“Utilization of Section 7872,” that’s the subject of today’s ACTEC Trust and Estate Talk.

Transcript/Show Notes

This is Jonathan Michael, ACTEC Fellow from Chicago, Illinois. IRS Code Section 7872 deals with the treatment of loans with below-market interest rates. ACTEC Fellow Jerry Hesch from Aventura, Florida, will explain what you need to keep in mind and how to stay out of trouble. Welcome, Jerry.

Thank you very much. What’s interesting is, there is a situation where we have what are called intrafamily loans, where a senior will lend money to a trust for the benefit of junior family members, and Code Section 7872 is a statute that says if you structure the loan exactly the way it’s required in the statute, it will not be a gift for gift tax purposes. So, let’s suppose that senior decides to lend a trust for the benefit of junior family members, $1 million and provides for adequate stated interest being the long-term AFR and it says the note terms satisfy all the requirements of Section 7872. Well, the statute says there is no gift for gift tax purposes, which implicitly means that the note receivable was made for adequate and full consideration in money and money’s worth. Obviously, that naturally follows because the statute says there’s no gift.

So let’s suppose that senior lends $10 million to the trust, fully satisfies Section 7872, provides for adequate stated interest, the interest is paid timely, the principal is tended to be paid timely and then senior dies while the note is still in existence. And senior’s executor looks at the note, goes to an appraiser and the appraiser says, “Based on all these factors, the note can be discounted.” So senior includes senior’s estate, values the note at 7 million dollars and the IRS looks at this and says, “Wait a minute, senior lends $10 million, expects to get $10 million in full payment of the note at maturity and now you’re valuing it in the gross estate at 7 million dollars? Where did the 3 million dollars go?”

So the IRS is taking the position that they want to apply the string provisions under 2036(a)(2)n and 2038 and they say in order to apply these string provisions, we call them ‘string provisions’ because they bring the property back in the gross estate. So, you put the property on the string and bring it back. So the IRS says, “even though the note was deemed not be a gift for gift tax purposes, we’re going to treat it as not being issued for full and adequate consideration and therefore, the string provisions under 2036 and 2038 can apply.” What? There seems to be a disconnect. Just because I value the promissory note in my gross estate at a discount from less than the stated principal amount, it’s not for full and adequate consideration? That doesn’t make sense. So, let’s go through some simple examples.

Intrafamily Loan with Financial Leverage Example

Let’s suppose senior is age 75 and senior creates a grantor trust for the benefit of senior’s descendants and funds that trust with a nominal $15,000 annual exclusion gift. So, we’ve created a trust which really doesn’t have any value, and then senior retains no powers, either directly or indirectly, in that trust that would expose the trust assets to estate tax inclusion under the string provisions. Everything sounds good, completed gift 15 thousand. Senior then loans a million dollars to the trust payable annual interest only at the 2.21 percent prevailing long-term AFR for September of 2019 with all note principal due at maturity in 25 years. Sounds good. Now the key here is the trust takes that $1 million and invests the loan proceeds in a 25-year bond paying 3.21 percent annual interest. Thus, the trust is doing what we call financial leverage. The trust is borrowing money at 2.21 percent and reinvesting it at 3.21 percent, so the trust intends to use the $32,100 of bond interest to pay the $21,100 of annual interest on its note obligation to senior and retain the excess $10,000 in the trust, which passes to the beneficiaries with no gift and estate taxes. Sounds easy. Right? And the parties intend in this situation that all the interest payments will be made by the bond interest that the trust receives and when the bond matures in 25 years, the million dollars of bond principal can then be used to pay the promissory note. And by the way, the trust has only $15,000. So for all practical purposes, the only security for senior’s loan is that bond that the trust bought. This is not like an installment sale to a grantor trust where people say the trust has to add seed money. For all practical purposes, this is a non-recourse note. If the trust goes bankrupt, senior is out of luck.

So, the question is, here’s something that’s interesting. Senior was 75 years old when senior made this loan. Senior’s life expectancy under the standard mortality tables is 11 years. The note is for 25 years. The probability that senior will be living at note maturity — senior needs to live to age 100 — is 2.9 percent. Senior is lending money where senior never intends to collect it? The IRS says that doesn’t sound good. But the statute says this is not a gift. Now, the sole motivation for this intrafamily loan was pure estate planning. It’s to take advantage of the ability to shift $10,000 of value each year to the trust without any gift and estate tax exposure. Hey, this sounds like a GRAT where the estate planning was the only reason for the transaction. So, we’re admitting there is no other business purpose for the loan. You know, the tax court comes out to say “all these family limited partnerships — you got to show another purpose other than estate planning.” Here, I’m admitting there was no other purpose other than estate tax savings.

