Article on “Reality of Sale” Framework for IDGT Sales for Estate Tax Purposes

Elizabeth Carrott Minnigh, Jerome M. Hesch & Richard A. Oshins recently published an Article entitled, Reality of Sale: The Supreme Court Does Not Believe in the 10% Seeding Gift, So Why Would You?, 42 Tax Mgmt. Est. Gifts & Tr. J. 10 (2017). Provided below is an abstract of the Article: (subscriber login information required for link)

An installment note sale to a grantor trust is a popular and powerful wealth-shifting strategy. The sale is typically accomplished in three steps. First, the owner creates an intentionally defective grantor trust (IDGT). Second, the grantor funds that trust with ‘‘seed’’ money. Third, typically after a reasonable waiting period, to avoid any potential application of the step transaction doctrine, the grantor sells assets to the trust for a note. Since the grantor sold an asset to a grantor trust (i.e., the grantor’s alter ego for income tax purposes), there is no sale for income tax purposes. The expectation is that the deferred payment obligation will be satisfied out of the future cash flow from the acquired asset, and that any excess cash and appreciation associated therewith will inure to the benefit of the purchasing trust. The note typically bears interest at the Applicable Federal Rate (AFR), and thereby avoids treatment as a gift loan under §7872(f)(3). The grantor-seller also takes a secured interest in the transferred property. Pursuant to Rev. Rul. 85-13, the sale will be income tax-free because for income tax purposes the seller and the purchaser are the same person. Rarely does an intra-family loan contain commercial loan terms, but as long as reasonable formalities are observed, the transaction should be treated as a sale, not a gift, for estate and gift tax purposes. 

This Article will examine the formalities necessary to ensure the sale will be respected for transfer tax purposes. First, we will look at the requirements to avoid the potential application of §2036 or §2702. Second, we will review the holdings in several income tax cases, particularly four U.S. Supreme Court cases, outlining the framework for determining when a sale should be respected. Finally, this Article will propose a ‘‘Reality of Sale’’ framework for analyzing sales to IDGTs for estate tax purposes based on this long history of income tax cases on the same issue, which the authors contend should replace reliance on the 10% seed money rule of thumb approach commonly used. Our objective is to provide guidance with respect to how the courts evaluate whether to respect or disregard loans between related parties.