Financial advisors who do estate planning are always on the alert to do what is called an estate freeze.  An estate freeze is an estate planning technique in which a person is able to set the value of an appreciating asset at a value of the asset at an earlier date than his or other death.  The result is having to pay less death tax than would be required if the date of death valuation had been used.

One of the ways to make a gift of closely held stock which is increasing in value is through a Grantor Retained Annuity Trust (“GRAT”).  Such a gift can allow the donor to retain an income stream during his or her lifetime or term for years.  At the same time, he or she can fix the value of the stock for federal estate and gift tax purposes at the earlier gift time rather than at death if he lives through the term of the annuity.  Such a result is possible with a GRAT which provides for transferring the stock to a beneficiary after a stated term for the trust during which time an annuity is paid to the grantor.  Furthermore, there is no Pennsylvania gift tax, so the estate freeze would be effective also as to the Pennsylvania Inheritance Tax.

Besides being available for an estate freeze of closely held stock of a C-type corporation, a GRAT could also be useful in freezing the value of the ownership of pass through entities, like S corporations, limited liability corporations, and partnerships.  The concept is the same, but there are details which are different.  For simplicity, this article only deals with the use of a GRAT for closely held C-type corporation stock.

The GRAT estate freeze result which “zeros out” is possible because of the value of a remainder interest in an asset as a completed gift for gift tax purposes where there is an annuity if the transfer value of the asset is less than the present value of the annuity.  On the other hand, if the asset is held until death, the value of the asset for federal estate tax purposes is the market value at the time of death.  Thus, if a donor can qualify a gift as a completed gift at an earlier time the appreciation of the value of the asset is not included in the estate at its later appreciated value.  Of course, the annuity payments to the donor are taxable to the donor for federal income tax purposes.

The valuation of an asset which is an annuity and a remainder for federal gift tax purposes is governed generally by § 2702 of the Internal Revenue Code of 1986 (“IRC”), the Treasury Regulations thereunder, and the case of Walton v Commissioner, 115 T.C. 589 (2000).  If an annuity in trust is payable to the donor for a stated period, the Walton case holds that the gifted remainder is a complete gift and is not included in the estate of the donor for federal estate tax purposes if the value of the annuity, calculated when the gift is given in trust, equals or exceeds the transfer value of the asset.  The value of the annuity is determined by using the IRC § 7520 rate which is 120% of the federal midterm rate in effect for the month of the transfer.  As indicated above, the value of the remainder gift is the difference between the transfer value of the gift and the present value of the annuity.

For example, assume a donor transfers $1,000,000 worth of closely held stock to a trust drafted in accordance with the requirements of IRC § 2702 and Walton. Under the terms of the trust, the donor has the right to $280,000 payable annually for a period of four years.  If the IRC § 7520 rate is 4.6%, the value of the remainder interest is $0. A transfer in trust of any kind is considered a completed gift for Pennsylvania personal income tax purposes.  If the annuity is not completely paid at the death of the donor, however, the value of the remaining portion of the annuity is taxable for Pennsylvania Inheritance Tax purpose. 72 P.S. 9107(c)(5) and 72 P.S. 9121(a).

A downside of use of a GRAT is that if the grantor/donor does not live through the term of the trust, the asset returns to the donor, and it is valued at market value in the donor’s estate. Of course, if a surviving spouse is the heir of the donor under the donor’s will, there will be no estate tax on the death of the donor.  There would also be no tax if under the donor’s will, a charity was the heir.

Care must be taken to avoid having the transaction labeled as an “abusive transaction” by the IRS.  “Reduction or elimination of gift or estate taxes” is specifically mentioned as a warning sign of an abusive tax arrangement in IRS Notice 97-24.  Federal legislation was recently introduced to require that a GRAT have a term of at least ten years and a remainder interest of more than zero.  Although two-year annuities or a series of two-year annuities are popular examples, their use and the four-year term in the above example would certainly invite scrutiny by the IRS.

The situations in which zeroing out GRATs are practical with closely held stock may be very limited.  Most corporations with closely held stock have stock purchase agreements which limit the purchasers or transferees of stock and transfers by gift.  Although donors holding over 5% of the stock of closely held corporations usually are required to have an appraisal, smaller holdings are required under such agreements to use a formula for valuation which may prohibit use of a valuation using IRS §§ 2702 and 7520.  In any case, to support a GRAT transaction valuation, it is recommended that there be a contemporary appraisal at the time of the transfer by a professional appraiser.

Further, a corporation with closely held stock may not have a steady stream of income which could result in cash not being available to the trust to pay the annuity payments.  In such a situation, stock in the trust would have to be sold, defeating, at least partially, the point of the trust.

In conclusion, although a zeroed out GRAT has possibilities for an estate freeze, the limited ability to value a gifted remainder at zero for gift tax purposes proscribes its usefulness in general.  Further, the existence of a stock purchase agreement could inhibit the flexibility necessary to have a short-term trust as a shareholder with closely held stock.  Finally, the fluctuation in income usually present in a corporation with closely held stock makes funding an annuity with any degree of certainty a difficult proposition.