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Tuesday, February 21, 2006


Trusts are useful mechanisms to own interests in start-up ventures. If the beneficiaries of the trust are members of younger generations, the growth in value of the business can occur for their benefit without substantial transfer tax consequences.

Often, the funding for the new venture is accomplished in part by loans from parents or other older generation members to the trust. However, such loans can have some tax drawbacks and exposures. These include:

-interest income to the lenders, when the borrowing trust may not be able to effectively deduct the interest;

-risk of a taxable gift if the venture doesn’t work out and the loans cannot be repaid, at least if the lenders don’t aggressively pursue collection of the loans; and

-the general risk of the IRS attempting to recast the loans as taxable gifts.

In a recent article in the Estate Planning Journal, the authors suggest the use of a zeroed out grantor retained annuity trust (GRAT) as an alternative method to funding the initial capital. Instead of loaning money to the trust, the family members providing the funding contribute the funds. As a near zeroed-out GRAT, the grantors make only a de minimis taxable gift to the trust. As a GRAT the grantors receive back regular payments from the trust, until they receive back an actuarial total annuity amount equivalent to the value contributed plus the applicable interest rate factor. Any remaining value belongs to the younger generation beneficiaries.

By using a GRAT instead of a loan, the interest issue goes away, as does the risk of the loan being treated as a taxable gift. As a grantor trust, the GRAT will further allow the grantors to be taxable on the income of the trust (which in effect allows for the transfer of more funds through the payment of tax to the trust in a tax-advantaged manner) and may allow to the grantors deductions for any losses relating to the business venture.

The article notes two negative aspects to the use of a GRAT in this context. First, GRATs generally last for a term of years. If the grantor dies during that term, the IRS will likely assert that the grantor will be subject to estate tax on the assets in the trust, including any appreciation that has occurred. While many tax practitioners believe the estate tax inclusion is much more limited than that, a disagreement with the IRS can be anticipated. Second, a GRAT is not a useful planning devise where substantial generation skipping is anticipated.

Consequently, this use of a GRAT to hold interests in start-up ventures will not always make sense, but can be of use in some planning circumstances.

The Opportunity GRAT (OPGRAT) Can Reward Success and Minimize Adverse Tax Risks
, R.A. Oshins, M.J. Jones, and G.E. Lunn, Jr., 33 Estate Planning, No. 3, 20 (March 2006)

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