term capital gains rates remain at 15%, plus 7% for Oklahoma, then that part of the tax bill will be $17,600 ($150,000 – $70,000 = $80,000 x 22% = $17,600). 

(b)  In addition, they will be taxed at ordinary income tax rates, for all of the depreciation I have taken on the property (e.g., $50,000) – this tax is called “recapture of depreciation”.  If my children are in the 25% income tax bracket, this tax will be $12,500 ($50,000 x 25% = $12,500). 

Thus, the total income tax to be paid when the commercial real estate is sold by children is $30,100 ($17,600 + $12,500 = $30,100).

So how might we plan around this scenario?  I might create a Charitable Remainder Trust (Reg. §1.664-1), to eliminate the income taxes for me and my heirs.  First, I would locate and retain a sharp accountant and lawyer to help create the trust; I would probably ask them to modify one of the forms the Treasury Department has promulgated (that ought to save some legal and accounting fees; sample forms may be found at Rev. Proc 90-30 and 2003-53).  The agreement would provide that during my lifetime, and during the lifetime of my spouse, the trustee would pay me 5% of the fair market value of property every year (I will have to pay income taxes on this annual payment).  Secondly, I will have the property appraised, on an annual basis (this requirement is part of the agreement, which is a Charitable Remainder Unitrust, as opposed to a Charitable Remainder Annuity Trust).  Third, I will be able to take an income tax deduction for donating the property to charity, based on some very complicated calculations (the amount of the deduction depends on the value of the property, the life expectancies of me and my wife, using a variable rate of interest established by the Treasury Department).  And finally, I will have to find a good charity, which will own the trust property after my wife and I die.

Once the trust has been established, the trustee can then sell the commercial real estate, and pay no income tax (the CRT is, in effect, treated as a private foundation, but the CRT is not required to request tax exempt status, by filing a Form 1023).  Thus, there are no capital gains taxes to pay, nor are there any ordinary income taxes to pay for recapture of depreciation.  The proceeds from the sale will be retained until both my wife and I are deceased.

When both my wife and I are deceased, the charity named in the trust will inherit whatever is left in the trust corpus.  As a technical note, the charity is required to receive at least 10% of the value of the CRT, and this qualifying determination will be made before the trust is established.  In addition, the amount paid to the grantor cannot be less than 5% nor more than 50% of the trust corpus.

All of this sounds good, but notice what has happened:  I no longer own the commercial real estate – after the trust has been created, all my wife and I own is the right to receive income while we are alive.  Once we are deceased, the charity inherits the trust corpus.  So my children will not inherit the $150,000 commercial real estate.  To replace this “lost wealth”, I will probably arrange for the purchase of a life insurance policy for $150,000 (perhaps a second to die policy), and arrange for the policy to be owned by an irrevocable life insurance trust, or by my children directly.  If the estate taxes are permanently repealed, then I might decide to own the policy myself (as things now stand, if I have any incidents of ownership over the policy, it is counted as part of my taxable estate, for estate tax purposes – to keep the policy out my taxable estate, it must be owned by someone else, viz., my children or the trustee of an ILIT).

So what have we done with this process?  First, we have eliminated any income taxes on the sale of the commercial real estate.  Second, we have provided an income stream (which is taxable as income) for me and my wife.  Third, my wife and I will be able to deduct part of the gift’s value, as a charitable donation.  Fourth, the charity will receive an inheritance when my wife and I die.  And fifth, my children will inherit (without income or estate taxes) the face value of a life insurance policy.

With these benefits, there are also some burdens: I have to purchase a life insurance policy to replace the wealth I have transferred to the CRT (more insurance premiums), and I have limited my income from the commercial real estate to a minimum of 5% per year.  I will have more tax returns to file (the CRT will have to file income tax returns), and I will have to pay more legal and accounting fees to create the CRT.

Here are some rules and definitions: A charitable remainder annuity trust is a trust that pays a specified sum, not less than 5% of the initial net fair market value of all property placed intrust, at least annually to its income beneficiary or beneficiaries; at the death of the income beneficiary or at the end of a term of years, not more than 20, the remainder interest must be paid to a qualified charity; see Code Sec. 664(d)(1) and Reg §1.664-2 (in general). A charitable remainder unitrust is a trust that is similar to a charitable remainder annuity trust, except that it pays the income beneficiary or beneficiaries a fixed percentage, not less than 5%, of the net fair market value of its assets valued annually; see Code Sec. 664(d)(2) and Reg. §1.664-3.

So there you have it.  Whether or not Congress permanently repeals the estate taxes, charitable remainder trusts are important estate and income tax planning tools.  So let’s conclude this portion of the outline with this thought:  if Congress permanently repeals the Estate Taxes, leaving our heirs with Capital Gains Taxes and ordinary income taxes to pay on the sale of capital assets, it would appear that Charitable Remainder Trusts will play a more prominent part in the estate planning process. 

Pooled Income Funds

A variation of a charitable remainder trust is a pooled income fund.  In essence, the donor transfers property which will be commingled with other property, and at the same time, conveys an irrevocable interest in the property to a 50%-type charitable organization (under the CRT rules, there is no requirement that a 50%-type charity, i.e., a public charity, be designated as the remainderman beneficiary).  The donor retains a life-income interest in the property for himself or for one or more persons.  Unlike CRTs, however, there is no requirement that the 10% minimum rule applies to the charitable remainder beneficiary.

A pooled income fund is taxed under general trust rules, but the provisions which tax grantors and others as owners don’t apply.  The fund is taxed as a trust even though it isn’t a trust under local law.  A fund which meets the requirements of a pooled income fund won’t be treated as an association taxable as a corporation.  Reg. §1.642(c)-5(a)(2)

Charitable Lead Trusts

A charitable lead trust is, in essence, a gift to a charity for a term of years.  After the completion of the term of years, the remaining trust corpus is distributed to the grantor’s children or other beneficiaries (even the grantor may be a reversionary beneficiary).  If the income interest is either a guaranteed annuity interest or a unitrust interest, the donor will receive a charitable income tax deduction (which is subject to a 30% AGI limitation), if the donor is also considered as the owner of the income (in this instance, the donor is regarded as a grantor, for purposes of the grantor trust rules).  The donor receives a current charitable contribution deduction, for income tax purposes, equal to the present value of the amounts that are required to be paid to qualifying charities from the CLT during its term. With the benefit comes the burden, because the donor will also pay income taxes on the income generated by the assets owned by the CLT, and would be taxed on a “recapture” amount if the CLT ceased to qualify as a grantor trust before the end of the term of the CLT. Thus, the benefit of the initial income tax deduction will be reduced, and perhaps eliminated, during subsequent tax years, in situations where the tax rates are similar for ordinary income, dividends, and long-term capital gains.

If the donor receives a charitable income tax deduction, the deduction is subject to the 30% AGI limitation, because the income interest is transferred “for the use of” the charity and not “to” the charity. The practical problem is obtaining a sufficient tax–free yield to make the guaranteed payments to charity without unduly depleting the trust corpus, which is intended to pass to the grantor’s descendants. Since the grantor normally retains no interest in the property transferred to the trust, the income is taxed to the trust. The trust can deduct each year the charitable contributions it makes out of income, without regard to the percentage limitations on charitable contribution deductions which apply to individual donors.

Normally, the donor will not want to be considered as the owner of the income, so the donor will receive no income tax deduction (this can be characterized as a non-grantor CLT).

CLTs are subject to the private foundation rules, which are to be avoided (and are beyond the scope of this outline).  If the remainder beneficiary is someone other than the donor, the remaining corpus passes to the remaindermen without additional gift or estate taxes. Reg §20.2055-2(e)(2)(vi)(e)  Because a CLT is subject to the private foundation rules, it should not be made a grantor trust by giving the grantor any of the administrative powers under Code Sec. 675. The CLT can be made a grantor trust by giving a third party the power, in a nonfiduciary capacity, to acquire any property held in the trust by substituting other property of equivalent value.

There are two types of CLTs: annuity trusts and unitrusts.  The primary difference between the two relates to whether the trust corpus is revalued each year (in a CLAT, the assets are not revalued; in CLUTs, the assets are revalued). 

When the grantor transfers property to this trust, the remainder interests are subject to gift taxes.  Because the remainder interest is reduced by the value of the charitable contribution of the annuity or unitrust interest, the gift taxes are usually at a minimum. The value of the assets transferred into such trust are not included in the grantor’s estate. The amount of the taxable gift incurred at the inception of the trust will be added to the grantor’s taxable estate for the purpose of determining the estate tax bracket applicable to his estate.

C.  Sophisticated Life Insurance Estate Planning

We now turn to the topic heading, “sophisticated” life insurance estate planning.  The principles of irrevocable life insurance trusts are fairly well known (you may read my article on this subject at, which is written for non-lawyers), as well as insurance funded buy-sell agreements.  Use of split-dollar life insurance plans (as well as charitable split dollar) has fallen out of favor, so the question must be asked, are there any “sophisticated” life insurance planning techniques left to discuss?  The answer is obviously, “yes”, but for purposes of this article, we will only cover four applications:  the WRAP Trust, the Gatewood Endorsement, Purchasing Insurance Through the By-pass Trust, and Section 419 (and 419A) Plans for Single Employers.

The WRAP Trust. An interesting life insurance application is discussed in the Journal of the American Society of CLU & ChFC, September, 1997, entitled The WRAP Trust. The article (by James G. Blase) should be referenced for further details. The gist of a WRAP trust is this:  As cash value in an insurance policy (owned by the ILIT) increases, the trustee borrows from the policy, and loans the cash to the Grantor, in exchange for the Grantor’s note and pledge of assets (this is a secured loan). The grantor will presumably spend the cash.  When the grantor dies, the ILIT owns a note from the Grantor’s estate, but also holds the securities the Grantor has pledged, as collateral for the loan.  The trustee of the ILIT will collect the debt by using the pledged assets (thereby reducing the size of the grantor’s federal taxable estate).

The Gatewood Endorsement.  Sometime in the late 1980’s, a short article appeared in the Journal of the American Society of CLU & ChFC, entitled “The Gatewood Endorsement”.  I have lost the article, but not the concept, which was developed by an insurance salesman in St. Louis.  Here is the setting:  husband and wife have purchased a second-to-die life insurance product.  Neither husband nor wife want to create an irrevocable life insurance trust, but both want to enjoy the benefits of an ILIT (which permits insurance policy proceeds to be paid to beneficiaries, without including the proceeds in the taxable estate). The “Gatewood Endorsement” might provide such a benefit, and here’s how it works.  Ownership of the policy is in both names, but on the first death, ownership shifts to the estate of the first to die (that is, when no policy proceeds are paid).  When the second insured dies, the life insurance is not included in his or her estate (ownership of the policy is in the estate of the first to die).  Here is some sample language:

Ownership of policy: Husband and wife are the initial owners, but on the death of the first to die, ownership shall vest in estate of the first to die.

