Before delving into IRC Sec. 2702, the latest final word involving the use of trusts in estate planning, a basic understanding of its evolution, is necessary. In its formative years, the estate freeze was a collection of various concepts. The buy-sell agreement, private annuities, and installment sales involving family members were some of the methods implemented with success. From these theories, it was a natural lead to corporate reorganizations, partnerships using multiple tiers, and Crown loans. With these as a base and creativity as their guide, estate planners developed the self canceling installment note (SCIN), remainder interest purchases, and the private lead trust.
The Private Lead Trust
The private lead trust, also referred to as the grantor annuity trust, was, as its name suggests, a trust where the settlor retained a lead interest. The trust was typically structured for a given term of years, and assuming the grantor lived out the term, it terminated in favor of the grantor's heirs free and clear of estate and gift taxes. The advantages were numerous, especially during periods of inflation. Back in those golden pre-IRC Sec. 7520 days, the IRS used valuation tables whose interest rates were significantly lower than those of which any good money manager was capable of achieving. During the 1970s and early 1980s, the IRS valued annuity interests under the assumption that the trust would only yield 6% a year. Accordingly, given the correct annuity term and amount, by the time the trust terminated, the principle would be assumed to have been entirely consumed. This would, of course, mean that there was nothing to pass to the grantor's heirs, and accordingly there was no transfer tax to pay. (See Rev. Rul. 77-454, 1977-2 CB.)
For example, a trust for a term of 12 years, with an annuity of 11.92% would have produced the desired "zero-out" trust, i.e., no gift tax. Thus, the grantor could transfer securities yielding 12% sufficient to pay the annuity and within 12 years would be able to transfer the principal amount without any gift tax. Variations of the term and the annuity interest were structured around the unified credit. Furthermore, if the grantor died within the term, only the present value of the remaining interest would be included in the estate. (Reg. Sec. 20.2031-10(a)(1).)
Next Came GRITs
The next technique involving the use of the "trust freeze" was the GRIT, or grantor retained income trust. The primary distinction between the grantor annuity trust and the GRIT was that in a GRIT the grantor was entitled to all of the income or use of the property rather than a fixed and determined amount of income. Secondly, a GRIT could not reduce the value of the remainder interest down to zero for gift tax purposes. Therefore, inherent in a GRIT was some valued gift of the remainder interest, though no tax would have to be paid if the unified credit were properly utilized. However, if the grantor survived the term, the original trust corpus and all of the built-up appreciation would have passed to the grantor's heirs free of tax, once again dependent on the unified credit used. If the grantor died during the term, the property would be included in his estate (IRC Sec. 2036 (a)(1)), however, his unified credit would be restored. As such, a GRIT was virtually risk-free save the fees incurred in implementing the trust.
RA 87 attempted to eliminate estate freezes by enacting Sec 2036(c). In a nutshell, Sec. 2036(c) was overly broad and generally unfair and as such was repealed retroactively. The section attempted to forbid any appreciation from passing to the donee if any "string" was retained by the donor. The section also lacked definitional guidelines as to its scope and nature.
Along came IRS Notice 89-99, which purported to give guidelines and examples as to transactions which would be included within the reach of Sec. 2036(c). The notice provided a safe harbor for reversionary interests if the actuarial value of the reversion is less than 25% of the value of the income interest. …