OLD OUTLINE FOR SPEECH ON QPRTs (Given to estate planning attorneys -so level may be to technical). For informational purposes only, seek advise from a qualified attorney if you want to set one up. NOTE: Fianl Regulations have come out and the IRS fixed the mistake I point out in the outline. THIS IS TECHNICAL. AN UPDATE ON ESTATE PLANNING WITH QUALIFIED PERSONAL RESIDENCE TRUSTS (QPRTs), AND GRATs and GRUTs A Presentation to the South Suburban Estate Planning Council February 18, 1997 Michael R. Conway, Jr. Barnes & Thornburg Copyrighted by Michael R. Conway, Jr. INTRODUCTION A. The Qualified Personal Residence Trust ("QPRT") is strictly a creation of statute and IRS regulation. On October 8, 1990, Congress enacted Section 2702 of the Code. Section 2702 eliminated the common law GRIT (Grantor Retained Income Trust) in family situations and substituted in its place GRATs (Grantor Retained Annuity Trust) and GRUTs (Grantor Retained Unitrust). Section 2702(a)(3)(A)(ii) carved out one exception to the elimination of the common law GRIT -- The personal residence trust. On February 4, 1992, the IRS issued final regulations for the newly enacted Chapter 14 of the Code. In regulation Section 25.2702-5, the IRS set forth the requirements for a QPRT. B. A QPRT is solely an estate tax saving technique. C. Any client who needs estate tax planning beyond the basic A-B Trusts and Life Insurance Trust can benefit from using a QPRT. D. On April 16, 1996, the IRS issued proposed regulations for QPRTs that would make several significant changes to the requirements of a QPRT. These proposed regulations were effective for QPRTs established after May 16, 1996; however, the proposed regulations included language that the IRS may attack QPRTs established before May 16, 1996 that used the so-called "bait and switch" technique that the IRS perceived as being abusive and contrary to the purpose of Section 2702 of the Code. The word on the street is that the regulations will be finalized without substantial modification. In there present form, many people in the estate planning community believe the proposed regulations constitute overreaching by the IRS. The proposed regulations, if enacted in its current form, could drastically reduce the benefit of using a QPRT for most clients.II. WHAT IS A QPRT? A. The concept of a QPRT is that a grantor transfers a residence to the QPRT and retains the right to live in and to use the residence for a specified term of years. At the end of the term, the property in the QPRT is distributed to or in trust for the benefit of the grantor's children or other younger generation family members. If the grantor dies before the end of the term of the QPRT, the property generally will revert to the grantor's estate or will be subject to a general power of appointment held by the grantor. B. Upon transferring the residence to the QPRT, the grantor makes a gift to the remaindermen of the trust equal to the full value of the residence transferred to the QPRT reduced by the actuarial value of (a) the grantor's retained right to use the residence during the term of the QPRT (the income interest) and (b) the grantor's estate's right to receive the residence if the grantor dies before the end of the term (the reversionary interest). Thus, the amount of the gift upon the transfer of the residence to the QPRT is only a fraction of the total value of the residence. C. If the grantor survives until the end of the term, the property passes at that time to the younger generation family members without any further gift or estate tax consequences (although the property may be subject to the generation skipping transfer tax). If the grantor dies before the end of the term, the property is included in the grantor's estate under Section 2036(a) because the grantor retained an interest in the property for the grantor's life. D. The estate and gift tax savings in using a QPRT is two-fold: 1. The value of the grantor's retained interests avoids any estate or gift tax; and 2. Any appreciation in the value of the residence after it is transferred to the QPRT avoids any estate or gift tax and inures to the benefit of the remaindermen. E. To obtain the estate tax and gift tax benefits of the QPRT, the grantor must live past the end of the term of the QPRT. However, if the grantor does not survive the trust term and the QPRT is properly structured, the grantor's estate is in the same position as if the grantor had never created the QPRT. Therefore, there is no downside risk to the client to using a QPRT (other than the time and cost to set it up). F. Technical Requirements and Administration of QPRTs 1. The Regulations under Section 2702 contain numerous technical requirements for a QPRT. Set forth below are some of the more relevant requirements. 2. A grantor may hold an interest in no more than two QPRTs. Regulation Section 25.2702-5(a). Trusts holding fractional interests in the same residence are treated as one trust. Id. One of the residences must be the grantor's principal residence. A residence is not just the living structure but includes the surrounding property. The IRS has interpreted the term residence very liberally in several private letter rulings. The test apparently is whether (a) the property is used as a unit and (b) the total acreage is comparable to that of other adjacent and comparable parcels. See PLR 9705017 (several parcels containing a main house and two quest houses qualified as one residence); PLR 9701046 (5 parcels qualified as a residence). 