A variation of this technique might be to place the ownership in the by-pass trust:

Ownership of policy:  Husband and wife are the initial owners, but on the death of the first to die, ownership of this policy shall vest in the Acting Trustee of the Smith Family By-Pass Trust, dated August 1, 1997

After the death of the first insured, premium payments would be made by the beneficiaries, presumably through a gifting program from the parent who is living. The cash value of the policy would be included in the estate tax return of the first to die.  Use of this technique gives most of the benefits of an ILIT, without the administrative burden and expenses of having an ILIT.

Purchasing Insurance Through the By-Pass Trust.  This application is used for very large estates, and here is the scenario:  H dies in 2002, and leaves W surviving him.  H’s by-pass trust is fully funded (to the maximum allowed by law, which is $1,000,000).  Assume W does not die in 2010, when there is no estate tax. If she dies in any other year than 2010, W will have a taxable estate. The Trustee of H’s by-pass trust purchases a $2,000,000 life insurance policy, on the life of W.  When W dies, the remaining assets of the by-pass trust will pass to her children, and the life insurance (owned by the by-pass trust) will not be part of her taxable estate. The proceeds from that policy can be used to pay for the estate taxes which will be due when W dies.  In effect, we are creating an ILIT, using the by-pass trust (which is irrevocable) as the insurance conduit.

Section 419 and 419A Single Employer Plans. With soaring health care and prescription drug costs, small business owners may adopt single employer welfare benefit plans as attractive fringe benefits for retaining key employees. Employers can deduct contributions made to Section 419A plans which provide post retirement health care and life insurance benefits, using a single employer welfare benefit plan.  A single employer welfare benefit plan is a generic name used to describe any one of several plans established by a single business to provide miscellaneous welfare benefits to its employees and their dependents. 

Here are some benefits that may be provided under a single employer welfare benefit plan (Section 419A(a)):

  • Medical and hospitalization expense including insurance premiums, co-pays, deductibles and non-insured medical expenses.
  • Prescription and over the counter drugs.
  • Long-term care, home health care and nursing home expenses.
  • Life insurance benefits including individual and survivorship.

There are no minimum contribution requirements. Consequently, an employer can skip a contribution in one year and make significant contributions during peak profit years. The employer’s deductible contribution is limited to what is reasonably and actuarially necessary to fund eligible post retirement claims of the employees, their spouse and dependents.  Contributions made to the fund are based on the working lives of the covered employees and on the basis of current medical costs.  Of course, this form of funding will result in the largest contributions going to older married employees.

With the exception of sole proprietorships, most employers (whether they be S-Corporations, LLCs, partnerships, professional practices, C Corporations) can establish a welfare benefit plan.  Sole proprietorships with W-2 employees may be eligible, but must be reviewed on a case-by-case basis. The businesses should have good cash flow and be willing to comply with ERISA employee participation coverage requirements (Section 419A(e)).

Favorable tax treatment extends to employees, their spouse and dependents.  Discrimination is not permitted, but ERISA employee exclusions may be applied.  In general, this means that 70% of employees must be covered, but the plan can exclude employees with less than 36 months of service, part-time employees and employees younger than 25 (e.g. eligible employees might be defined to be those who are age 55 and older, and who have 10 years of service). It is generally wise to include all eligible employees in small companies.

While all eligible employees must participate, welfare benefit plans do not have vesting schedules.  Instead of “vesting dates”, employers will establish an “entitlement date”, which usually requires lengthy service by an employee.  If a participant quits before reaching the entitlement date, his benefits will be reallocated to the remaining participants in the plan.   The employer is, in effect, creating a “golden handcuff” to retain key employees.

Employer contributions to the plan are not taxable to the participants.  Only the value of the life insurance protection – measured by government table 2001 rates – is currently includable in the participant’s income.  Life insurance and medial benefits are generally received income tax-free by the participants (IRC §101 (a)).

To adopt such a plan, the employer will meet with a plan administrator who helps to design and adopt a plan.  A list of three plan administrators is given at the end of this section of the outline.  The typical scenario is as follows:

Employer provides the plan administrator with the initial and annually updated employee census data.

Plan administrator determines contribution amounts.  Employer makes tax-deductible contributions to a trust that has been established to hold the employer’s plan assets.

The trust accumulates funds and buys products on the employee participants.  When life insurance is used to finance the benefit, the welfare benefit trust should be the owner and beneficiary of the policy.   The accumulations are used to meet the plan’s obligations to the participants and dependents.  The assets of the trust are beyond the reach of the sponsoring employer and its creditors.

The plan administrator provides full plan administrative support. 

When a covered event occurs (e.g. medical expense, long term care) the participant submits a request for payment to the plan administrator who processes the payment of the claim by the trust.  Such payments are generally not taxable when paid.

A single employer welfare benefit plan can help preserve retirement assets for owners and key employees.  It’s a good idea to save for retirement expenses; it’s better yet to fund for those expenses with tax-favored dollars.

Some Technical Notes.  Sections 419 and 419A are part of the “ERISA” sections of the Internal Revenue Code, and they deal with Employer Welfare Benefit Plans.  Without going into all of the details of Sections 419 and 419A, assume for a minute that an employer makes contributions to a 419A Employer Welfare Benefit Plan.  The contributions are, by definition, deductible for income tax purposes. Section 419A(a)

When one thinks of Section 419 plans, one normally imagines a plan involving multiple employers who contribute dollars to an administrator, who in turn, buys insurance products.  But Section 419 also covers single employers, and that is what is being discussed in this article.

Single employer welfare benefit plans should not be confused with plans structured as multiple employer welfare benefit plans under IRC §419A (f)(6). Single employer plans have their own set of rules, and for that reason, avoid the controversy surrounding the marketing of multiple employer welfare benefit plans.  Single employer welfare benefit plans are not nonqualified deferred compensation plan for selected employees. 

IRC §419A provides special limits on the amount an employer can contribute to a fund which provides for post retirement health care and life insurance.  Generally, an employer’s deductible contribution is limited to what is reasonably and actuarially necessary to fund eligible post retirement  claims of employees, their spouse and dependents. Section 419A(c)(2)

The contributions to the fund must be on a level basis over the working lives of the covered employees and on the basis of current medical costs.  Of course, with this form of funding, the largest contributions will be for older, married employees.

There is no minimum amount that an employer must contribute to the Section 419 fund.   However, if an employer’s contributions to the fund exceed the plan’s qualified cost, the excess contributions are treated as contributions to the fund during the next taxable year.  This enables the employer to take a deduction for the excess contributions in the next taxable year. Section 419(d)

Employer contributions to the plan are not taxable to the participants.  Only the value of the life insurance protection – measured by government table 2001 rates – is currently includable in the participant’s income. Generally speaking, life and medical benefits are income-tax free when received by the participants.

The amount that an employer can contribute to a welfare benefit fund is reduced by the fund’s after-tax income, so life insurance is an ideal medium of investment (Section 419(c)(4) and (e)(4)). In addition, the lesser of the funds earnings or any reserves for post retirement medical benefits are subject to tax under the Unrelated Business Taxable Income (UBIT) rules of IRC §512 (Section 419A(g)). Because the internal build-up of life insurance policies cash value will not be taxed, insurance is an attractive investment vehicle.

Life insurance product choices to finance a welfare benefit plan are a factor of the plan’s design and the needs and circumstances of the employer.  Any type of life insurance policy can be used, including term, permanent, single life and survivorship.  In addition, it is possible to use a combination of policy types within a fund.   For example, an employer may want to use term and other investments to fund support staff benefits because of high turn over rates, but use permanent coverage for key employees.   When life insurance is used, the welfare benefit trust should be the owner and beneficiary of the policy.

If a participant leaves employment before reaching the entitlement date the participant forfeits all the benefits.  Upon separation, the funds allocated to the terminated participant are reallocated to the remaining participants and can reduce future contributions. When life insurance is used as a financing vehicle (and the plan document permits) the employer can elect to sell the policy to the employee.

A plan can be terminated; however, a plan should be adopted with the intention of maintaining it into the future.

The benefits of employees who have reached entitlement are preserved in the plan.  The remaining assets can either be “frozen”, remain within the plan or distributed.  If the assets remain in the plan, benefits will continue to be delivered;  however, the benefit amounts will be proportionately smaller.  Benefits will continue until assets are paid out. The benefits received by the retiree are granted tax-favored treatment.  If the remaining assets are distributed, they may not revert to the employer.  They must be distributed to all participants in a non-discriminatory manner in accordance with IRS guidelines; whether the recipients are taxed depends on the intended nature of the benefit. 

Aside from providing the business owner valuable post retirement tax-favored benefits on a tax-deductible basis, the plan can offer the following advantages:

  • The ability to benefit long-term loyal employees (including owner-employees).
  • Protection of the plan assets from the claims of the business creditors.
  • An opportunity to purchase life insurance on a tax-deductible basis.
  • Depending on how the plan is designed, estate tax-free death proceeds.
  • No required minimum contributions.  A business may skip a contribution in one year and made a significant contribution during peak profit years.
  • No legislatively prescribed vesting schedule.  The business owner establishes the entitlement date that must apply equally to all employees, but there is no benefit for employees who prematurely terminate employment.
  • Benefits favor older married employees with higher incomes.  For legal and tax reasons benefits are frequently funded with any combination of life insurance and annuity product.
  • Plan funds are in trust for the exclusive benefit of the employees.  Therefore, the funds are beyond the reach of business creditors.



Plan Name: CRESP (Commonwealth Retirement Security Plan)
Plan Promoter: Doug Williams
Plan Benefits: Post-Retirement Medical Expense and Life Insurance
Contract Information: 
            Address: Commonwealth Plans
            28494 Westinghouse Pl. Ste 114
            Santa Clarita, CA  91355
            Phone: (661) 702-8818

Plan Name:    Greater Metropolitan Single Employer Death-Benefit-Only Plan & Trust
Plan Promoter:    Steve Wechsler
Plan Benefits:  Death Only Benefit
Contract Information:
            Address: The Wechsler Financial Group, Inc.
            757 Third Avenue, Ste 2402
            New York, NY   10017
            Phone: (212)583-0800

Plan Name: The Heritage Individual Employer welfare Benefit Plan Trust
Plan Promoter: John Donnelly
Plan Benefits: Death Benefit Only
Contact Information:
            Address:    The Heritage Group
            105 Broadhollow Road
            Melville, NY 1174aa7
            Phone: (631 423-0505

D.  Sophisticated Marital Deduction Planning

The Marital Deduction

The marital deduction is permitted for property given to a surviving spouse outright, or through a qualifying QTIP trust. The marital deduction is available without the use of a QTIP trust, through outright bequests, holding title in joint tenancy, general power of appointment trusts and estate trusts but the marital deduction for QTIPs is available only if the executor of the decedent’s estate elects such treatment, by listing QTIP property in Schedule M of the Form 706.

Why use a QTIP trust?

There are several reasons for using a QTIP trust.

