Reducing Capital Gains by Creative Use of SMLLCs and Installment Notes

A popular estate planning technique for estates facing the prospect of incurring federal estate tax has been for a grantor (G) to set up an irrevocable, grantor trust (the Trust) then sell an asset (e.g. an interest in a partnership [PSP]) to the Trust, taking back an installment note.

As an irrevocable trust, the asset would no longer be includible in G’s estate for estate tax purposes. Instead, G’s estate would include the outstanding note. The asset would appreciate outside G’s estate, while the note would decrease in value over time.

As a grantor trust, G, rather than the Trust, would pay the income tax on the Trust’s income, so that the Trust itself would grow income-tax free, outside G’s estate. The income tax payments by G would reduce G’s estate. As well, G would not recognize capital gain on the sale or any interest income on the note, since for income tax purposes the grantor and the grantor trust would be treated as the same taxpayer. It would be as if the grantor had sold the asset to and was making payments to himself.

Despite these benefits, this transaction has some issues and problems upon G’s death, namely:

1. The “phantom income” issue (details below).
2. If the note payments would be deemed as “income in respect of a decedent,” with the note not getting any basis step-up.
3. If payments on the note after G’s death would trigger recognition of capital gain on the sale and interest income on the note.
4. Since the asset owned by the Trust is outside G’s estate, it would not get any basis step-up upon G’s death, meaning that a future sale of the asset would trigger more capital gain than would be the case if there was a basis step-up.

Phantom Income

Perhaps the most significant issue has to do with how the grantor’s death may trigger what is referred to herein as phantom income.

Upon a grantor’s death, a grantor trust will often own a low-basis asset that is still subject to a purchase money note obligation owed to the grantor. For example, assume that at the time of a grantor’s death, the grantor trust holds an asset worth $100M, with zero tax basis, subject to an outstanding $50M purchase money note held by the grantor.

IRS takes the position that when a grantor dies, there is a deemed transfer of the asset in the trust by the grantor to the trust. Hence, there is a deemed transfer of a $100M asset, with zero basis, subject to a $50M debt.

A transfer of an asset whose basis is less than the debt collateralized by the asset ($50M less, in the above example) would trigger the recognition of a $50M capital gain by the estate.

For this reason alone, it is often advisable to pay off a purchase money note before a grantor’s death, if possible. Paying off the note would cure the “phantom income” issue, as well as issues 2 and 3 above. For various reasons, however, including uncertainty about when the grantor will die, paying down the note prior to death may not be possible.

QUESTIONS:

1. Is there a way to make the note (issues 1-3 listed above) “disappear?”
2. Is there a way to get some basis step-up for the asset to reduce capital gain upon a future sale (see issue 4 above)?

USING AN LLC TO MAKE A NOTE “DISAPPEAR”

When an individual creates a limited liability company, the LLC is a single-member LLC (SMLLC) and for income tax purposes, it is treated as a disregarded entity.

Therefore, if G and G’s grantor trust were to create an LLC, it would be considered a disregarded entity.  This is because G and G’s grantor trust are, in effect, the same taxpayer, and for tax purposes the LLC is deemed to have a single member.

In continuation of the foregoing example, assume that a grantor trust contributes an asset worth $100M, subject to a $50M debt, to an LLC. Assume further that the grantor contributes the $50M note to the LLC. The grantor trust and the grantor would each have contributed $50M to the LLC; each would have a 50% interest in the LLC.

Upon formation, the LLC would both own the note and owe the note. Under state law, the note and the note obligation would be merged, and the note obligation would, by law, be extinguished.

Result: The note would no longer be an asset of G’s estate, thus obviating (issue 1) the phantom income issue, (issue 2) the note valuation concern, and (issue 3) the concern regarding post-death income tax treatment of note payments.

USING AN LLC TO GET STEPPED-UP BASIS

Consistent with the foregoing example, assume that a SMLLC owns a $100M asset, with the grantor (G) and G’s grantor trust each owning 50% of the SMLLC. According to IRS, when the grantor dies, there is a “deemed” transfer of a 50% interest in the asset from the Trust to G. Since the Trust is, upon the grantor’s death, no longer a grantor trust, the SMLLC is converted to a partnership. It is no longer a disregarded entity.

Conversion of a SMLLC to a partnership is, according to IRS, treated as an acquisition of the asset by the respective members, followed by a contribution of the asset by the members to a new partnership.

The grantor’s estate would be deemed to own a 50% share of the asset ($50M). Inclusion of the 50% share of the asset in the grantor’s estate would result in a stepped-up basis for the asset—$50M in the above example—followed by a contribution of the asset to a new LLC.

Result: The grantor’s estate would have an LLC interest with outside basis of $50M; the LLC, upon making an appropriate election, would have inside basis of $50M for the asset.

The Trust’s 50% share of the asset ($50M), would not be included in the grantor’s estate and would not get a basis step-up. Upon the deemed contribution to the new LLC, the LLC will have zero inside basis for this portion of the asset.

The grantor’s estate would not recognize any gain on a later sale of its 50% LLC member interest, since it has tax basis equal to the value of its LLC member interest.

Without the use of an LLC, the non-grantor trust would recognize a $100M capital gain on a later sale of the asset. With use of an LLC, and the creation of basis of $50M, the overall gain on sale of the asset would be $50M.

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