The Advantage of Using an Installment Sale to a Grantor Trust

In the estate planning world, one of the goals is to move appreciating assets down to the next generation and if possible, avoid capital gains taxes while the assets grow.

The use of an installment sale to a Grantor trust (ISGT) could play a key role in future generational planning. The tradeoff in using an ISGT while transferring appreciating assets, is the Grantor must relinquish control over the sold assets and at the same time retain the liability for the payment for the trusts income tax obligations.

In today’s interest rate environment, the use of an installment note can utilize the very low applicable federal rates, while moving the future appreciation off of the owner’s balance sheet. Some of the extraordinary features of this approach include:

  1. The grantor pays the trust taxation as a non-gift item.
  2. Substitution powers.
  3. The use of formula clauses to adjust valuation.
  4. Optimizing the trusts probability of success.

The ISGT will help freeze the estate and succeed the asset down to the next generation. The mechanics are as follows:

A grantor sells an asset for the fair market value to a Grantor trust. The asset may be illiquid but appreciating. Such assets may include a family business, real estate or other appreciating type assets.  The asset is sold using an installment sale, thus preserving the assets for the next generation by removing it and the appreciation from the grantor’s estate and replacing it with a non-appreciating interest bearing note.

The use of a Grantor trust allows the income to be disregarded for income tax purposes, thus not generating any income or gain to the seller. In addition, the appreciation in the trust will not be effected by any estate tax at the grantor’s death.  Caveat, if the grantor dies while the note term is in effect, the notes value will be included in the grantor’s estate.  Planning tip, structure the note so that it will be less than the grantor’s anticipated life expectancy.

As long as the notes value is equal to the fair market value of the asset sold, the ISGT should not constitute a taxable transfer for either federal gift or generation skipping transfer tax purposes. One caution is the note must charge sufficient interest in order to avoid an unintended gift. The use of the Applicable Federal Rate (AFR) in affect for the month of the sale will justify the proper interest to be used.  The grantor should seed a gift to the trust in an effort to capitalize the trust prior to the sale. This will show that the trust can meet its note obligations.

ISGT’s can help preserve liquid assets with proper planning, implementation and monitoring by ensuring the value of the installment note matches the fair market value of the assets sold and making sure the trust has sufficient ability to pay its obligations. This will safeguard that the parties involved will respect and comply with the note terms and payment requirements, helping to assure a successful sale.