  1. Control Issue Eliminated. Where the estate owner wants to control where the trust corpus is to be distributed, when the surviving spouse dies, he or she can do so with a QTIP trust.  If the surviving spouse remarries, he or she will receive lifetime income, but will have no control over the trust corpus when he or she dies.  By using a QTIP trust, the estate owner insures that his or her share of property and any separately owned property will not be diverted to beneficiaries who are not intended heirs.
    Thus, the surviving spouse enjoys the income from the property during her life, but does not control disposition of the trust property itself (other than the income). The creator of the QTIP trust specifies the residual beneficiaries, but does not jeopardize use of the marital deduction. If the surviving spouse later remarries, her children cannot be disinherited under the QTIP trust.       
  2. Power to invade may be given to trustee or others. In addition to giving the surviving spouse the income from the QTIP trust, a limited or unlimited power to invade trust principal for the spouse’s benefit may be given to a trustee other than the spouse or to persons other than the trustee.
  3. Special power of appointment permitted after death of surviving spouse. The surviving spouse may be given a limited testamentary power (a special power of appointment) to appoint trust principal, to a class of persons, such as children, grandchildren, nephews, nieces issue, etc.
  4. General power of appointment permitted after death of surviving spouse.  If the surviving spouse is given a general (unlimited) testamentary power of appointment over trust principal, the trust would qualify for the marital deduction as a life estate – power of appointment trust. 
  5. Miscellaneous.  In addition to the benefits mentioned, here are some additional factors to consider:
  • The Executor can choose the most advantageous marital deduction by electing the marital deduction for less than all of the property in the trust.  This advantage can best be understood by contrasting two approaches: Suppose H and W own stock in a closely held corporation.  H dies first:  (1)  If W inherits H’s stock, through a marital deduction trust, where W receives income for life, with a general power of appointment to W, the gift to W qualifies for the marital deduction.  But, W’s stock would have to be aggregated, for valuation purposes, with the stock she owns outright.  Bonner, Louis Sr. Est v. U.S., (1996, CA5) 77 AFTR 2d 96-2369, 84 F3d 196, 96-2 USTC 60237;Mellinger, Harriett R. Est, (1999) 112 TC 26, acq 1999-35 IRB 314, as corrected by Ann 99-116, 1999-52 IRB ; Nowell, Ethel S. Est, (1999) TC Memo 1999-15, RIA TC Memo 99015;Lopes, Ambrosina Blanche Est, (1999) TC Memo 1999-225, RIA TC Memo 99225, 78 CCH TCM 46. (2) Suppose a QTIP trust is created, for the A-portion.  The Executor can elect to treat part, but not all, of the property as marital deduction property, because only the Executor can elect QTIP treatment. Had a qualifying life-estate-power-of-appointment trust been used, the entire value of the trust qualifies for the marital deduction, without any post-mortem decision by the executor. If a QTIP trust is used, a ‘second look’ at the marital deduction is permitted, and the executor may elect not to treat the entire A trust as being marital deduction property. Such an option is not available had a life-estate-power-of-appointment trust been used. If H’s stock is allotted to a QTIP trust for W’s benefit, the stock does not have to be valued as a controlling interest in the corporation. If, on the other hand, H leaves his stock to a life-estate-power-of-appointment trust for W’s benefit, then, on her death, the stock in the trust (which is includible in the wife’s gross estate under Code Secs. 2041) will have to be aggregated with the stock she owns outright for valuation purposes.  Fontana, Aldo H. Est, (2002) 118 TC No. 16;Field Service Advice 200119013.
  • Use of a QTIP trust can save generation-skipping transfer (GST) taxes, through a “reverse QTIP” election.  The reverse QTIP election to treat the first spouse to die as the transferor for GST tax purposes can be made only if a QTIP trust is used.  This benefit will be covered separately.
  • When the estate taxes are repealed (year 2010), the spousal basis adjustment for purposes of the carryover basis rules can be augmented in a QTIP trust.  Sec. 501, 531, 532, 901 PL 107-16, 6/7/2001.  A QTIP trust permits allocation of $3 million spousal basis adjustment under carryover basis rules in 2010. The carryover basis rules will generally provide that assets received from a decedent take the same basis in the hands of the recipient that they had in the decedent’s hand on the date of death. The decedent’s executor will, however, be able to allocate $1.3 million of additional basis to assets (regardless of to whom they pass), and $3 million of basis to assets passing to the decedent’s surviving spouse, either outright or to a qualified terminable interest property (‘QTIP’) trust.  Sec. 542(a) PL 107-16, 6/7/2001; Code Sec. 1022(c). This is known as the spousal property adjustment, and it can increase the basis of assets received from a decedent, but not beyond their fair market value on the date of death.  The carryover basis rules define a QTIP trust using the same requirements that exist under current estate tax law, except that no election is required from the decedent’s executor. The surviving spouse must be entitled to all the income from the trust property, payable at least annually, and no person (including the surviving spouse) can have a power to appoint any part of the property to any person other than the surviving spouse.   Sec. 542(a) PL 107-16, 6/7/2001; Code Sec. 1022(c)(5).
  • The fraction or percentage of the QTIP trust for which the marital deduction is to be claimed may be defined by means of a formula.  Formula elections help executors in situations where the exact amount of marital deduction needed to produce the best tax result cannot be determined at the time the election must irrevocably be made. For example, if the election decision was based on the value of the estate as originally reported on the estate tax return, a change in that value, as the result of an audit completed after the time to make the election had expired, would leave the executor in a difficult situation. In order to avoid this problem, the executor can, on the decedent’s estate tax return, elect the marital deduction for that fraction (or percentage) of the estate which will reduce the federal estate tax owed to the lowest possible amount (including zero). Another type of formula election which could be used would be an ‘equalization’ formula designed to use a partial QTIP election to equalize the estates of two spouses who have died simultaneously or within a short time of one another. This type of formula QTIP election  could be very useful when, at the time the election must be made in the estate of the first spouse to die, the value and composition of the surviving spouse’s estate has not been completely determined.

What is a QTIP trust?

A QTIP trust is (a) a trust (b) under which the surviving spouse is entitled to all the income for life and (c) no person can appoint any part of the property to anyone other than the surviving spouse during his or her life.

Each of these elements is critical.  The surviving spouse must be entitled to all of the income from the trust corpus during his or her entire life. Anything less will disqualify the trust for marital deduction purposes. For example, the following trust provisions disqualify the trust for marital deduction purposes:

  • A trust which pays the spouse income for a term of years (even though that period exceeds her life expectancy).
  • If the survivor’s income rights are curtailed if he or she remarries
  • If the trust income may be sprinkled among a class of beneficiaries, which includes the spouse and others
  • Power to accumulate all or part of the trust income, even though all income will be payable to the surviving spouse prior to death.
  • Power to withhold income from the spouse in the event of remarriage.
  • Power to appoint trust corpus to any person other than the surviving spouse (however, if the principal may be appointed to non-spouse beneficiaries, after the surviving spouse’s death, the trust will qualify for marital deduction purposes).
  • Power of the surviving spouse during her lifetime to appoint principal to her children, issue, descendants, etc.
  • Power of the trustee to invade principal during the spouse’s lifetime for benefit of persons other than the surviving spouse.

In addition to these “disqualifying” powers, there are certain types of property which cannot be placed in a QTIP trust.  For example, if non-income producing real estate is placed in the QTIP, the QTIP criteria is not satisfied.  If the spouse has the right to direct that the non-income producing property be sold and converted to income producing property, then the QTIP criteria is satisfied.  Reg § 20.2056(b)-5(f)(4); Reg § 20.2056(b)-7(d)(2). As a practical matter, the trustee is normally permitted to sell and re-invest trust property, and such a trust provision will normally protect the QTIP’s eligibility for the marital deduction; the surviving spouse would have to consent to the QTIP holding unproductive property for an unreasonable time.  Reg. §20.2056(b)-7(d)(3)(i), the Clayton QTIP Trust  regulation, permits a Personal Representative to choose between property interests which fund the QTIP, as well as lists variations on the sorts of remainder interests which are permitted under QTIP trusts.

Here are some powers which do not disqualify the trust for the marital deduction (stated differently, a trust will qualify for the marital deduction if the following powers are present):

  • The surviving spouse may appoint principal to herself (including a power invasion solely for her own benefit), even though such a power permits the surviving spouse to make tax-free gifts (within the annual exclusion) to other persons and avoid estate tax in her estate on the amounts given away.
  • A limited or unlimited power to invade trust principal for the spouse’s benefit may be given to a trustee other than the spouse or to persons other than the trustee.
  • The executor’s power to elect all or a fractional/percentage portion of the QTIP trust property to qualify for the marital deduction. The decision as to the amount of property to qualify for the marital deduction may be postponed until after the spouse’s death at a time when financial resources and needs may be more clear.

If the QTIP requirements are met, certain property not in trust, such as life insurance proceeds and a joint and survivor annuity, can qualify under the QTIP rules for the marital deduction.

QTIP Trusts Used In Conjunction with Other Trusts.

Only part of the decedent’s trust assets need be placed in a QTIP trust.  In a second marriage situation, of some duration, the surviving spouse might want the power to appoint part of the martial assets to designated beneficiaries.  The remainder of the martial assets might be placed in a QTIP trust, over which the decedent Settlor demands the right to designate the ultimate beneficiaries. 

QTIP Trust Compared with Estate Trust.

The ‘estate trust’ under which the surviving spouse is the income beneficiary with the remainder payable to the surviving spouse’s estate has traditionally been used to qualify property for the marital deduction where it was desirable to provide for accumulation of income by the trustee rather than paying income out annually to the surviving spouse. This has permitted all or part of the income to be accumulated and taxed to the trust rather than to the surviving spouse. An estate trust also permits retention in the trust of unproductive property. In a QTIP trust, income may not be accumulated and unproductive property may not be retained without the surviving spouse’s consent.

Under the estate trust, the marital deduction will be obtained automatically for the estate owner’s estate, without satisfying the requirement that the executor elect to treat property as QTIP property.  

Checklist for QTIP trusts

If an estate owner’s will provides for a QTIP trust for his surviving spouse, several additional provisions should be considered for inclusion in his will. These are:

  • Factors to be considered by executor in making election decision
  • Provision for payment of estate tax on QTIP trust included in surviving spouse’s estate.  QTIP trust property for which a marital deduction election was made is included in the gross estate of the surviving spouse at her death, Code Sec. 2044(a), provided she made no prior disposition of all or part of her income interest.  Code Sec. 2044(b)(2). However, the surviving spouse’s estate is entitled to recover the estate tax on the QTIP trust property from the recipients of the trust property (e.g., the remaindermen).  Code Sec. 2207A(a).  To insure that the surviving spouse’s estate will receive estate tax and other death taxes on the QTIP trust property prior to distribution of the QTIP trust property to the remaindermen, it may be desirable to incorporate into the estate owner’s will a provision requiring the trustee of the QTIP trust to pay over from the trust property to the executor of the surviving spouse’s estate an amount equal to the death taxes caused by inclusion of the QTIP trust property in the surviving spouse’s estate, before the remainder is distributed to the designated recipients.
  • Restriction on power of executor or trustee to retain unproductive property in QTIP trust
  • Authorization to create separate QTIP trust when reverse QTIP election is made.

Lifetime QTIPS

Creating an inter vivos QTIP is a useful technique to equalize the estates of married couples. The inter vivos QTIP enables one spouse to increase the other’s estate for estate tax purposes, without (1) incurring a gift tax, (2) giving the other spouse control over the transferred assets, or (3) depriving the donor of the future benefit of the property.In PLR 200406004, the IRS outlined the steps required to draft and execute an inter vivos QTIP.

