Valuation discounts and annuity pricing for the IDGT
A key factor in structuring a private annuity sale to an intentionally defective grantor trust (IDGT) is determining the value of the asset being transferred and the annuity payments that will be received in return. Valuation discounts and actuarial assumptions play a significant role in this calculation and can substantially affect the effectiveness of the overall estate planning strategy.
Because the subject of the sale is often a minority, illiquid interest, and qualified valuation discounts for lack of control and marketability, as mentioned above, can reduce the stated purchase price. The annuity is calibrated to equal the discounted purchase price, actuarially spread over the seller’s lifetime. Small changes in discounts, discount rate, and life expectancy can materially affect the annuity amount and the strategy’s economics, as can the IDGT’s cash flow capacity.
Part two of this three-part series examines how valuation discounts and annuity pricing can influence the effectiveness of a private annuity sale to IDGT. It is not legal, tax, or valuation advice. Outcomes are fact- and jurisdiction-specific and require coordinated professional guidance.
Grantor trust income tax features
Both strategies typically use a grantor trust. The grantor is taxed on trust income, allowing assets to compound inside the trust free of current income tax drag at the trust level, and further reducing the grantor’s taxable estate by paying the tax personally. Sales and annuity payments between the grantor and a grantor trust are generally ignored for income tax while grantor trust status continues; the termination of grantor trust status (usually for reasons other than death, many will argue) can trigger different consequences.
When Is One Approach Better than the Other?
GRAT advantages in specific fact patterns
A GRAT can be preferable when a client: 1. Wants a fixed-term, retained annuity they expect to outlive, locking in a near-zero gift and shifting excess performance over the Code Section 7520 rate. 2. Prefers short “rolling” GRATs to repeatedly capture near-term volatility or episodic appreciation, resetting Code Section 7520 rate exposure with each new GRAT (this way, you can keep locking in short-term appreciations to be removed from your taxable estate). 3. Holds assets with high near-term growth potential but modest cash yield, and is comfortable using in-kind annuity distributions if needed. 4. Accepts that if the grantor dies during the GRAT term, most or all assets are pulled back into the grantor’s estate, reducing or eliminating the transfer tax benefit, and that the annuity stops at the grantor’s death.
Private annuity sale to an IDGT has advantages in specific fact patterns
A private annuity sale can be preferable when a client:
- Wants an annuity stream for life rather than a fixed term, shifting longevity risk to the IDGT and its beneficiaries.
- Prefers mortality risk economics different from a GRAT: the annuity obligation ends at the grantor’s death, and the IDGT retains any residual value; therefore with a GRAT, you need to outlive the GRAT retained annuity term, whereas with the annuity transaction, the sooner you die, the more the estate tax savings.
- Seeks to pair valuation discounts on closely held or illiquid assets with grantor-trust income tax treatment to amplify wealth transfer. 4. Wants an alternative to relying on spouse-created SLATs (i.e., a spousal lifetime access trust, in which one settlor/spouse creates a trust for the benefit of the settlor’s spouse and descendants, for example) for an income stream; here, the grantor receives payments directly from the IDGT’s annuity promise without reciprocal trust exposure (explained in part three), subject to careful structuring and inclusion risk controls.
Mortality risk and what happens at death
- GRAT: If the grantor dies during the GRAT’s term, the remaining assets are generally included in the grantor’s estate and the annuity terminates. If the grantor survives the term, the remainder passes outside the grantor’s estate (subject to GST planning as implemented).
- Private annuity to IDGT: The annuity ceases at the grantor’s death by design. If the grantor dies “early,” the IDGT may achieve a superior transfer result; if the grantor lives longer than expected, the IDGT must keep paying, potentially reducing or eliminating the anticipated remainder, which also means you did not reduce your taxable estate (unless you spent the annuity payments), although at least you were “guaranteed” cash flow payments for life.
This publication is provided by Greenspoon Marder LLP is issued for informational purposes only and is not intended to be construed or used as general legal advice nor a solicitation of any type. Please contact the author(s) or your Greenspoon Marder LLP contact if you have any questions regarding the currency of this information. The hiring of a lawyer is an important decision. Before you decide, ask for written information about the lawyer’s legal qualifications and experience.
