Round Two: PDT Battle of the Aronyms
Over the last two months, I introduced this battle and the leading contender GRAT. Our underdog, PDT, converts a defect into a strength that makes her a versatile, flexible fighter; but she does have her vulnerabilities. This month, I'll cover her strengths and weaknesses, to be followed next month by a direct face off between these two leading estate planning contenders.
PDT actually is the acronym for a nickname, Perfectly Defective Trust, because she's not in the registered-candidate rule book. Well, that s not exactly true. She uses expressly permitted tactics, but the referee (the IRS) has not explicitly sanctioned their combination. That uncertainty compares unfavorably to GRAT, which is unequivocally approved by the authorities.
Let's go for a behind-the-scenes look at this contender.
PDT's subtle elegance is that she turns an ostensibly punitive income tax law on its head to create income, gift and estate tax savings. If her trust instrument includes a carefully selected provision, the trust becomes defective for income tax purposes, but remains effective for gift and estate tax purposes. That means the trust is ignored for income purposes and its income is taxed to the grantor (its creator). But, its assets are not included in the grantor's taxable estate.
GRAT does the same thing, but we need to go one step further to reveal PDT's greater strength. Transactions between the grantor and PDT are ignored for income tax purposes. So, you can sell family business stock or other assets to PDT without being taxed on the gain. Assuming PDT issues a note to buy the stock, the trust benefits from future dividends and appreciation in excess of the interest rate on the note.
Follow the Money Trail
PDT offers stunning flexibility in structuring the note terms. You can minimize and defer principal payments so that assets are left in the trust longer to appreciate for the beneficiaries. A typical note might provide a 15-20 year payment term, minimal principal payments in the early years, and a balloon payment at the end. Financial modeling with your fact situation is crucial to understand the benefit.
PDT can transfer wealth (including income and appreciation) to grandchildren and later generations without generation skipping tax. You simply have to apply your generation skipping exemption against the seed capital gift, which is discussed below.
And, unlike GRAT, you can die whenever you want without causing PDT's assets to be taxable in your estate!
What happens if the IRS successfully challenges the value of the stock that you sold to PDT? You would have a taxable gift to the extent that you under-priced the stock. Some advisors incorporate a purchase price adjustment clause, which attempts to retroactively adjust the price to offset such a challenge. However, IRS hates them (both the clause and advisors who use them) and the courts seem to be following the IRS position.
Seed Capital Gift
Most advisors believe PDT must be funded with a gift of cash or property to make it a substantive buyer. I call this seed capital. Nobody knows how much, but most bookies believe PDT has the best chance of withstanding an attack if its debt-to-equity ratio is no greater than 9 to 1. So, if you re really wealthy, you and your spouse could use your lifetime exemptions to give $2 million to PDT, which then could support a purchase of $18 million worth of family business stock. You could sell additional stock in later years as PDT's net worth increases.
Although the initial seed capital must be reported as a gift, cash would not raise any eyebrows. More importantly, the sale transaction does not have to be reported. Imagine the referee taking an extended coffee break and missing the action! The trade-off is that the statute of limitations will never run, so IRS has an unlimited time period to challenge PDT if it ever figures out she was in the fight.
IRS has informally mumbled that it may challenge some provisions used to make PDT defective for income tax purposes but effective for estate tax purposes. The mumbling is so garbled that we cannot be sure whether the potential challenge is the income or estate tax arena or both.
For example, a power of substitution, which merely grants someone the equivalent of the right to purchase assets from the trust for their fair market value, is an effective defect. But, IRS policy is that only an IRS agent in the field can make that determination. We have virtually no clue as to what the agent will consider to be important. As to estate tax consequences, it is difficult to understand how a grantor's ability to swap assets of equal value somehow causes estate inclusion, but a recent private letter ruling was cleverly worded to raise some doubt. So, some advisors have become a bit queasy with the power of substitution.
Death s Disadvantages
If the grantor dies, the IRS might argue that there is a taxable gain for the excess of PDT's liabilities (e.g., the purchase money debt to the grantor) over the basis in its assets. Live long enough and the debt might be paid down below basis. Or, give your advisors notice of your pending departure and they can arrange for the trust to pay down the debt to eliminate the risk.
So, now you have the inside scoop on each contender. Next month, we ll directly compare the two as they compete for your bet. Please retain this tip sheet you might need to refer back to it as the fight progresses.
Ross Nager is Senior Managing
Director of Sentinel Trust Company of