Here is the factual setting: The donor made a gift to an irrevocable trust for the lifetime benefit of his spouse. The trust instrument required that all of the trust net income be distributed to the spouse at least quarter-annually, while the donor and the spouse were both alive. The trust instrument also stated that the trustee had discretion to distribute to the spouse any principal that the trustee deemed appropriate for any purpose. If the spouse survived the donor, the trustee is also required to distribute the whole trust fund to the spouse, outright and free of trust. The trust instrument also provided that if the donor survived the spouse, the trustee must distribute all of the trust’s net income to the donor at least quarter-annually. After the donor’s death, if the donor survives the spouse, the trustee shall distribute the trust principal as the donor may appoint by will, among a class that includes only the donor’s issue and charitable organizations. Any unappointed principal would be used to pay estate taxes, and the remaining funds would pass in trust to the donor’s then living children and the issue of any deceased child of the donor.

The trust instrument gave the spouse the power to compel that the trustee make productive any property held in the trust during the spouse’s lifetime. The trust also required that at the spouse’s death and the death of the donor, if the donor survives the spouse, unless the decedent provided to the contrary by provision in his or her last will, the trustee will pay the incremental federal and state estate and inheritance taxes imposed with respect to the trust fund.

The donor was named initial trustee of the trust. An attorney named in the trust instrument was named trustee to serve upon the spouse’s death, whether or not the donor survived the spouse. The trust did not prohibit the spouse from serving as trustee, but if she does serve as trustee, she is prohibited from possessing or participating in the exercise of any power or discretion in favor of herself or her issue.

The IRS ruled that the trust created in the spouse a qualifying life estate that could be deducted, upon appropriate election by the donor and further ruled that if the donor predeceased the spouse, none of the trust assets will be included in the donor’s gross estate to the extent that the gift has been deducted as a QTIP. The value of QTIP property deducted by the donor is not included in the donor’s gross estate, and any subsequent transfer by the donor of any reserved interest in the trust is not a taxable gift.

The IRS further concluded that if the donor survived the spouse and if the spouse and donor are married at the spouse’s death, the executor of the spouse’s estate can elect to deduct the trust fund and to qualify the fund for the estate tax marital deduction in the spouse’s estate. The property will be included in the donor’s gross estate under Section 2044(a) if the QTIP election is made. The trust fund will not be included in the donor’s gross estate under Section 2036 or 2038, because the income interest will be deemed to pass to the donor from the spouse, and not to have been reserved by the donor.

There are many reasons why an inter vivos QTIP is an appropriate component of a married client’s estate plan:

  1. Gifts to an inter vivos QTIP will increase the donee spouse’s gross estate, and may enable the donee spouse to use all of his or her estate tax exemption and GST exemption. The recent changes in the law make it more likely that spouses will need to transfer assets between themselves to take full advantage of the increased exemptions.
  2. Using a QTIP marital trust can assure that the property is preserved for ultimate distribution to those family members the donor prefers. The donee spouse need not be granted any right to change the remainder beneficiaries of the trust.
  3. The donee spouse may be given limited rights to change the remainder beneficiaries of the QTIP marital trust, to vary the interests within a defined class of beneficiaries, such as the donor’s children and more remote descendants.
  4. The donor may serve as the trustee of a QTIP marital trust, retaining control over the management of the trust fund and reducing administrative costs by eliminating the commissions charged by independent trustees. The donor’s managerial control over the trust as trustee will not cause the trust to be includable in the donor’s gross estate, if the donee spouse predeceases the donor.
  5. The donor can reserve a continued income interest in trust, if the donor survives the donee spouse. This will not cause the trust funds to be included in the donor’s gross estate unless the donor’s interests in the survivorship trust amount to a general power of appointment.
  6. A donor who is married more than once may create a QTIP with respect to each donee spouse, taking advantage of each spouse’s estate tax credit and GST tax exemption.
  7. A QTIP marital trust affords the donee spouse protection against the claims of creditors, at least with respect to the trust’s principal. Because income must be distributed currently, creditors may attach the income.
  8. An inter vivos QTIP may create and preserve significant discounts for lack of marketability and lack of control over various assets, even though the entire asset ultimately passes to the same person or persons. The IRS has agreed with several court decisions that held that assets owned by a deceased donee spouse outright (or in a trust over which the donee spouse has a general power of appointment) are valued independently of those owned by a QTIP trust for the benefit of the donee spouse. The independent valuation means that partial interests in the same asset or entity held by the QTIP trust are valued with discounts for lack of marketability and lack of control, without regard to the fact that the deceased donee spouse also separately holds other interests in the same assets.

Reverse QTIPS

If there is an ambush in estate taxes, it might be argued that it is the generation skipping transfer tax.  Since it is not unusual for grandparents to provide for their grandchildren, especially if the grandparents are extremely wealthy, the issue becomes, how do we avoid incurring the generation skipping transfer tax?

In a normal estate plan, lawyers and accountants usually think no further than the creation of an A/B tax sheltered trust, with the thought that such action is about all that can be done for those with estates of about $3 million.  In some instances, however, the trust will name grandchildren as the residual beneficiaries (the parents are either mad at their children, or their children don’t need the money). 

Because of the GSTT, additional steps should be taken, through the use of a reverse QTIP, to “double” the GST exclusion. Although the $1,500,000 exclusion (for 2005) will not be precisely doubled when a reverse QTIP is used, because of the math required to compute the GST, the overall estate taxes and GSTT will be reduced.

To implement the reverse QTIP, the terms of the trust should permit the trustee, and direct the trustee, as circumstances so warrant, to divide the Q-tip trust into sub-trusts.  One sub-trust will require an special election under Schedule R on the Federal Estate Tax Return, when W dies.  The surviving spouse still receives income, as required under the Q-tip rules, but the residual beneficiaries, who are grandchildren, will enjoy a second GST exclusion.  In other words, the surviving spouse will not be regarded as inheriting all of the Q-tip trust, for purposes of the GST exclusion.  Here are the needed additions to tax sheltered A/B trusts:

First, the trust should authorize splitting the QTIP trust.  One QTIP trust can hold the exact amount of the unused GST exemption (‘the reverse QTIP trust’) and a second QTIP trust takes the balance of the QTIP bequest. Because the estate tax credit exemption increases between now and 2009, the importance of the reverse QTIP election will be less as time goes by.  However, in 2011, we return to the 2001 tax rates, and reverse QTIPs will be important again.

Most estate plans provide for the surviving spouse and children, but not to remote issue.  In many instances, the trust for the children will continue until the children reach an age when they are mature enough to handle significant amounts of property.  For example, a provision that a child’s trust terminates when the child reaches age 30 or 35 is common. If the child dies during the term of such a trust and his share passes to his children, this will be treated as a generation-skipping transfer for GST tax purposes. 

Any portion of a decedent’s GST exemption that has not been allocated to lifetime transfers or by the fiduciary of his will or living trust agreement by the due date of his estate tax return will be automatically allocated in a prescribed way. Code Sec. 2632(c)(2) ; Reg § 26.2632-1(d)(2). Because statutory allocation may not produce the best GST tax results, the governing instrument should alert the fiduciary that he should allocate the GST exemption whenever statutory allocation would not be appropriate.  One approach is to include in the list of fiduciary powers the power to allocate the GST exemption in the complete discretion of the fiduciary. If this approach is taken, the fiduciary should be authorized to allocate the GST exemption to both lifetime transfers and transfers occurring at death. The fiduciary should also be given the discretion to treat beneficiaries differently, and the fiduciary should be exonerated from liability for all decisions made in good faith and without gross negligence.

The client may be concerned about delegating so much authority to the fiduciary (for example, when the second spouse will be acting as fiduciary and allocations will affect transfers to issue of a first marriage). The client may prefer instead to direct the fiduciary to allocate GST exemption in a specified manner. The disadvantage of this approach is that the fiduciary has no flexibility to adjust for circumstances that have changed since the drafting of the will or living trust agreement. A possible compromise approach is to name an independent fiduciary and give him discretion with some suggested guidelines.

If the will or living trust agreement uses a reverse QTIP trust formula clause and if the balance of the estate does not pass to the surviving spouse in a form that will qualify for the marital deduction, the governing instrument should mandate how the GST exemption is to be allocated.  The fiduciary should not be given any discretion to allocate the GST exemption

The fiduciary will make a special election under Code Secs. 2652(a)(3)  to treat the trust for GST tax purposes as if the estate tax QTIP election had not been made (the ‘reverse QTIP election’). When a reverse QTIP election is made with respect to a trust, the identity of the transferor is determined, solely for GST tax purposes, without regard to the application of Code Secs. 2044, Code Secs. 2207A, and Code Secs. 2519.  Code Sec. 2044 ; Code Sec. 2519. Reg § 26.2652-1(a)(3). This means that the transferor’s surviving spouse doesn’t become the transferor for GST tax purposes at the surviving spouse’s later death even though the trust is included, under Code Secs. 2044, in the surviving spouse’s gross estate for estate tax purposes. Because the predeceased spouse remains the transferor for GST tax purposes, the fiduciary can effectively allocate the predeceased spouse’s GST exemption to the reverse QTIP trust.

In contrast to an estate tax QTIP election, the effect of the reverse QTIP election is not the deferral of tax.  Deferral of the GST tax is accomplished simply by making the spouse the sole current beneficiary (whether or not the transfer is in a QTIP trust and whether or not the reverse QTIP election is made). Making use of the reverse QTIP election is similar in concept to taking advantage of both spouses’ credits against estate and gift taxes if the value of their combined assets exceeds the amount of one credit equivalent amount. Just as there is no provision under the estate and gift tax laws for one spouse to make his unused credit available to the other spouse upon his death, so too there is no provision under the GST tax law for one spouse to make his unused GST exemption available to the surviving spouse. However, when both spouses’ estates equal or exceed the amount of the spouse’s remaining GST exemption, effective use of a reverse QTIP election can ensure that neither spouse’s GST exemption will be wasted.

If the clients want the marital share to pass, upon the surviving spouse’s death, outright to their children or in a trust that will be includible in the children’s estates (or outright to, or in an estate-includible trust for grandchildren when the grandchildren’s interest is in representation of a predeceased parent), then there will be no reason to use the reverse QTIP election.  And if the clients are willing to pay some upfront estate tax (i.e., upon the first spouse’s death), then a GST exemption trust can be used (rather than a credit shelter trust).

Avoid having the fiduciary make reverse QTIP election for entire QTIP trust if trust’s value exceeds unused portion of GST exemption.

The fiduciary must make the reverse QTIP election with respect to all of the property QTIP’ed for estate tax purposes. Code Sec. 2652(a)(3).  While a partial QTIP election is permitted for estate tax purposes, a partial reverse QTIP election is not permitted for GST tax purposes.

Where a reverse QTIP election is made when the unused portion of the deceased spouse’s GST exemption is less than the value of the reverse QTIP trust (producing an inclusion ratio between zero and one), the deceased spouse remains the transferor of the entire reverse QTIP trust. However, the GST tax is not eliminated;  the rate of tax is merely reduced.

