In order to keep the estate tax burden from continually growing in your estate with further appreciation, you may want to do what many other clients have done: introduce some discounting and freezing techniques to your overall estate plan. Gifting is also important, as each individual can make annual and lifetime gifts tax-free and decrease the size of his or her estate.
A popular freeze technique is where a client’s interest in limited liability companies, corporations, partnerships or real estate (the “Property”) is sold to a defective grantor trust (DGT) in exchange for an installment note. The beneficiaries of the DGT will be the client’s children and their descendants. It is called a “defective” trust because the trust is a grantor trust, meaning the IRS ignores it for income tax purposes, but not for estate tax purposes (i.e., the grantor trust is “defective” for income tax purposes).
A DGT allows the value of the assets in such trust to be removed from your estates for estate tax purposes; however, the trust and any transaction(s) between the grantor (you) and the trust is disregarded for income tax purposes. For example, you would still pay income taxes on taxable income of the DGT. This is a good tax result. Your assets are being used to cover tax liabilities attributable to a DGT. This “tax haircut” is, in essence, gifting (paying someone else’s tax liability), but the IRS does not interpret this activity as gifting.
Your interest in the Property will be sold to the DGT in return for an installment note payable to you. This will “freeze” the entire value of the Property; for estate tax purposes the unpaid balance of the installment note remains in your taxable estate, while the Property is not. An income stream is generated for you from the DGT via payments on the installment note. The payments from the DGT to you are ignored by the IRS since the payments are coming from a grantor trust. The only “leakage” is the unusually small interest rate we are able to put on the promissory note to you. As discussed, payments on the installment note are typically interest only but we can work with that number based on the income and cash flow generated by the LLC property. However, keep in mind that it is advisable to pay the interest yearly as the IRS may frown upon a balloon note with the interest and principal payable at the end of the term of the note.
The sale to the DGT allows you to not only freeze the value of the Property in your taxable estate, but to also reduce the size of your taxable estate based on the income taxes paid by you for the DGT’s income taxes, again, the “tax haircut”. Also, you are able to take advantage of significant discounting in valuing the fractional LLC interests being sold to the DGT.
The non-voting membership interest in the LLC would be partially gifted and partially sold to the DGT in exchange for an installment note. This way you freeze most of the value of the LLC in your taxable estate, but retain control of the LLC via your continued ownership of the voting membership interest. The underlying property in the LLC would need to be appraised. The fees for these appraisals can vary depending on the appraiser. Once those appraisals are received, the non-voting membership interest of the LLC would be valued. After the non-voting membership interest is valued, we would use this number to determine the sale price for the non-voting membership interest.
For more information regarding estate planning, business law or tax controversy and compliance, please visit the Hoffman & Associates website at www.hoffmanestatelaw.com or call us at 404-255-7400.
In accordance with IRS Circular 230, this article is not to be considered a “covered opinion” or other written tax advice and should not be relied upon for IRS audit, tax dispute, or any other purpose. The information contained herein is provided “as is” for general guidance on matters of interest only. Hoffman & Associates, Attorneys-at-Law, LLC is not herein engaged in rendering legal, accounting, tax, or other professional advice and services. Before making any decision or taking any action, you should consult a competent professional advisor.