USE OF GRAT WITH S CORPORATION STOCK

By Maurice Rosen

Two recent private letter rulings, PLR 9448018 (August 30, 1994) and PLR 9444033 (August 5, 1994) confirm that the IRS will allow the transfer of S corporation stock to younger family members. Since the shares are valued for gift- tax purposes at the date of transfer, all future appreciation is excluded from the grantor's estate if he survives the term of the trust.

The technique is twofold and requires the following:

1. The creation of a grantor retained annuity trust (GRAT). If properly drafted, the grantor trust will qualify as an S corporation shareholder pursuant to IRC Sec. 1361(c)(2)(A)(c); and

2. The utilization of minority and lack of marketability discounts (IRS Rev. Rul. 93-1).

Creation of the GRAT

The grantor transfers his stock to a GRAT, which must pay the grantor a fixed annuity amount for the term of the trust. At the end of term of trust, the beneficiaries of the GRAT receive all of the assets remaining in the trust. During the term of the trust, all items of income and deduction attributable to the GRAT are included in computing the grantor's taxable income.

The amount of gift is the value of the shares less the value of the grantor's retained annuity interest. The factors that are used to determine the actual gift and gift tax are as follows:

a) The value of the gifted property;

b) The annuity amount paid to the grantor;

c) The age of the grantor and the term of trust; and

d) The interest rate determined under IRC Sec. 7520 (the value of the retained interest will increase as the 7520 rate decreases).

PLR 9448018 lists the trust provisions that a GRAT should contain in order to qualify as a GRAT under Reg. Secs. 25.2702-3(b) and 25.2702-3(d). The required provisions are listed below:

* The qualified annuity interest should be an irrevocable right to receive a fixed amount, payable to the grantor every tax year, and to no other individual.

* The fixed amount should be stated as a percentage of the initial value of the gifted property and such amount will be recomputed to reflect any changes finally determined, for Federal tax purposes, based upon an initially incorrect determination of the fair market value of
the gift.

* The trust will not be disqualified if income is paid in excess of the amount required.

* The annuity amount shall be prorated for short taxable years.

* No additional contributions to the trust can be made.

* The term of the annuity must be fixed for a specified number of years, or the life of the grantor, whichever is less.

* No prepayment can be made of the annuity holder's interest.

The issue in PLR 9444033 was whether, if a grantor of the GRAT pays income tax on income received by trustee, but not distributed to the grantor, those taxes paid constitute an additional gift to the beneficiary.

The letter ruling stated that if there is a reimbursement provision for income tax liability and the income exceeds the annuity amount, the income tax paid by the grantor on trust income not paid to the grantor will not constitute an additional gift to the beneficiaries. Conversely, if the GRAT has no reimbursement provision, an additional gift to the remaindermen would occur if the grantor paid tax on any income that would otherwise have been payable from the corpus of the trust.

This is another effective way of reducing the grantor's gross estate without the payment of additional gift taxes. (Income remains in the trust for beneficiaries and the grantor pays the tax.)

There will be no step-up in basis at the grantor's death unless the grantor purchases the trust assets prior to the termination of the trust term. This individual purchase can be accomplished with no gain recognized by the trust or the grantor (Rev. Rul. 85-13, PLR 9504021 and PLR 9519029).

An Example to Illustrate

The above techniques can be illustrated with the following example:

Taxpayer, age 67, owns 100% of Sub S Corp. shares in the family business and wishes to gift 40% to his child who works in the family business. If we assume an appraised company value of $3,000,000, discounts totaling 35% for minority interest and lack of marketability, the term of seven years for the GRAT, a qualified annuity payment of 12% ($96,000 per year), and a IRC Sec. 7520 rate of 8.2%, (June 1995 rate) the results are as follows:

Appraisal of company $3,000,000

Gift of 40% 1,200,000

Minority discount 35% 400,000

Fair market value of GRAT 800,000

Retained interest 454,685

Value of gift $ 345,315

If the taxpayer survives the term of the GRAT, the shares will be excluded from his estate, even if there was appreciation in those shares. In this example, the taxpayer made a gift of $1,200,000 and paid a gift tax on only $345,315 (assuminghis lifetime exemption has been utilized).

It should be noted, however, that private letter rulings may only be relied upon as authority by the taxpayer to whom they are addressed. Interested taxpayers should seek guidance via a letter ruling request, or rely on the advice and counsel of experienced estate practitioners. *

Editors:
Marco Svagna, CPA
Lopez Edwards Frank &
Company, LLP

Edward A. Slott, CPA
E. Slott & Company

Contributing Editors:
Richard H. Sonet, CPA
Zeitlin Sonet Hoff & Company

Lawrence M. Lipoff, CEBS, CPA
Lipoff and Company, CPA, PC

Frank G. Colella, LLM, CPA
Own Account

Jerome Landau, JD, CPA

Eric Kramer, JD, CPA
Farrell, Fritz, Caemmerer, Cleary, Barnosky & Armentano, P.C.

James McEvoy, CPA
Chemical Bank Corporation

DECEMBER 1995 / THE CPA JOURNAL