A reverse QTIP trust with an inclusion ratio between  zero and one is undesirable for the following reasons:

  1. The surviving spouse’s GST exemption cannot be allocated to the reverse QTIP trust because the first spouse to die remains the transferor of the trust for GST tax purposes. Reg § 26.2652-1(a)(6), Ex (6). Thus, the surviving spouse’s GST exemption will be wasted if she does not have sufficient assets of her own to which the surviving spouse’s GST exemption can be allocated.
  2. Any transfer from the reverse QTIP trust to skip persons occurring at the surviving spouse’s death is treated as a taxable termination, not a direct skip.  Reg § 26.2652-2(d), Ex (1) ; Rev Rul 92-26, 1992-1 CB 314. The GST tax is computed on a ‘tax-inclusive’ basis with respect to taxable terminations, which means that the taxable amount includes the GST tax.  Genl Expl of Tax Reform Act of ’86, Pl 99-514, 5/4/87, p. 1266.
  3. Part of the GST exemption is wasted if the reverse QTIP trust is reduced by–
    a. principal distributions, or
    b. death taxes.
  4. The ‘predeceased parent rule’ is not available at the death of the transferor’s spouse to ‘move’ the grandchildren of the transferor up one generation level if their parent dies during the term of the reverse QTIP trust and they take in representation of their deceased parent.   Rev Rul 92-26, 1992-1 CB 314.

If the governing instrument contains no direction or authorization to create a separate reverse QTIP trust, the fiduciary would be able to create a separate trust that will be respected for GST tax purposes only if a state statute or a state court authorizes the fiduciary to divide the QTIP trust into two trusts. But don’t rely on a state statute to solve the problem because the client’s domicile may not  be the same at the time of his death. And don’t rely on a state court to rewrite the will or living trust agreement because a reformation proceeding will result in extra costs and cause delay in estate administration.

If the sunset provisions of  EGTRRA become effective and the estate tax is restored in 2011, the prior rule on division of trusts for GST tax purposes would be restored.  Sec. 562, 901 PL 107-16, 6/7/2001.

When the value of a couple’s combined estates is equal to $2,120,000, both spouse’s GST exemptions (assuming that the GST exemption is $1,500,000, the amount for 2005) will be used in full if each spouse has $1,500,000 in individual name, and if the will or living trust agreement of the first spouse to die creates a QTIP trust. (The typical estate plan will also include a credit shelter trust.)  No special drafting is required.

The special election under Code Secs. 2652(a)(1)  to treat the first spouse as the transferor for GST tax purposes (reverse QTIP election) can be made only with respect to a QTIP trust.  Reg § 26.2652-2(a) ; Peterson Marital Trust, E. Norman, (1994) 102 TC 790, affd on other issue (1996, CA2) 77 AFTR 2d 96-1184, 78 F3d 795, 96-1 USTC 60225. Thus, the first spouse’s GST exemption can be allocated to a reverse QTIP trust, whereas it cannot be effectively allocated to other kinds of marital deduction transfers.

A married couple must decide whether the surviving spouse is willing to relinquish complete control over assets to save GST taxes. A husband and wife face the same choice when deciding whether to give all property outright to the surviving spouse, or instead to hold the credit equivalent amount in trust so that the property is sheltered from estate taxes at the surviving spouse’s death.

Some couples want to postpone making a decision about a credit shelter trust until the death of the first spouse so that the surviving spouse can take into account the circumstances at that time and his or her feelings about having such a trust.  Similarly, a couple may want to keep the option of a reverse QTIP trust open. Also, with the amount of the estate tax credit increasing until 2009, postponing the decision about the credit shelter trust and reverse QTIP trust can allow for a decision based on the most current tax picture at the date of the first spouse’s death. This postponement can be accomplished by providing in the will or living trust agreement that if the surviving spouse disclaims a portion (which will be equal in amount to the first spouse’s remaining GST exemption) of an outright bequest, the disclaimed property  will pass to a QTIP trust.

While the surviving spouse controls whether a trust will be created when a disclaimer reverse QTIP trust is used, she is not permitted to change the disposition of such a trust through the exercise of a power of appointment.  Code Sec. 2518(b)(4) ; Reg § 25.2518-2(e)(2) ; Reg § 25.2518-2(e)(5), Ex (5).

If a trust included in the transferor’s gross estate or created under the transferor’s will is severed under a direction in the governing instrument, it will be treated as a separate trust for GST tax purposes.  Reg § 26.2654-1(b)(1)(i) ; Reg § 26.2654-1(b)(3).

Creation of a reverse QTIP trust should be mandated by the will or living trust agreement in either of two circumstances:

  1. when the clients want the entire marital share held in a QTIP trust and the amount of property passing to a single QTIP trust is likely to exceed the remaining GST exemption, or
  2. when the clients will accept the trust arrangement to the extent that it may shelter property from the GST tax.

When the reverse QTIP trust is set up under a direction in the will or living trust agreement (rather than being created under the fiduciary’s discretionary power to divide the QTIP trust into two trusts), the clients may have more opportunity to achieve their dispositive objectives and derive maximum benefit from the GST exemption. 

No requirements are stated in the final GST regs for a mandatory severance of trusts, in contrast to the rules for separate and independent shares of trusts, and for discretionary severances of trusts.  It is not clear whether this distinction made by the final GST regs between mandatory and other types of severances was intended, and IRS’s corrections to the final regs did not resolve the issue.  Therefore, it may be prudent to satisfy the funding requirements for discretionary severances for mandatory severances as well.  Note also that mandatory severances made on a pecuniary basis are subject to similar funding requirements for valuation purposes.

The numerator of the applicable fraction is the amount of GST exemption allocated to the trust.  Code Sec. 2642(a)(2)(A). The inclusion ratio of the trust equals one minus the applicable fraction.   Code Sec. 2642(a)(1).

The fiduciary should be required to fund the reverse QTIP trust in accordance with the GST regs . This will ensure that:

  • Only the reverse QTIP trust’s value (and not the combined value of the reverse and ‘regular’ QTIP trusts) will be included in the denominator of the applicable fraction, because the reverse QTIP trust is respected as a separate trust for GST tax purposes (the separate trust rules ); and
  • Federal estate tax values, rather than date of distribution values, may be used in the denominator of the trust’s applicable fraction (the valuation rules ).

Producing a GST inclusion ratio of zero for a trust intended to be GST-protected is the most important objective.  For this reason, it’s important to satisfy all of the separate trust requirements so that only that amount of the GST exemption equal to the reverse QTIP trust need be allocated to produce an applicable fraction with a numerator equal to the denominator (1 -1/1  = 0).

A secondary objective is the maximization of the value of the GST-protected trust.  If appreciation in the value of estate assets occurs between the estate’s valuation date and the funding of the pecuniary amount, it’s more advantageous to use the lower federal estate tax values in the denominator of the applicable fraction because less GST exemption is required to produce a zero inclusion ratio.

The separate trust and the valuation rules under the GST regs are intended to prevent abusive practices in achieving these objectives. However, failure to comply with the separate trust rules results in harsher treatment (the denominator of the applicable fraction is the value of the single trust, not the separate trust) than results from failure to comply with the valuation rules (date of distribution values, not estate tax values, must be used in the applicable fraction and, under certain circumstances, the denominator of the applicable fraction is reduced by only the discounted  value of a pecuniary payment).

If a single QTIP trust (in the amount of the maximum marital deduction) is created, the fiduciary may be authorized to sever the trust into two trusts (the reverse QTIP trust and the ‘regular’ QTIP trust).

For purposes of the separate trust rules, if the severance is required by the terms of the governing instrument to be made on the basis of a pecuniary amount, the pecuniary amount must be satisfied in a manner that would meet the requirements of Reg § 26.2654-1(a)  if it were paid to an individual.  Reg § 26.2654-1(b)(1)(C)(2).

For purposes of the valuation rules, where a pecuniary payment is satisfied with cash, the denominator of the applicable fraction is the pecuniary amount.  But if property other than cash is used to satisfy a pecuniary payment, the denominator of the applicable fraction is the pecuniary amount only if the pecuniary payment must be made with property on the basis of the value of the property on —

  1. the date of distribution, or
  2.   a date other than the date of distribution, but only if the pecuniary payment must be made on a basis that fairly reflects net appreciation and depreciation (occurring between the valuation date and the date of distribution) in all of the assets from which the distribution could have been made.  Reg § 26.2642-2(b)(2)(i).

The denominator of the applicable fraction with respect to any property used to satisfy any other pecuniary payment payable in kind must be the date of distribution value of the property.  Reg § 26.2642-2(b)(2)(ii).

The denominator of the applicable fraction with respect to a residual transfer of property after the satisfaction of a pecuniary payment is generally the estate tax value of the assets available to satisfy the pecuniary payment reduced, if the pecuniary payment carries appropriate interest, by the pecuniary amount.  Reg § 26.2642-2(b)(3)(i).

However, the denominator of the applicable fraction with respect to any residuary transfer after satisfaction of a pecuniary payment payable in kind is the date of distribution value of the property distributed in satisfaction of the residuary transfer, unless the pecuniary payment must be satisfied on the basis of the value of the property on –

  1. the date of distribution; or
  2.  a date other than the date of distribution, but only if the pecuniary payment must be satisfied on a basis that fairly reflects net appreciation and depreciation (occurring between the valuation date and the date of distribution) in all of the assets from which the distribution could have been made.   Reg § 26.2642-2(b)(3)(ii).

The purpose of Reg § 26.2642-2(b) is to prevent the ‘leveraging’ of the GST exemption by overfunding a trust that is exempt from the generation-skipping transfer (GST) tax.  If the rules regarding funding a pecuniary payment in kind aren’t satisfied, estate tax value can’t be used in the denominator of the applicable fraction.

Be careful when using a formula to define amount of bequest passing to reverse QTIP trust.

Where there is a direction in the governing instrument to create a separate reverse qualified terminable interest property (QTIP) trust, the value of the reverse QTIP trust should not be fixed in the will or living trust agreement at a stated dollar amount (such as $400,000), especially in light of the fact that the estate tax credit is increasing until 2009 and GST exemption has been adjusted for inflation through 2003 and then increasing on the same schedule as the estate tax credit. Rather, a formula should define the amount of the bequest passing to the reverse QTIP trust. The amount of the bequest should equal the testator’s remaining generation-skipping transfer (GST) exemption, after taking into account:

  • Allocations made by the testator to lifetime transfers;
  • Allocations deemed to have been made by the testator to lifetime transfers;
  • Allocations made by the fiduciary to lifetime transfers; and
  • Allocations made by the fiduciary to other transfers occurring at death.

The estate will realize capital gain on the distribution of appreciated assets in kind in satisfaction of a pecuniary bequest.  Rev Rul 86-105, 1986-2 CB 82.

The advantage of using a formula is that the formula adjusts for allocations of the GST exemption to:

  • Transfers that occur before the governing instrument is drafted where the client is unaware of the GST tax consequences (e.g., a direct skip to which GST exemption was automatically allocated);
  • Transfers that occur after the governing instrument is drafted and that cannot be anticipated (e.g., future gifts); and
  • Expected future transfers of indeterminate amounts (e.g., the bequest to the credit shelter trust, the value of which will be reduced by gifts in excess of the annual exclusion amount and by state death taxes and nondeductible items charged to it).

