Reducing Mortality Risk in DGT Sale
Clients often freeze the value of their taxable estates through sales of businesses, family LLCs, family partnerships, or real estate to defective grantor trusts (“DGTs”), which are disregarded for income tax purposes but recognized for estate tax purposes. The value in these transactions is generally that they cause future appreciation of the entity to be outside of the client’s taxable estate.
Unfortunately, the benefit from a DGT sale is limited if the client passes away a short time after the sale (so called “mortality risk”). For example, suppose a client, John, age 75 and in ill health, has a business currently worth $10,000,000. Assume John sells that business to a DGT for a $10,000,000 promissory note. John passes away the following year. The remaining unpaid balance of that $10,000,000 promissory note is included in John’s taxable estate and, because so little time has passed between the DGT sale and John’s passing, the DGT sale “freeze” does not work to exclude much appreciation from John’s taxable estate.
To deal with this so called “mortality risk”, we often recommend going forward with a DGT sale, but have the client take back a self canceling installment note (“SCIN”), rather than an ordinary installment note, in return. A SCIN terminates all payment obligations under the note upon the death of the client. The DGT pays a premium interest rate (in John’s case, 6% higher than a normal interest rate) for the self-canceling feature of the SCIN.
In our example, above, assume John takes back a $10,000,000 SCIN bearing interest at 9% (3% AFR rate plus 6% mortality risk premium). Now, assume the John passes away within one year of the transaction. The unpaid portion of the $10,000,000 note would cancel upon John’s death and would not be included in his taxable estate. Thus, a SCIN addresses the mortality risk inherent in a DGT sale transaction in that it excludes the unpaid balance of the DGT note from the client’s taxable estate.
However, use of a SCIN is not without drawbacks. If we use a SCIN and the client survives to see the note paid off, the client has paid a much higher interest rate (in the example above, 9% vs. 3%) than they would have otherwise have paid under a normal note, and the full value of the payments on the note are included in client’s taxable estate. Thus, there is a “reverse mortality risk” in that, if the client survives the term of the SCIN, there is no benefit (and actually a detriment) from the use of a SCIN versus a regular installment note.
To address this reverse mortality risk, we have in certain cases recommended that clients gift their SCIN (via a wholly owned LLC) to a zeroed out grantor retained annuity trust (“GRAT”). In our example, assume the client takes back a $10,000,000 SCIN, and then contributes that SCIN to a wholly owned LLC, which he then gifts to a zeroed out GRAT. The result is that all of the funds paid on the note are passed through the LLC to the zeroed out GRAT with little or no gift or estate tax consequence. If the note is paid in full, all of the payments made on the note will be transferred to the GRAT, outside of the client’s taxable estate.
This structure addresses both mortality risk and reverse mortality risk. If the client passes away before the note is paid off, the SCIN will operate to exclude the unpaid balance of the note from client’s taxable estate. If the client passes away after the SCIN is paid off (causing the SCIN to fail), the GRAT will operate to exclude all payments on the note from client’s estate. This is a win win scenario – if the SCIN works, the client receives a substantial estate tax benefit. If the SCIN fails, the GRAT works, and the client still receives a substantial estate tax benefit.
If you would like more information, please call or email Hoffman & Associates today.
404.255.7400
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