Now, suppose senior dies ten years later and the long-term AFR when the note was issued at 2.21 percent ten years later is still 2.21 percent. And at the date of senior’s death, the bond that the trust purchased was still worth a million dollars. But they value this note in senior’s gross estate at a discount value of say, $600,000. And we know that if the bond is held to maturity, the million-dollar principal the trust receives on the bond will be able to fully satisfy the principal due on the note of the senior’s estate at maturity. So what happens in this situation is the IRS, in abusive situations, is taking the position that a loan issued to a related party — even at the AFR it is in full compliance with Section 7872 — was not issued for full and adequate consideration if it’s later valued in the note holder’s gross estate at a substantial discount. And therefore, senior’s trust, which he has no string provisions other than this note receivable, is included in his gross estate because Section 2036 says it doesn’t apply unless the original transfer was for full and adequate consideration.

Now, the key is very interesting. How did the appraiser value the note at a discount when its stated principal amount is a million dollars and the trust is still obligated to pay the million dollars. Okay? Now, interestingly enough, valuation is a question of fact that is determined at the time of the valuation date, which is the date senior died. Well, there are other factors that indicate that the promissory note could be discounted from its stated principal amount. And this is the key. And, when you look at a situation, for example, let’s suppose that senior owns $10 million of marketable securities and contributes that $10 million of marketable securities to a family-limited partnership getting a $10 million capital account. Now, senior has a limited partnership interest with a $10 million capital account. Therefore, senior is entitled to be allocated income based on its $10 million capital contribution and if the partnership liquidates, senior is entitled to a distribution equal to its $10 million capital account.

But what happens is, senior has this limited partnership interest and senior values this limited partnership interest at $7 million for purposes of doing some estate planning such as selling it to grantor trust or gifting it or even putting it into a GRAT. Okay? Now, the IRS has argued in these situations that when senior transfers $10 million to the partnership and gets back a limited partnership interest that senior then values at $7 million, there is a $3 million dollar gift on formation. And the tax court has said the fact that it’s worth less in your hands doesn’t change the fact you’re still entitled to that $10 million capital account and therefore, there is no gift on formation. In other words, there are a whole bunch of family limited partnership cases that John Porter lectures on extensively that’s deemed to be a transfer for full and adequate consideration. So, the question becomes, in this situation how can the IRS say we’re going to ignore a statute that says it was issued for full and adequate consideration? It can’t.

Generational Split-dollar Transactions

Now, here is the situation that has been used and what we call generational split-dollar transactions. Senior lends $10 million to a grantor trust for the benefit of senior’s descendants. Well, I always call senior, G1 for generation one, because therefore, when your students take the notes it’s easier to write G1 than spell it out; and the children are G2 and the grandchildren are G3. So, you always have to remember that when you are teaching; you want to make it easy for the students to take notes. That’s why in all my examples — what I use in my class — I call the taxpayers, “Ted Player” and “Terry Player.” Why do I call them Ted Player and Terry Player? Because the abbreviation is TP, taxpayer. Cool, huh? Alright, little bit of humor. So the trust takes the $10 million of loan proceeds and uses it to pay the premiums on a life insurance policy, insuring the life of senior’s son G2 who is age 45. Now, the trust’s only asset is this life insurance policy.

The loan fully complies with the requirements for a split-dollar loan set out in the treasury regulations under Section 7872-15. By the way, these regulations are rulemaking regulations, not interpretive regulations, because there’s a delegation in the statute that says the Treasury is authorized to issue regulations to fully explain Section 7872 that have the force of law. So these rulemaking regulations are the same thing as if Congress enacted the statute. Now, what is interesting in the split-dollar loan regime regulations — it says all you have to do is use the AFR at the time the loan was issued. Well, that’s 7872. But it also says the interest doesn’t have to be paid. It can accrue and all be paid at the maturity of the note. And the maturity of the note is G2, who is 30 years younger. So when G1 dies, the note will still be in existence and it’s in full compliance with the regulations. So essentially, in this situation, G1 dies, say five years later at age 80, the $10 million plus all the accrued interest is included in G1’s gross estate and they take a valuation discount, valuing the note receivable at $6 million.