There have been a couple of recent revenue procedures, Rev Proc 2004-46 and Rev Proc 2004-47, which provide a simplified method to obtain an extension of time to allocate generation-skipping transfer (GST) tax exemption in accordance with Code Sec. 2642(b)(1), and to make a reverse QTIP election, in very specific situations. In each instance, the request for relief is made under Reg. § 301.9100-3, but the lengthy private letter ruling process that is generally necessary to obtain this relief (and which requires the taxpayer to pay a user fee) can be avoided by following the two procedures (if the facts so warrant). Rev Proc 2004-46 applies to certain transfers which qualified for and made use of the gift tax annual exclusion under Code Sec. 2503(b)  Rev Proc 2004-47 applies to testamentary QTIPs to which the automatic unused GST exemption rule would allocate sufficient GST exemption to result in a zero inclusion ratio.

Recent PLR Dealing With Marital Deduction and Retirement Funds

In PLR 200447040 (Nov. 19, 2004), the IRS allowed favorable income and estate tax treatment for a series of disclaimers. The decedent, D, was survived by his wife, S, two children, two grandchildren, and various collateral relations. D died before he reached age 70 1/2, and he was a participant in a state government’s qualified retirement plan and its nonqualified eligible deferred compensation plan. D died without validly naming a designated beneficiary for his retirement plan benefits, so they were paid to his residuary estate. D’s will and revocable trust would divide these benefits between a marital trust and a nonmarital trust, both for the lifetime benefit of D’s wife and thereafter for the benefit of other family members. All the beneficiaries proposed to disclaim their interests in the nonmarital trust, so that D’s residuary estate passes to his heirs-at-law, determined under applicable state law. The children and grandchildren would also disclaim their interests in the residue of D’s estate, so that the entire residue would pass to S. S will then roll over the retirement plan distributions into an individual retirement account established and maintained in her name, before the last day of the year.

The IRS ruled that the proposed disclaimers were all qualified under Code Sec. 2518 and that the property passing to S by intestacy on account of the disclaimers will be deemed to have passed to her outright for estate tax purposes and therefore will qualify for the estate tax marital deduction. The IRS also stated that, as a result of the disclaimers, S will be deemed to have received D’s retirement plan benefits directly from D and will be able to roll both benefits over to her IRA without current income taxation ( Code Sec. 402(c) and Code Sec. 457(e)).

E.  Generation-Skipping Transfer Tax Planning

Generation Skipping Transfer Tax.  Although most financial advisors, attorneys or CPAs will never have a client whose heirs are faced with a GST, one must still understand the concept:  the tax on a GST is basically a surcharge made for passing wealth to grandchildren (and other “skip persons”).  A generation skipping transfer (GST) comes about when ‘generation-skipping’ transfers are made to persons more than one generation below the transferor’s generation. The taxable event occurs in four situations: a lifetime direct skip, a testamentary direct skip, a lifetime taxable termination or distribution, or a testamentary termination or distribution.  Stated differently, the tax is owed on three types of GST transfers: taxable terminations, taxable distributions, and direct skips. 

There are several concepts to consider.  First, the GST rate is the maximum estate tax rate, which is 47% in 2005, 46% in 2006, and 45% for 2007 through 2009. Under EGTRRA, the GST is repealed in 2010, but then is reinstated (at 55%) in 2011 (when EGTRRA “sunsets”).  IRC §§2601-2663

Second, there is a GST exemption of $1,000,000 for every donor, which was indexed for inflation through 2003.  Under EGTRRA, the exemption is increased to $1,500,000 in 2004 and 2005, $2,000,000 in 2006 through 2008, and $3,500,000 in 2009.  If the act sunsets in 2011, the exemption will return to the inflation-adjusted sum of $1,000,000.

Third, since the GST is (a) a flat tax, (b) imposed at the highest estate tax rate applicable to any transfer of property (lifetime or death), annual gifts of $11,000 or less should be considered as a valuable estate planning tool, since these gifts are not subject to the GST.  In addition, a donor may also make annual “qualified transfers”, which are not subject to the GST.  Qualified transfers include:

  • Tuition paid to an educational institution that meets the IRS income tax deductible contribution eligibility guidelines.
  • Payments made to a medical care provider by the transferor for such care.

“Qualified transfers” are not subject to any dollar amount limitations so long as they meet the IRC §2503(e) criteria, which is the section dealing with “qualified transfers”. 

Application of GST.  With this background in mind, let’s explore how the GST applies. There are basically three types of generation skipping transfers:

Direct Skips – Any transfer that is subject to any estate (see IRC Chapter 11, §§2001-2210) or gift (see IRC Chapter 12, §§2501-2524) taxes made to a skip person.  A ‘skip person’ is

(1)   a natural person assigned to a generation which is 2 or more generations below the generation assignment of the transferor, or

(2)   a trust—

(A) if all interests in such trust are held by skip persons, or

(B) if—

                         (i) there is no person holding an interest in such trust, and

                         (ii) at no time after such transfer may a distribution (including distributions on termination) be made from such trust    to a nonskip person.  IRC §2613(a)

 Explanatory regulation:  No person holds an interest in the trust and no distributions, other than a distribution the probability of which occurring is so remote as to be negligible (including distributions at the termination of the trust), may be made after the transfer to a person other than a skip person. For this purpose, the probability that a distribution will occur is so remote as to be negligible only if it can be ascertained by actuarial standards that there is less than a 5 percent probability that the distribution will occur.  Reg § 26.2612-1(d)(2)(ii).

Taxable Termination – Any termination of an interest of any beneficiary in a trust unless: a) a non-skip person has an interest in the property, or b) no distribution can be made from the trust to a skip person after the termination.

Taxable Distributions – Any distribution other than a Direct Skip or a Taxable Termination made to a skip person.  Thus, a taxable distribution is any distribution from a trust to a ‘skip person’, other than a taxable termination or a direct skip. The distribution is subject to generation-skipping transfer (GST) tax whether it is made out of trust income or corpus.

Examples:  To put some meat on the bones, so to speak, let’s consider how this actually works.

Lifetime Direct Skips. First, assume a grandparent has an estate valued at $25,000,000. The grandparent wants to benefit the grandchildren by giving a grandchild $3,000,000. If the gift were made in the year 2005, as a “lifetime direct gift”, it will take $6,482,700 of resources to complete the gift.  Here is how the tax is computed:

The amount to be given to grandchild                   $3,000,000.

GST applicable rate:  47%

Estate/Gift tax rate:  47%


GST tax ($3,000,000 x 47%)                                 1,410,000.

Gift Tax on Gift ($3,000,000 x 47%)                       1,410,000.

Gift Tax on GSTT ($1,410,000 x 47%)                       662,700.

Total Taxes                                                         3,482,700.

To make a transfer of $3,000,000 it takes             $6,482,700.

Testamentary Direct SkipLet’s say the same grandparent wants to leave his grandchild $3,000,000.  To do this through a testamentary gift takes $8,320,754.72 in resources.

Federal Taxable Estate                                       $8,320,754.72

GST applicable rate:  47%

Estate/Gift tax rate:  47%


Federal Estate tax ($8,320,754.72 x 47%)            $3,910,754.72

Amount remaining before GSTT                           $4,410,000.00

GSTT ($3,000,000 x 47%)                                    $1,410,000.00

Gift remaining for grandchild                                  3,000,000.

Lifetime Taxable Termination or Distribution.  Suppose the grandparent has established an inter vivos trust, through which a gift is made to a grandchild when a non-skip person dies (i.e., the son of the grandparent).  Assume also there is no change in values of the trust corpus over time, and that the tax is paid out of the property which will ultimately go to the grandchild.  Here is the computation:

Beginning Amount Needed for $3,000,000 gift       8,320,754.72*

GST applicable rate:  47%

Estate/Gift tax rate:  47%


Federal Estate tax                                               2,660,377.36

Amount remaining before GSTT                             5,660,377.36

GSTT ($5,660,377.36 x 47%)                                2,660,377.36

Gift remaining for grandchild                                  3,000,000.

*This is a “plugged” amount; it is the sum of $5,660,377.36 + $2,660,377.36.  From this example, it is impossible to determine or know how the Federal Estate Tax of $2,660,377.36 was computed.

Testamentary Taxable Termination or Distribution.  Suppose the grandparent has established a testamentary trust, through which a gift is made to a grandchild when a non-skip person dies (i.e., the son of the grandparent).  Assume also there is no change in values of the trust corpus over time, and that the tax is paid out of the property which will ultimately go to the grandchild.  Here is the computation:

Beginning Amount Needed for $3,000,000 gift       10,679,957.28

GST applicable rate:  47%

Estate/Gift tax rate:  47%


Federal Estate tax ($10,679,957.28 x 47%)            5,019,579.92

Amount remaining before GSTT                             5,660,377.36

GSTT ($5,660,377 x 47%)                                     2,660,377.36

Gift remaining for grandchild                                  3,000,000.

Deductions: Inclusions and Exclusions. Every U.S. Citizen is entitled to an exemption, IRC §2631, which may be applied to generation skipping transfers.  The question is, of course, how does this work?  A calculation must be made to determine what can be excluded from the gift.  First, we must determine the “exclusion ratio” by dividing the total value of the gift by the amount of the exemption. 

Suppose granddad and grandma give $3,00,000 to their grandson in 2005  Both are entitled to deduct an annual gift exemption of $11,000, so the net gift is $2,978,000.  Now we shift into higher math.  First, divide the net gift of $2,978,000 into $1,500,000, which is the GST exemption permitted for the year 2005.  This produces a factor of .5037; subtract this number from 1, to compute the inclusion ratio (.4963).  Multiply the inclusion ratio by the applicable maximum estate tax rate (.47 for 2005), to yield the applicable tax rate of .2333.  The tax rate is multiplied by the gift of 2,978,000, to compute the GST tax of $694,651.

This same principle applies to wills and trusts; it is advisable to give the Executor or Successor Trustee the power to allocate the GST exemption.  Here is some verbiage which permits such an allocation:

After the decease of both Settlors, Settlors authorize and empower the Trustee to exercise, in Trustee’s sole and absolute discretion, any elections and options given to it by any provision of the Internal Revenue Code, and other statute or Regulation, state or federal, governing the administration of the Settlors’ estate(s) with respect to the following:

(i). Allocating Generation-Skipping Tax Exemption.  To exercise the power to allocate any exemption from the federal tax on generation-skipping transfers provided by IRC §2631 et. seq. to any property with respect to which a Grantor is treated as the transferor, without regard to whether such property is part of a Grantor’s probate estate, and to exclude any such property from such allocation.

(ii). Division of Trusts for Inclusion Ratio Under Generation-Skipping Tax.  To divide any trust created hereunder into separate trusts in order that the inclusion ratio for federal generation-skipping tax purposes for one such trust shall be zero or one.

With respect to the powers granted in paragraphs (i) and (ii) and the paragraph preceding those two paragraphs, Trustee shall have no liability for or obligation to make compensating adjustments between principal and income or in the interests of the beneficiaries by reason of having made or not made any such election.  Any decision made by the Trustee in good faith with respect to the exercise or non-exercise of any such elections shall be binding and conclusive on all interested persons.