3. The residence held in a QPRT can be either: a. the term holder's principal residence (as used in Section 1034 of the Code); b. another residence of the term holder (as used in Section 280A(d)(1) of the Code, but without considering Section 280A(d)(2)); or c. an undivided fractional interest in either such residence. Regulation Sections 25.2702-5(b)(2)(i). 4. The primary use of the residence must be as a residence of the term holder when occupied by the term holder. Regulation Sections 25.2702-5(b)(2)(iii) and (c)(2)(iii). If a portion of the residence is used as an activity meeting the requirements of Section 280A(c)(1) or (4) of the Code, the residence is a personal residence if such use is secondary to the use as a residence. Regulation Sections 25.2702-5(b)(2)(iii) and (c)(2)(iii). a. The term holder's use of a room in the residence as an office does not violate this requirement. Regulation Section 25.2702-5(d), example 1. b. Renting a vacation home which is treated under Section 280A(d)(1) as the grantor's residence is permitted. Regulation Section 25.2702-5(d), example 2. 5. Sale and Purchase of Residences The residence in the QPRT can be sold and a replacement residence can be purchased. If the QPRT is a grantor trust, the residence will be eligible for the roll-over of gain and the one time exclusion from gain under Sections 1034 and 121 of the Code. The best way to ensure grantor trust status of the QPRT is under Section 673 of the Code -- by having the grantor's reversion interest exceed 5% of the value of the total interest. Grantor Trust status for the QPRT will also allow the grantor to deduct real estate taxes and other expenses paid by the grantor. 6. Cessation of Use as a QPRT If the trust ceases to be a QPRT, the trust agreement must provide that within thirty days of the date the trust ceases to qualify as a QPRT, the assets will be (a) distributed outright to the term holder, (b) converted to and held for the balance of the term holder's term in a separate share of the trust meeting the requirements of a qualified annuity interest (i.e., a grantor retained annuity trust or "GRAT") or (c) in the trustee's discretion, either (a) or (b). Regulation Section 25.2702-5(c)(8)(i). 7. What Happens to the Residence at the End of the Trust Term? a. The main question your clients have regarding the use of a QPRT is whether they can continue to live in the residence at the end of the trust term. There are three possibilities for what happens to the residence at the end of the trust term. b. Residence passes to children. (1) One option is that the residence passes to the younger generation family members at the end of the trust term with no strings attached. In this case, the parents would not have any right to live in the residence at that time although the children could rent the residence to the parents for its fair market rental value. (2) Although this option sounds workable, this option is not realistic if the residence is the parents' primary residence because the parents want some assurance that they can continue to live in that residence at the end of the trust term. c. Parents rent the residence at the end of the trust term. The parents can have an informal agreement or even an absolute right given to them in the trust agreement to rent the residence for its fair market rental value. d. Parents Repurchase Residence Before End of Term. (1) The third option was for the parents to repurchase the residence just prior to the termination of the trust term. This option allowed the parents to keep the residence and have the substituted property pass to the younger generation family members at the end of the trust term. (2) No capital gain resulted from the purchase of the residence by the grantor if the QPRT was a grantor trust for income tax purposes. See Rev. Rul. 85-13. Cash or other high basis assets preferably would be used to repurchase the residence because the property passing to the younger generation family members from the QPRT did not get a step-up in basis at the grantor's subsequent death. (3) This option has been prohibited by the proposed regulations issued by the IRS because this "bait and switch" technique allowed taxpayers to retain their residence and transfer other assets to their descendants without complying with the stricter annuity or unitrust requirements under Section 2702. III. THE PROPOSED REGULATIONS AND THEIR EFFECT ON QPRTs A. The proposed regulations issued on April 16, 1996 and effective for QPRTs created after May 16, 1996 contain two main provisions. First, the proposed regulations provide relief for correcting defective QPRTs that fail to meet all of the numerous technical requirements. Second, the proposed regulations effectively preclude the use of the "buy-back" technique that made QPRTs so popular. B. Correcting Defective QPRTs 1. A QPRT that does not meet all of the technical requirements under the Regulations will be treated as satisfying these requirements if the trust is modified by judicial reformation or non-judicial reformation (if such reformation is effective under state law) to comply with these requirements. See Proposed Regulation 25.2702-5(a)(2). 2. The reformation must be commenced within 90 days after the due date (including extensions) for the gift tax return reporting the QPRT gift and the reformation must be completed within a reasonable time after commencement. 