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Thursday, November 02, 2006


A popular estate tax planning technique is a sale of an interest in a corporation or a partnership to a grantor trust (also known as a sale to a defective grantor trust). If properly structured, future growth in the value of the sold interest will not be subject to estate tax when the transferor dies. Further, no income tax arises on the sale.

If the sales price equals the fair market value of what was sold, there is no gift on the transaction, and no gift tax return reporting is of the transaction is required. Since valuing an interest in an entity is not an exact science, gift tax exposure exists if the IRS can establish a higher value than the sales price. Many practitioners elect not to report the transaction, so as to avoid the risk of IRS scrutiny. Since the transaction doesn't typically show up on a gift tax or income tax return, IRS scrutiny is thus substantially diminished.

This type of thinking may shortly fall by the wayside. On a recently released draft Form 706 (estate tax return), the IRS now has a question whether a decedent at any time during his or her lifetime transferred or sold an interest in a partnership, a limited liability company or a closely-held corporation to a trust that was in existence at the decedent’s death and that was (1) created by the decedent during his or her lifetime or (2) created by someone other than the decedent under which the decedent possessed any power, beneficial interest or trusteeship. This question will bring to the IRS' attention a sale to grantor trust transaction, at least at the time of the decedent's death, thus inviting IRS scrutiny of the transaction.

If the IRS determines that a gift occurred on the sale, it can impose gift taxes, penalties, and interest, even if the sale transaction occurred many years prior to death. If this question makes it into the final Form 706, practioners may now want to specifically disclose sale to grantor trust transactions on gift tax returns to get the statute of limitations running since there is a good chance that IRS scrutiny may arise later at the time of estate tax audit due to the Form 706 disclosure. If the IRS does not challenge the transaction within 3 years, this will usually foreclose further tax adjustments by the IRS (including at the subsequent death of the transferor). This is especially true since very few gift taxes are audited.

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