Because EGTRRA made sweeping changes to the gift, estate, and generation-skipping transfer (GST) tax provisions of the Code, there are concerns relating to allocation of the GST exemption. The proposed regulations provide the manner in which taxpayers can make an election pursuant to Code Sec. 2632(c)(5)(A)(i) and Code Sec. 2632(c)(5)(A)(ii), which generally provide how to elect out of the application of the automatic allocation rules or to treat affirmatively any trust as a GST trust. The former option is what most practitioners are likely to encounter; it is also the situation likely to cause the most trouble.

Proposed Regulations Dealing With Trust Severances

The IRS has proposed regulations under section 2642(a)(3), on qualifying severances of a trust for GST purposes. Section 2642(a)(3) allows a trust with an inclusion ratio between zero and one to be divided into two trusts, one with an inclusion ratio of one, and the other with an inclusion ratio of zero.  Each of the two new trusts created may be further divided into two or more trusts under section 2642(a)(3)(B)(i). Under section 2642(a)(3)(C), a trustee may elect to sever a trust in a qualified severance at any time, and the manner in which the qualified severance is to be reported is to be specified by regulation. Section 2642(a)(3) is applicable for severances of trusts occurring after December 31, 2000.

For example, the severance of a single trust on the basis that one trust is to be funded with 30% of the trust assets and that the other trust is to be funded with the remaining 70% of the trust assets would satisfy the requirements of section 2642(a)(3)(B)(i). Similarly, a severance stated in terms of a fraction of the trust assets such that one trust is to receive, for example, that fraction of the trust assets the numerator of which is $1,500,000 and the denominator of which is the fair market value of the trust assets on a specified date and the second trust is to receive the remaining fraction, would also satisfy this requirement. However, the severance of a trust based on a pecuniary amount (for example, severance of a single trust on the basis that one trust is to be funded with $1,500,000, and the other trust is to be funded with the balance of the trust corpus) would not satisfy the requirements of section 2642(a)(3)(B)(i).

The proposed regulations provide that each separate trust need not be funded with a pro rata portion of each asset held by the original trust. Rather, the separate trusts may be funded on a non pro rata basis (that is, where each resulting trust does not receive a pro-rata portion of each asset) provided that funding is based on the total fair market value of the assets on the date of funding. This avoids the necessity of dividing each and every asset on a fractional basis to fund the severed trusts.

Under section 2642(a)(3)(B)(i)(II), the new trusts created as a result of the qualified severance must provide in the aggregate for the same succession of interests of beneficiaries as provided in the original trust. Under the regulations, the beneficiaries of each separate trust resulting from the severance need not be identical to those of the original trust. In the case of trusts that grant the trustee the discretionary power to make non pro rata distributions to beneficiaries, the separate trusts will be considered to have the same succession of interests of beneficiaries if the terms of the separate trusts are the same as the terms of the original trust, the severance does not shift a beneficial interest in the trust to any beneficiary in a lower generation (as determined under section 2651) than the person or persons who held the beneficial interest in the original trust, and the severance does not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust. This rule for discretionary trusts is intended to facilitate the severance of trusts along family lines.

A qualified severance is to be reported by filing a Form 706-GS(T), “Generation-Skipping Transfer Tax Return for Terminations,” or such other form that may be published by the IRS in the future that is specifically designated to be utilized to report qualified severances. When Form 706-GS(T) is utilized, the filer should write “Qualified Severance” in red at the top of the return and attach a Notice of Qualified Severance to the return that clearly identifies the trust that is being severed and the new trusts created as a result of the severance. The notice must also provide the inclusion ratio of the trust that was severed and the inclusion ratios of the new trusts resulting from the severance. The return and attached notice must be filed even if the severance does not result in a taxable termination. A transition rule applies in the case of severances occurring before the date of publication of the final regulations.

The regulations under section 1001, as proposed, apply to severances occurring on or after the date of publication of the Treasury decision adopting these rules as final regulations. However, taxpayers may apply the proposed regulations under section 1001 to severances occurring after August 24, 2004, and before publication of final regulations. Prop Regs. 8/24/2004. Fed. Reg. Vol. 69, No. 163, p. 51967, REG-145987-03, Qualified Severance of a Trust for Generation-Skipping Transfer (GST) Tax Purposes Reg. §§1.1001-1, 26.2600-1, 26.2642-6, 26.2654-1

Summary.  Suffice to say, if you encounter a GST situation, you should conduct an in-depth analysis, and do lots of research.  This portion of the outline is only an introduction to the subject. 

F. Lifetime Freeze Transactions

To “freeze” the value of business assets, as a means of eliminating the uncertainty of valuation issues for both gift and estate tax returns, business owners sometimes sell their interests or other property to family members at a fixed price.  The types of intrafamily installment sales that may be used for estate planning include traditional installment sales, private annuity sales, sales using self-canceling installment notes, and sales to an intentionally defective grantor trust.

Since we are dealing with an actual sale, and not a gift, the basis of the property being sold will usually result in capital gains to the Seller, and a fixed cost basis for the Buyer.  The future value of the assets depends on the buying family member. Let me mention each of these techniques.

Installment sales.  The first sales technique is simply an installment sale.  As an example, assume Mr. C owns a business, which he now operates with his son.  He has three other children who are not involved in the business operations.  Mr. C decides to retire, and sells the business to his son, who signs a note and perhaps a security agreement. The note will be paid over a fixed period of time, and works much the same as the sale of real estate, in which an owner carries the note and mortgage. An installment sale has the estate planning advantage of freezing the value of Mr. C’s business interest for gift and estate tax purposes, and should Mr. C die before the note has been paid, the value of the remaining installment obligations will become part of his taxable estate when he dies. This technique might not save any estate taxes, because of the unpaid note balance due from his son will become part of Mr. C’s estate.  His other three children will approve of this transaction, however, because they will inherit part of his estate.

Private Annuities. The easiest way of describing how a private annuity can be used is by example.  Let’s say that Stan, age 84, sells a $1,000,000 piece of real estate to his son, George, in exchange for a private annuity.  There is no mortgage given to secure the annuity, but George agrees to pay his Dad, Stan, the sum of $190,150 every year that his dad lives.  When Stan dies, the annuity will not have any balance due, for it is (on Stan’s death) regarded as being paid in full.  Thus, if Stan dies within a couple of years after the transfer, George will have paid Stan the sum of $380,300, but George will owe nothing additional for this $1,000,000 piece of real estate, and there will be no estate tax due on Stan’s death.

Let’s first consider the nature of an annuity. Historically, an annuity is simply an obligation to pay to holder a fixed amount each year until the holder dies; at that time, the borrower owes no more on the obligation.  This instrument, known as a private annuity, occasionally lends itself to some creative estate planning. 

Because this transaction is a sale of real estate, the property being transferred is not included in Stan’s gross estate for estate tax purposes (even though he made the transfer within three years of his death).  Stated differently, Stan’s gross estate is now $1,000,000 less than it was (except for the payments of $380,300 which Stan might not have spent before he died).

From a practitioner’s vantage, the difficulty in structuring a private annuity is knowing how much is to be paid to Stan, and what the income tax consequences of the transaction are.  To calculate the amount of the annuity payments, you must know what the §7520 rate of interest is.  If we use the September 2002 §7520 rate of interest, which is 4.62%, for purposes of this illustration, and if we assume a basis in the real estate of $50,000, and if we also assume that the annuity payment will be made annually at the end of the period, then we can determine the annual payout to be $190,150 per year.  Using this amount, we can calculate the income tax consequences to Stan, as follows: $7,246 of the annual annuity payment will not be taxed for income tax purposes, $137,681 will be subject to capital gains tax and $45,223 will be taxed as ordinary income.  All of these calculations are based on a single life expectancy for an 84 year old, which is, 7.4 years.  I have used Number Cruncher to make these calculations.

Though this outline has made reference to Number Cruncher, you should be made aware of how to buy this program. Go to the website at, for ordering information. Number Cruncher has dozens of programs which can perform tax calculations described in this outline, including private annuities.   

As an estate planner, the benefit of a private annuity is this – if the owner of the property is in ill health, or might not meet ordinary life expectancy for his or her age, then a private annuity is a good means of eliminating property from the federal taxable estate.  Admittedly, the maker of the annuity will have to purchase the property and pay the annuity on an annual basis (or more frequently, if desired).  But that might not be a bad alternative, if the estate tax consequences of leaving the property in the estate outweighs the annual cash outlay for the private annuity. 

There are certainly other uses for private annuities (e.g., they can be prepared for two lives, rather than a single life), but hopefully this illustration will be of use to you in determining whether highly appreciated property should be sold in exchange for a private annuity.

Technical notes dealing with private annuities. The Maker of the annuity must not be a person who is engaged in the business of issuing annuity contracts, even occasionally. Otherwise, the difference between the present value of the annuity on the date of exchange (set by Treasury regulations)and the Annuitant’s basis in the property is immediately recognized as a capital gain. ( Rev Rul 62-136, 1962-2 CB 12)

As soon as the private annuity agreement is executed, the Maker acquires legal title to the transferred property and may sell or otherwise dispose of it as desired. The Annuitant could retain a security interest in the transferred property, but there are adverse tax consequences, because the annuitant will immediately have to recognize gain on the sale of the property (Estate of Bell, (1973) 60 T.C. 469). This is not an issue, of course, when the property sold is cash or a high-basis capital asset.

For the desired estate tax results, the annuity will continue for the Annuitant’s lifetime, no matter how long, but not one day more. This, of course, has an economic impact on the Annuitant and Maker quite apart from tax considerations. The annuity installments are ordinarily level for life, but may be inflation-adjusted so long as the present value at the date of exchange is the same. ( PLR 9009064)

A private annuity should not be confused with a life estate. A private annuity provides a predetermined income lasting for the lifetime of the Annuitant, whereas a life estate does not guarantee income, and pays only as much income as the supporting principal earns. With a life estate, the transferor transfers the property but retains an interest in it. This is not the case with a properly arranged private annuity. The IRS has argued that the purchase of a private annuity constitutes a transfer with a retained interest, which will cause the property to be included in the annuitant’s gross estate under Code Sec. 2036(a), as if it were a life estate. The courts, however, have firmly rejected that contention, based on the character of the private annuity transaction as a purchase and sale at fair market value. (Stern v. Commissioner, (1986) 650 F. Supp 16 (1986); see also Estate of Fabric vs. Commissioner, (1984) 83 TC 932 , 935

Self-canceling installment notes (SCINs). An installment note which is cancelled at death is referred to as a ‘self-canceling installment note,’ or ‘SCIN.’  Normally, a note’s unpaid principal and interest balances are part of the decedent’s estate.  In a SCIN, however, the note is canceled at death. 

SCIN’s are occasionally used as when a business is sold to a family member.  If this technique is used, the property is sold to family members, who pay mom or dad the FMV of the business, under the terms of a SCIN.  When mom and dad die, the business is not part of their estate (it has been sold), and there is no balance owed on the note, since it is cancelled at death. 