3. If the reformation is not completed when the gift tax return is due, the grantor or grantor's spouse must attach a statement to the return stating that the reformation has commenced or will be commenced within the 90-day period. C. Sale of Residence to Grantor or Grantor's spouse 1. The proposed regulations state that the trust agreement must prohibit the sale of the residence, directly or indirectly, to the grantor, the grantor's spouse, or an entity controlled by the grantor or the grantor's spouse either during the original term interest or at any time after the original term interest that the trust is a grantor trust under Sections 671-677 of the Code. This requirement is effective for QPRTs created after May 16, 1996. 2. The IRS has indicated that it will scrutinize pre-5/16/96 QPRTs to determine if under general gift tax principles the trust is inconsistent with the purpose of Section 2702. Thus, the IRS may disqualify a trust in which the grantor actually repurchases the residence pursuant to a right or option specifically stated in the trust agreement or a collateral document. However, informal discussions with the IRS indicates that they will not attack the "buy-back" for pre-5/16/96 QPRTs if there was no pre-arrangement or specific provision in the QPRT for such buy-back. 3. If kept in its present form, the proposed regulations would eliminate the grantor's ability to buy back the residence from the QPRT and have other assets pass to the children. Because many clients may be unwilling to vacate the residence or pay rent, this prohibition against the buy-back of the residence could greatly decrease the viability of the QPRT as an estate tax saving technique. 4. Planning for QPRTs and the buy-back under the proposed regulations. a. Wait and see - the final regulations have not yet been issued and may be in different form from the proposed regulations. b. Challenge the validity of the proposed regulations - the prohibition against the sale to a grantor trust after the end of the original term of the QPRT appears to be of questionable validity. c. Trust language - consider using language in the QPRT that prohibits the sale of the residence in a manner that conflicts with the regulation rather than including the specific prohibition as set forth in the proposed regulations. Covey suggests, "The trustee shall not sell or otherwise transfer the residence in a manner that conflicts with the provisions of Treas.Reg.Sec. 25.2702-5(c)(9). Also, consider language that would require the trustee to amend the trust to comply with any final regulations. d. Reformation - consider leaving out the prohibition required by the proposed regulations and amend/reform the trust as permitted within 90 days of the gift tax return if necessary. e. Pay Capital Gain Tax - pay the capital gains tax upon the buy-back of the residence if the gain is not significant. Use the grantor's one time exclusion. f. Pay Rent to a Grantor Trust - (1) A lease (or an option to lease) can be entered into either at the beginning of the QPRT or at the time the residence is transferred to the younger generation family members at the end of the trust term. See PLR 9425028. The right to lease the residence at the end of the trust term will not cause estate tax inclusion under Section 2036(a) of the Code. See PLR 9249014; PLR 9433016; PLR 9448035. (2) The rental amount must be the fair market rental value of the property. (3) If a grantor trust holds the residence after the original term of the QPRT, the payment of rent should not produce any income tax consequences. (a) Payment of rent is an additional tax free gift to the trust beneficiaries. (b) Be careful how you establish this intentionally defective grantor trust - does the power to substitute trust property violate the proposed regulations? g. Provide for a trust with a discretionary interest in the spouse after the original term of QPRT. (1) A grantor can transfer a residence to a QPRT that provides that at the end of the trust term (if the grantor is then living) the residence will be held in a trust in which the other spouse has a discretionary interest, including the right to use the residence for the rest of the spouse's life. This should not cause estate tax problems for the grantor or the grantor's spouse. See Gutchess Estate, 46 TC 554 (1966); Union Planters National Bank v. U.S., 361 F.2d 662 (6th Cir. 1966); Estate of Binkley v. U.S., 358 F.2d 639 (3d Cir. 1966); Rev. Rul. 70-155, 1970-1 CB 189. (2) This allows the parents to use the residence for their lifetime (if the non-grantor spouse is the surviving spouse). (3) The gift tax value of the gift will not be reduced by the non-grantor spouse's discretionary interest. (4) This plan would not work in the following situations: (a) If both spouses set up QPRTs giving the other spouse a discretionary interest at the end of the trust term, the IRS is likely to apply the reciprocal trust doctrine so that the trust property is included in the grantor's estate at the grantor's death. But See PLR 9441039. (b) If the spouses transfer joint tenancy property to a single QPRT for a term of years or the prior death of one spouse, and the other spouse has an interest in the property after the end of the trust term, the property (or at least one-half of the property) should be included in that second spouse's estate as a retained interest. (c) The grantor does not have a spouse. h. Is the "bait and switch" alive and well, or am I missing the boat? (1) The proposed regulations prohibit the sale of a residence held in the trust directly or indirectly to the grantor, the