Now, interestingly enough, there’s an interesting issue. When G1 dies, the trust converts to a non-grantor trust. So, all the interest income has to be reported, but the interest expense cannot be deducted because it’s used to pay the premiums on a life insurance policy. So, you have an income tax problem. But the question is, in this situation can the IRS basically say, the note was not issued for adequate and full consideration? And here is the key in all of this. Going back to the same situation, where you put the marketable securities into a partnership, and the courts have said as long as you have the rights to that full $10 million capital account, the fact that your limited partnership interests in a separate transaction that you can dispose of that is worth less is totally irrelevant. There is no gift on formation. Okay? So here is what is very interesting in this whole situation. If you look at the regulations and the proposed regulations and the final regulations under 7872 and 2512 and 1001-2; I’m not going to go through all the citations like some of my colleagues do to quote code sections at the top of their head and just confuse everybody. All of these proposed and final regulations and a whole series of private letter rulings have said, if you issue a note in full compliance with the statute and regulations at the time of issuance, then the value of the note shall be presumed to be equal to the face amount of the note. That’s all that they say.

Now, what is interesting is the applicable federal rate is based on the one-year Treasury Bill rate. The one-year Treasury Bill rate is not a market rate. It is always less than market rates. So, if I have an AFR of 2 percent, which is one-year Treasury Bill rates, market rates for everybody else, except the US government, is about 3 percent. So, what a lot of people are saying is, “True, when I issued the note, no gift but when I want to dispose of it, I can use general valuation principles.” And general valuation principles look at market factors. And market factors say “Wait a minute. I issued a note at 2 percent, when market rates are 3 percent; I die years later when market rates are 3 percent and the AFR is still 2 percent. I can use market rates to discount it because there is no limitation in the statute or final regulations that say that you can ignore market rates.” And, under general valuation principles, you look at market factors.

Well, guess what? The IRS was apprised of this and realized there was this disconnect. And if you look at the legislative history of Section 7872, it’s very clear they basically say, “even though the AFR is less than market rates, if you issue a note at the AFR, it will be presumed to be no gift for gift tax purposes, which implicitly means that it was issued for full and adequate consideration.” Now. So it’s a bona fide debt. Now here is the key. And let me go over this. The IRS, shortly after Section 7872 was enacted in 1984, realized there was this disconnect. So it quickly issued a proposed Regulation 7872-1, which basically said “we will value a gift term loan at the present value of all payments using the AFR.” So, they realized this disconnect. They said, “we’re not going to value that promissory note later using the market rates; we’re going to make you use the AFR so you can’t have that disconnect.” Well guess what? It’s only a proposed regulation. Proposed regulations are just proposals that have no force; they’re not binding on the IRS and not binding on the taxpayer. So, until the IRS finalizes this regulation — wait a minute. It’s been 1984 when it’s issued, 1984 to 2019. That’s 35 years it’s been in proposed form. But the IRS, in its proposed regulation, has recognized this disconnect and therefore, so it’s a tacit recognition by the Treasury Department that you can use market rates and other factors — legitimate loan factors — to value the note in the gross estate when you later dispose of it.

Conclusion of Utilizing Code Section 7872

So the conclusion is, even if you value it at a discount, you’re entitled to value it under the discount because the split-dollar regulations under 7872 say in valuing the split-dollar loan, we will use general estate tax principles and general estate tax principles look at market rates and all the other facts and circumstances. So until the IRS finalizes this proposed regulation, we’re entitled to value these promissory notes at a discount for estate tax valuation purposes, or if you later make a gift of it for gift tax valuation purposes; and the IRS cannot go back and say it was not a transfer for full and adequate consideration. So therefore, you’re exposed to 2036 and 2038. Very simplistically, I tried to lay it out. I always said that in teaching tax to my students, I always say “What’s the difference between teaching tax to law students and first-graders in elementary school?” And the answer is none. With that, I hope I’m able to kind of lay it all out for you in very simplistic terms and therefore, I think the IRS position in these split-dollar loan transactions, Morrissette and Cahill, cannot take the position that a note issued in full compliance with rulemaking regulations is not for full and adequate consideration. Thank you.

Thank you, Jerry. Thank you for your presentation on 7872.

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