The self-cancellation provision should be properly designed, and the interest rate used will be above market rates. The note will have a principal risk premium (calculated above market sales price) or an interest rate premium (calculated above market interest rate).  As in a private annuity, the seller ought not to retain any control over the business (or property) being sold, after the sale has been concluded (which means, the note should not be secured by the business being sold, and there should be no restrictions on any subsequent sale of the business).

If errors are made in the design of the self-cancellation provision, the seller may be deemed to have made a part-sale part-gift, and if that happens, the entire value of the property sold, less the consideration actually paid, will be included in the decedent’s gross estate.

Installment sale rules of IRC §453 and the imputed interest or original issue discount (OID) rules of IRC §§483, 1274, or 1274A apply to SCINS. Selecting the applicable market interest rate for the SCIN is a challenge, because of conflicting rules under the OID rules and the gift tax discounting rules of IRC §7520.  Here are some guidelines:

If the Term of the Note Is:

  • Not Over 3 Years then the Applicable Federal Rate Is Federal Short Term Rate.
  • Over 3 Years Up to 9 Years then the Applicable Federal Rate Is Federal Midterm Rate.
  • Over 9 Years then the Applicable Federal Rate Is Federal Long Term Rate.

The rate used equals or exceeds the lowest of the appropriate-term rates for the month in which the transaction takes place or the prior two months. If the note is 6 years, and is signed in June, the interest rate will be selected from the lowest federal midterm rate for April, May, or June.

There are, however, several exceptions for selecting the required interest rate for income-tax purposes. If the transaction involves a sale-leaseback, the interest rate is 110-percent of the applicable federal rate for the appropriate term. If the total sales price of the property is less than $2,800,000 (indexed for inflation after 1990), there is a cap of 9 percent compounded semiannually, meaning, if the appropriate AFR exceeds 9 percent, 9 percent may be used; if not, the appropriate AFR is the minimum permitted rate. Installment sales relating to transfers of land between family members may use a 6 percent interest rate compounded semiannually, providing the sales price does not exceed $500,000.

Valuations of remainder interests for gift tax purposes are governed by the §7520 rules, which is 120-percent of the applicable federal midterm rate. Should the seller die prematurely, if the price is an inadequate price or interest rate is too low, there is a potential gift tax issue.  To hedge against this possibility, the §7520 rate, which is typically higher than the AFR under the imputed interest rules, might provide a safe-harbor rate, for both income and gift tax purposes.  Of course, higher interest rates mean greater payments on the note. If the objective is to minimize the cost to the buyer, which is usually the case in intra-family transfers, then AFR rates would be used.

The term of the SCIN should not exceed the seller’s actuarial life expectancy. Should that happen, the IRS might re-characterize the note as a private annuity for income tax purposes, which means, the income portion of the payments will be nondeductible to the buyer.  If the seller is in normal health for his or her age, the expected return multiples for a single life in Table V of IRC Reg. §1.72-9 are usually acceptable to measure life expectancy.

If death is imminent, which means death is expected to occur within one year, special actuarial factors, rather than the standard factors, must be used in valuing the interest. Terminal illness is an “incurable illness or other deteriorating physical condition that would substantially reduce a person’s life expectancy to the extent that there is at least a 50 percent probability that the individual will not survive for more than one year from the valuation date.”  Serious diseases and conditions, such as heart disease, diabetes, many cancers, Alzheimer’s disease, etc., are not in this category, unless they are in advanced stages.  Presumably, if the special factors are used, the life expectancy would be less, and the amount of the payments due under the SCIN would be more.

Of course, if the buyer and seller are not close family members and the transaction is at arm’s length by an informed seller and informed buyer, neither of whom is under any obligation to sell or buy, the negotiated sales price and note terms can generally be presumed to reflect an adequate premium for the cancellation feature. There is a tax law presumption that the transaction is between family members. With this in mind, the risk premium for the cancellation feature must be adequate. A risk premium is measured by the fair market value or the market rate of interest, so appraisals are needed to support the FMV of the property being sold, as well as the appropriate market rate of interest.

The mortality factors used for computing the risk premium for the cancellation feature typically are the same as those used for valuing annuities, life estates, and remainders for gift and estate tax purposes as provided in Table 80CNSMT or Table 90CM.  These mortality factors are different from the mortality factors used to compute the life expectancies of Table V of IRC Reg. §1.72-9.

Generally, the traditional installment sale, whether or not made to an intentionally defective grantor trust, shifts total return above the relevant applicable federal rate.  A private annuity sale shifts all growth above the Section 7520 rate, as well as eliminates the underlying value of the assets from the seller’s gross estate in case of premature death.  A sale for a self-canceling installment note shifts the total return above the relevant applicable federal rate, less a premium factor reflecting the chance that the unpaid principal will be removed from the seller’s gross estate if the seller dies before the note is repaid.  These techniques are especially appealing during the pendency of the estate tax repeal because they will freeze or reduce a client’s gross estate without incurring a gift tax that would not reduce the seller’s federal estate or GST taxes once these taxes are actually repealed.

Intentionally Defective Grantor Trusts. Intentionally defective grantor trusts (IDGTs) may be confusing at the outset, because of the “buzz” words used. Let’s not get lost in the concept.  Take this example:  Mr. C. sells all of his stock ownership to an irrevocable trust; his son is the trustee of the trust, and his four children are the beneficiaries.  However, in this example, his son (who is not adverse to what his dad is doing, and is serving as trustee), causes the trust to become “intentionally” defective, which simply means, the income from the trust will be taxed to Mr. C.

Here is the list of the sorts of things that make trusts “intentionally” defective:

(1) If the grantor has retained a reversionary interest in the trust, within specified time limits (section 673);  

(2) If the grantor or a nonadverse party has certain powers over the beneficial interests under the trust (section 674);  

(3) If certain administrative powers over the trust exist under which the grantor can or does benefit (section 675);  

(4) If the grantor or a nonadverse party has a power to revoke the trust or return the corpus to the grantor (section 676); or  

(5) If the grantor or a nonadverse party has the power to distribute income to or for the benefit of the grantor or the grantor’s spouse (section 677).

When a trust is not “intentionally” defective, then under IRC §678, income of a trust is taxed to a person other than the grantor to the extent that he has the sole power to vest corpus or income in himself.

Until last October, when Rev. Rul. 2004-64, 2004-27 IRB 7 was released, there was some uncertainty as to what would happened, for estate, gift and income tax purposes, when an irrevocable trust was established. With the release of this revenue ruling, here’s the lay of the land. When an IDGT is established, the grantor pays income tax, on income the trust earns. There are three variations on where the grantor gets the extra money to pay for the tax. Let’s examine each:

Illustration 1: Grantor pays tax from his own resources.

In Year 1, A establishes and funds an irrevocable trust (Trust) for the benefit of A’s issue (for purposes of this example, A will sell property to the trust, thereby fixing the value of the property sold). Trust includes provisions that cause A to be treated as the owner of Trust under the grantor trust rules for income tax purposes and, as a result, to be liable for any income tax attributable to Trust’s income. Thus, even though A is not a beneficiary of Trust, any income tax A pays that is attributable to Trust’s income is paid in discharge of A’s own liability, imposed on A by Code Sec. 671.

During Year 1, Trust receives taxable income of $10x, which A must include in his taxable income. As a result, A’s personal income tax liability for Year 1 increases by $2.5x. Neither state law nor Trust’s governing instrument contains any provision requiring or permitting the trustee to distribute to A amounts sufficient to satisfy A’s income tax liability attributable to the inclusion of Trust’s income in A’s taxable income, so A pays the additional $2.5x liability from his own funds. A’s payment of the $2.5x income tax liability is not a gift by A to Trust’s beneficiaries—A’s issue—for gift tax purposes because A, not the Trust, is liable for the income taxes.In addition, no portion of the trust is includible in A’s gross estate for federal estate tax purposes under §2036, because A has not retained the right to have trust property expended in discharge of A’s legal obligation.

Illustration 2: Trustee required to pay Grantor for Grantor’s Income Taxes

Assume the same facts as in Illustration 1, except that Trust’s governing instrument requires the trustee to reimburse A from Trust’s income or principal for the amount of income tax A pays that is attributable to Trust’s income. In this case, the trustee distributes $2.5x to A to reimburse A for the $2.5x income tax liability. As in Illustration 1, A’s payment of the $2.5x income tax liability is not a gift by A, because A is liable for the income tax. Moreover, the trustee’s distribution of $2.5x to A as reimbursement for the income tax payment by A is not a gift by the trust beneficiaries to A, because the distribution from Trust is mandated by the terms of the trust instrument. Because A has retained the right to have the trust property expended in discharge of his legal obligations, A’s retained right to receive reimbursement causes the full value of the Trust’s assets at A’s death to be included in A’s gross estate under IRC §2036(a)(1).

Illustration 3: Trustee has discretion to pay Grantor for Grantor’s Income Taxes

Assume the same facts as in Illustration 1, except that Trust’s governing instrument provides that the independent trustee may, in the independent trustee’s discretion, distribute to A, for the tax year, income or principal sufficient to satisfy A’s personal income tax liability attributable to the inclusion of all or part of Trust’s income in A’s taxable income. In this case, the trustee exercises this discretionary power and distributes $2.5x to A to reimburse A for the $2.5x income tax liability. As in Illustrations (1) and (2), A’s payment of the $2.5x income tax liability is not a gift by A, because A is liable for the income tax. Moreover, as in Illustration (2), the trustee’s distribution of $2.5x to A as reimbursement for the income tax payment by A is not a gift by the trust beneficiaries to A, in this case because the $2.5x is distributed under the exercise of the trustee’s discretionary authority granted under the terms of the trust instrument.Assuming there is no understanding, express or implied, between A and the trustee regarding the trustee’s exercise of discretion, the trustee’s discretion to satisfy A’s obligation would not alone cause the inclusion of the trust in A’s gross estate for federal estate purposes.

1 For estates of individuals dying after 2004, and under EGTRRA, the state death tax credit is repealed, and is replaced with a new deduction for state death taxes (IRC Sec. 2058). The value of the taxable estate is determined by deducting from the gross estate any estate, inheritance, legacy, or succession taxes actually paid to any state or the District of Columbia for any property included in the gross estate (this is an unlimited deduction), but excluding any taxes paid for the estate of a person other than the decedent. A deduction for state death taxes is allowed only for taxes actually paid and claimed as a deduction during the time period that ends before the later of:

(1) four years after the filing of the estate tax return;

(2) 60 days after the Tax Court decision becomes final if a timely petition for redetermination of a deficiency has been filed with the Tax Court;

(3) the expiration date of the extension period if an extension of time has been granted under Code Sec. 6161 or Code Sec. 6166 for payment of the tax; or

(4) if a timely claim for refund or credit of an overpayment of tax has been filed, the latest of: (i) 60 days after the IRS mails to the taxpayer by certified or registered mail a notice of disallowance of any part of the claim; (ii) 60 days after a decision by a court of competent jurisdiction becomes final as to a timely suit started upon the claim; or (iii) two years after a notice of the waiver of disallowance is filed under Code Sec. 6532(a)(3). (Code Sec. 2058(b))