grantor's spouse or an entity controlled by the same. The regulations further provide that a sale or transfer to another grantor trust of the grantor or the grantor's spouse is considered a sale or transfer to the grantor or the grantor's spouse. For purposes of the regulation, a grantor trust is a trust treated as owned by the grantor or the grantor's spouse within the meaning of sections 671-677. (2) Arguably, a section 678 grantor trust is not treated as a grantor trust for purposes of the regulation. If this is the case, a 671-677 grantor trust could sell the residence to a 678 grantor trust without violating the regulation while still avoiding capital gains taxes. (3) Thus, if a client is willing to risk repurchasing a residence from a QPRT, the client should strengthen their position by repurchasing the residence with a 678 grantor trust. IV. USING THE QPRT FOR LEVERAGE -- ESTATE AND GIFT TAX BENEFITS A. The benefits of using a QPRT instead of outright gifts (besides maintaining the use of the residence for the grantor) is that significant leverage for estate and gift tax purposes can be achieved. B. The gift made by the grantor when the residence is transferred to the QPRT equals the fair market value of the residence reduced by the grantor's retained interest in the residence and the grantor's estate's contingent reversion interest if the grantor dies before the end of the trust term. 1. The grantor's right to use the residence during the term of the QPRT is treated as a retained income interest for gift tax purposes. 2. The gift is a future interest gift that does not qualify for the grantor's annual exclusion from gift tax. C. The retained rights of the grantor significantly reduce the value of the gift and thereby leverage the grantor's gift tax savings. D. Example of Gift Tax Leverage Assume the grantor is born on January 30, 1942 and the grantor establishes a QPRT that is to last for ten years or the prior death of the grantor. The property is transferred to the trust on January 15, 1997. The interest rate under Section 7520 for January, 1997 is 7.4%. The value of the three interests are as follows: 1. Grantor's retained income interest -- 48.5327% 2. Grantor's contingent reversion interest - 8.7253% 3. Younger Generation Family Members' contingent remainder interest - 42.7419%. In this example, if the fair market value of the property transferred to the Residence Trust is $500,000, the amount of the gift is $500,000 times the contingent remainder interest: $500,000 x 42.7419% = $213,709. E. Additional Leverage by Transfer of Undivided Interests in Property to Separate QPRTs 1. Regulation Section 25.2702-5(b)(2)(i)(c) permits a spouse to transfer an undivided interest in a residence to a QPRT. 2. One benefit of having each spouse transfer an undivided one-half interest in the residence to separate QPRTs is that it reduces the risk of the grantor dying during the term of the QPRT and thus losing any transfer tax benefit. If one spouse dies during the trust term but the other spouse survives the trust term, one-half of the property passes to the younger generation family members without additional transfer tax. 3. Another benefit of this technique is that the value of each spouse's undivided interest in the property should be discounted because each spouse owns an undivided fractional interest in real estate. a. This discount has typically been 10-15% of the value of the partial interest. But See LeFrak v. Comm., 66 T.C.M. (CCH) 1297 (1993), where a 30% discount was allowed. 4. Example -- Same example as in D above, but each spouse (age 55) transfers one-half of the residence to separate QPRTs. The fair market value of each spouse's share of the residence is $250,000 x .85 = $212,500. Each spouse's gift is $212,500 x .427419 = $90,826, and the total gift is $181,652. In most cases, the spouses' remaining unified credit will cover the amount of the gift. Remember that the entire value of the residence passes to the children at this gift tax cost. F. Estate Tax Considerations 1. Grantor Dies Before the End of Term a. If the grantor dies before the end of the term of the QPRT, the entire trust property will be included in the grantor's estate under Section 2036(a) of the Code. In this situation, the gift tax savings will be lost. b. Under Section 2001(b) of the Code, if the trust property is included in the grantor's gross estate, an adjustment is made to the grantor's taxable gifts so that this property is not taxed twice. The result of this adjustment is that if the grantor dies before the end of the trust term, the grantor will be in the same position regarding estate and gift taxes as if the grantor had never established the QPRT. c. Be careful not to have the grantor's spouse consent to split the gift to the QPRT because if the grantor dies before the end of the trust term, the portion of the spouse's $600,000 exemption that was applied to this gift is not restored when the trust property is included in the grantor's estate. Therefore, it is advisable not to have spouses split the gift to a QPRT but to have each spouse transfer a partial interest in the residence to his or her own QPRT. G. Generation-Skipping Transfer Tax Considerations 1. A grantor cannot allocate GST exemption to a QPRT at the time the trust is established because the "Estate Tax Inclusion Period" for GST purposes does not stop running until the termination of the QPRT. This rule states that no GST exemption can be allocated to a gift during any time