Multitasking Property: Funding a GRAT with Property that also Serves as Loan Collateral

Multitasking Property: Funding a GRAT with Property that also Serves as Loan Collateral

Introduction
Many estate planning practitioners recommend the use of grantor retained annuity trusts (“GRATs”) as a tool through which individuals may reduce the ultimate estate tax liability of their estates. Property transferred to a GRAT is generally not includable in the grantor’s estate following the term of the GRAT, and therefore any appreciation on such property is not subject to estate tax at the grantor’s death.   (Upon termination of the GRAT, its property is distributed to its remainder beneficiaries – normally family members of the grantor – without any triggering of gift or estate tax as long as the grantor survives the term of the GRAT.)  The grantor continues to enjoy an annuity during the term of the GRAT, and the value of this retained interest reduces the grantor’s taxable gift to the GRAT. Thus, the reduction of the grantor’s taxable estate – including the “freeze” on any future appreciation on the GRAT property – can potentially be accomplished with relatively little accompanying gift tax liability if the value of the annuity is substantial. 
In order to ensure that a grantor enjoys the benefits of an intended GRAT, however, practitioners must take care to structure the trust properly. In particular, where the trust’s remainder beneficiaries are members of the grantor’s family, the trust must be structured as a qualified GRAT for the value of the retained annuity to be deducted from the value of the property transferred to the trust. Internal Revenue Code (the “Code”) Section 2702 sets forth a variety of requirements for a qualified GRAT. However, this article focuses particularly on the specific question posed by its title: Is it possible for an individual to fund a qualified GRAT with property that simultaneously serves as collateral for loans to the grantor from a third party?
This article briefly analyzes the relevant rules, concluding that from a tax perspective it most likely is permissible to use encumbered property to fund a GRAT as long as the grantor agrees to replace the value of any portion of the property that is used to satisfy the loans and the grantor holds legal title to the property at the time the GRAT is funded.
Analysis
The issue presented by funding a GRAT with property that secures a loan is whether this arrangement might violate any GRAT requirements such as the prohibition of trust distributions to anyone other than the annuity holder during the term of the annuity (if a portion of the property were called in satisfaction of the loan), or the prohibition against contributing additional property to the trust (if the transferor in turn attempted to replace the property by adding other assets to the trust).
The Treasury Regulations do not specifically address the question of whether a GRAT may be funded with property that secures a loan. However, the absence in the Regulations of any prohibition against the use of such property, coupled with related IRS letter rulings, indicates that this arrangement may be permissible.
 
IRS Private Letter Ruling (“PLR”) 9441031 provides evidence that it is permissible to substitute trust property without defeating a trust’s status as a GRAT. Although the facts presented in that letter ruling do not indicate that the trust property secured any debts, it does state that the relevant trust instrument provided that the grantor would have “the power, exercisable solely in a nonfiduciary capacity without the approval or consent of any person acting in a fiduciary capacity, to reacquire the corpus of the trust by substituting other property of an equal value or to borrow trust corpus or income without posting security.”[1] Despite this provision, the IRS ruled that the grantor held a qualified interest under Code Section 2702(b), so the trust’s status as a grantor retained unitrust was not defeated. (A grantor retained unitrust is nearly identical to a GRAT except that the payments are based on a percentage of the trust value rather than a fixed annuity amount, so this ruling also reflects the likely treatment of a GRAT under similar circumstances.)[2]
 
Analogy to the treatment of qualified personal residence trusts (“QPRTs”) also provides support for the position that a GRAT may be funded with property used to secure a loan. Retained interests under QPRTs, like retained interests under GRATs and grantor retained unitrusts, are deemed “qualified interests” under Code Section 2702 as discussed above. Thus, when an individual transfers his or her residence into a qualified personal residence trust, retaining a right to use the home for a designated period and granting a remainder interest in the home to a family member, the value of this retained interest is deducted from the value of the home, thereby reducing the transferor’s gift tax liability. In one relevant letter ruling regarding a QPRT, the trust property was a residence that “secure[d] loans under which the taxpayer and his spouse [would] continue to be liable for payment and under which the proposed trust [would] have no obligations.”[3] Despite the home being encumbered by this mortgage, the IRS ruled that the interest in question satisfied the requirements for a QPRT.[4] A QPRT and a GRAT are somewhat different types of trusts and therefore have somewhat different requirements, but the similarities between these two vehicles and their common exemption as qualified interests under Code Section 2702 makes the treatment of QPRTs fairly applicable to GRATs. Thus, the fact that a mortgage on trust property did not defeat a trust’s status as a QPRT may also indicate that the use of encumbered property to fund a trust would not defeat such trust’s intended status as a GRAT.
 
It should be noted in this context that the IRS could potentially take a different view if the proposed GRAT were not to be reimbursed for property claimed by the lender in the event of a default on the loan. (As noted above, this could violate the requirement that the trust instrument prohibit trust property from being transferred to anyone other than the annuity holder during the term of the annuity.) Therefore, the instrument establishing a GRAT that is to be funded by encumbered property should incorporate an agreement from the transferor to replace the value of any trust property taken in satisfaction of the loan. As noted previously, it appears that this substituted property need not be identical to the original trust property, but simply must be equal in value.
 
Thus, a grantor should be able to fund GRATs with property that secures loans from a third party to the grantor, as long as the grantor also provides guarantees that the grantor will replace the value of any portion of the property claimed by the third party lender in satisfaction of the loans.[5]
 
Conclusion
 
Related private letter rulings, as well as the absence of any prohibition in the Treasury Regulations, indicate that the IRS would most likely consider a trust to be a GRAT regardless of whether the trust property simultaneously acts as collateral for a loan, at least if an accompanying guarantee assures that the value of the trust property will be replaced if necessary. Therefore, a grantor should be able to fund a GRAT with encumbered property as long as the grantor also provides personal guarantees that he or she will transfer substituted assets to the GRAT to replace the value of any portion of the property that is claimed in satisfaction of the loan secured by the GRAT property. 
 
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Morrison & Foerster’s Trusts and Estates group provides sophisticated planning and administration services to a broad variety of clients. If you would like additional information or assistance, please contact Patrick McCabe at (415) 268-6296 or PMcCabe@mofo.com.
 
© Copyright 2009 Morrison & Foerster LLP. The views expressed in this article are those of the author only, are intended to be general in nature, and are not attributable to Morrison & Foerster LLP or any of its clients. The information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

This article is published with permission of Morrison & Foerster LLP.  Further duplication without the permission of Morrison & Foerster LLP is prohibited.  All rights reserved.  The views expressed in this article are those of the authors only, are intended to be general in nature, and are not attributable to Morrison & Foerster LLP or any of its clients.  The information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.


[1] PLR 9441031 (1994) at 4.
[2] PLRs may not be relied upon as legal precedent, but these rulings do provide good insight as to how the IRS is likely to treat taxpayers under similar circumstances.
[3] PLR 9340009 (1993) at 1.
[4] Id. at 4.
[5] For practical purposes, the grantor could also include a provision in the trust instruments allowing the grantor to substitute other property for the property held by the GRATs in case the grantor wishes to make this substitution at some point during the annuity term.