that the gifted property may be included in the grantor's estate. See Section 2642(f) of the Code. 2. The grantor can allocate GST exemption at the end of the trust term, but the allocation would be based on the value of the trust property at that time rather than the value of the trust property at the time the property was initially transferred to the QPRT. See Section 2642(f)(2) of the Code. 3. For this reason, a grantor generally will not allocate GST exemption to a QPRT. 4. Possible Taxable Termination at end of QPRT. a. If the grantor establishes a QPRT that provides that at the end of the trust term the trust property is distributed to the grantor's descendants per stirpes, and a child of the grantor dies before the end of the trust term, then if the grantor survives the trust term, a portion of the trust property will pass to the then living descendants of the deceased child at that time. This transfer will be a taxable termination for GST purposes and because it is not a direct skip, it does not qualify for the predeceased child exception. See Section 2612(c)(2) of the Code. In that event, the grantor would have to allocate GST exemption to avoid a GST tax at that time. b. To avoid this possible GST problem, it is advisable to provide that at the end of the trust term, the property will pass equally to the grantor's then living children (and thereby excluding the descendants of a deceased child). A make-up provision in the grantor's regular estate planning documents could give the descendants of the deceased child an equal amount of property as the then living children receive from the QPRT. The distribution to the descendants of the deceased child under the grantor's regular estate planning documents could qualify for the predeceased child exception and thus avoid GST tax. c. Another option is to give the children a general power of appointment over their share of the trust property.V. USING GRATs A. Like QPRTs, grantor retained annuity trusts (GRATs) are creatures of statute. GRATs are the statutory substitute for the common law GRIT. B. A GRAT is an irrevocable trust and is an estate tax savings device designed to take advantage of the rules which allow deferred gifts in trust to be valued an a discounted present value basis. To be advantageous, the property transferred to the GRAT must be able to beat the 7520 rate. The lower the 7520 rate the better for a GRAT. This is the opposite of a QPRT. C. Similar to the QPRT, the grantor of GRAT is only making a gift of the remainder interest. The grantor retains an annuity interest and a reversionary interest. D. The GRAT must pay either a percentage amount or a stated dollar amount. Stating the amount as a percentage is almost always preferable because the percentage will allow the value of the gift to be adjusted without adverse gift tax consequences. E. A Grantor Retained Unitrust (GRUT) is similar to a GRAT but is not as advantageous. When using a GRAT, the taxpayer assumes that the property will appreciate in value in excess of the 7520 rate. If a GRUT is used the annual annuity amount will also increase. F. The Zero-Out. The value of the grantor's retained interest in a GRAT is a function of the annuity that the grantor retains. Thus, it is mathematically possible for the grantor to make the remainder interest equal zero (i.e. zeroing out the GRAT). The IRS's position is that a GRAT cannot be zeroed out based upon their reading of Rev.Rul. 77-454. G. Revocable Spousal Interest. Because of the IRS's position that a GRAT cannot be zeroed out, a revocable spousal contingent annuity can be added which takes effect if the grantor dies before the trust term. The spousal interest is deemed to be a retained interest and thus reduces the amount of the remainder interest. Although the IRS has recently taken the informal position that a spousal interest does not reduce the value of the gift, they previously ruled otherwise. See PLRs 9352017 and 9416009. If the spousal interest is a retained interest, a near zero-out can be obtained even using the IRS's valuation method. The regulations do not directly deal with this issue. H. Use of Notes. Until recently, conventional wisdom was that the grantor could receive notes from the trust in satisfaction of the required annuity payments. The IRS, however, recently issued a ruling stating that the use of notes is not allowed. See PLR 9604005. The facts of this ruling are bad. Among other things, the Notes were not interest bearing. One alternative to issuing notes is to have the trust borrow money from a bank and distribute the cash or make an in kind distribution. If an in kind distribution is made, remember to apply the same valuations discounts. (It has been suggested that the in kind distribution is not an arms length transaction and thus no valuation discounts apply?) I. Valuation Discounts. The potential benefit of a GRAT can be enhanced if the value of property transferred to the GRAT can be discounted. For example, if a minority interest in closely held stock is transferred to a GRAT the retained interest calculation should be based upon the stock's value after taking into account minority and marketability discounts. J. The FLIP-GRAT. Similar to using closely held stock, limited partnership interests in a family limited partnership can be transferred to the GRAT. This technique almost guarantees that the total return on the transferred property can beat the 7520 rate.CHDSO1.15832.v1
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