Freeze an Asset's Value With an Installment Sale: Tax Lawyer

By Allison Bell

Conversation December 26, 2023 at 02:08 PM

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If you help high-net-worth clients transfer businesses, valuable homes or Rembrandts, you could consider the installment sale option.

Jack Elder wants financial advisors, estate planners, life insurance agents and others to keep the idea at the back of their mind when talking to clients who might have estate tax concerns.

Elder, a tax attorney who serves as the senior director of advanced sales at CBS Brokerage, said in a recent email interview that the installment sale strategy might work a lot better for some clients than for others.

"You need a family that's concerned about estate taxes and orderly transfer of their wealth, and has income-producing, appreciating assets," he said. "The family also needs to be comfortable with an elevated degree of complexity."

But, if a family has an appetite for undertaking a sophisticated wealth transfer technique, and it sells a valuable asset to a grantor trust for installment payments, the arrangements "can produce eye-popping transfer tax savings," Elder said.

What it means: Given that, on New Year's Day 2026, the federal estate tax exemption rules could go back to what they were in 2017, this might be a good time to think about the installment sale strategy and other estate planning strategies.

In just two years, the ordinary estate tax exemption for a couple could fall to about $7 million per spouse.

For a U.S. client's nonresident alien spouse, the estate tax exemption is already just $60,000 — barely enough to cover a typical high-net-worth client's cars.

The installment sale strategy: If you get $50,000 in dental work, you might arrange to pay the dentist in installments of $5,000 per year over 10 years, rather than paying the $50,000 in one lump sum.

Similarly, wealthy parents could transfer a business or other valuable asset to children or grandchildren through an installment sale process, in exchange for a series of payments, rather than in exchange for one lump sum.

The Internal Revenue Service discusses installment sales in documents such as Topic No. 705, Installment Sales and Installment Sales: Real Estate Tax Tips.

Typically, when families use installment sales in estate planning, the parents sell an attractive asset to a grantor trust, with one or more children, grandchildren or other members of later generations named as the trust beneficiaries.

The trust buys the asset using cash provided by the parents, through a transaction structured by a note — a debt security requiring the trust to pay off the note, at a specified interest rate, by a specified deadline.

The trust then makes installment payments, in accordance with the terms of the note, to pay off the note.

The value of the note is about the same as the value of the transferred asset at the time the installment sale begins.

For estate tax purposes, the transaction freezes the value of the asset at the value of the note.

If the value of the asset rises, the increase affects the wealth of the trust beneficiaries, not the value of the parents' estate.

The thinking: Through the email interview, Elder answered questions about installment sale transaction details. The answers have been edited.

THINKADVISOR: What kinds of assets are the best candidates for installment sale transactions?

JACK ELDER: In an installment sale transaction, the grantor sells an asset (or assets) that generates income that will appreciate rapidly in exchange for note. …

The swifter the appreciation, the more effective the transaction.

Additionally, the assets in play may be discounted, which provides further wealth transfer.

Does it matter whether the grantor trust makes the early installment payments using principal or income?

In an installment sale to a grantor trust, the grantor sells assets to the trust in exchange for interest and principal.

When I am asked to review these transactions, I sometimes see principal being paid during [the parents'] life — often with the very assets forecasted to appreciate so rapidly.

Pulling these assets back into the taxable estate undermines the transaction's efficiency.

Paying principal can reverse any discounts, too.

I am not stating that principal shouldn't be paid, but I am saying that practitioners should model interest-only designs that show paying off the principal at passing, too, because this design usually results in lower estate taxes.

From a math perspective, you do not want to pay off the note with assets that will experience rapid appreciation.

That said, a planner may feel it necessary for a variety of reasons to pay off principal during life.

Can the family use life insurance to help the grantor trust make the installment payments?

Yes. At a minimum, the parties should model the transaction with life insurance equal to the outstanding note, to determine if it provides an enhancement.

Life insurance is the financial product of choice in two different scenarios that overlap and work together in an installment sale to a grantor trust.

Those two scenarios are, first, covering outstanding debts, and second, efficient wealth transfer.

First, the trust has a debt to the grantor that the trustee must pay eventually.

If the trust doesn't have a liquidity source to pay off the debt, the trustee may be forced to use the same assets the family intended to transfer via trust to pay off the debt to the estate.

"In-kind" payments could spell doom for the plan, because it puts those highly appreciating assets back in the estate.

Alternatively, the trustee needs to sell or borrow against those assets to pay off the note.

Including life insurance is crucial to protect the planning.

Second, life insurance is the ideal financial tool for wealth transfer.

Including life insurance as an asset class in multi-generational portfolios is a no-brainer if the internal rate of return on the death benefit at — and a few years beyond — life expectancy enhances the portfolio returns.

The return on permanent life insurance lies in the eventual payout of the death proceeds upon the insured's death.

As an asset class, the timing of the return — at mortality — differentiates insurance from stocks, bonds, real estate, alternatives, etc.

A "leave on" mentality means the clients have a multi-generational perspective and are thinking about the impact they want to "leave on" their heirs.

Families engaged in estate freeze techniques already have this multi-generational, leave-on perspective.

These families can easily view insurance as an asset allocation, rather than an expense, once they understand that insurance provides the family with a substantial income and estate-tax-free gain with a highly competitive internal rate of return.

For instance, if the internal rate of return at life expectancy is 8% and the client is in the 40% bracket, that's a tax equivalent yield of 13.3%.

That return profile will enhance any leave-on portfolio.

In summary, permanent life insurance provides highly predictable, stable returns that provide a safety net to protect the installment sale technique, secure the wealth transfer plan and provide a competitive internal rate of return.

What would the alternative installment strategies be?

The grantor retained annuity trust (GRAT) is the classic comparable strategy.

To establish a GRAT, the grantor creates an irrevocable grantor trust in which the grantor retains the right to a fixed payment for a specific term (an annuity). At the end of the annuity term, any remaining assets in the GRAT (the remainder interest) are typically passed outright or in trust to the grantor's heirs. However, should the grantor die during the annuity term, the transferred assets will be included in the grantor's estate.

The GRAT technique allows the grantor to transfer substantial value to the trust with low immediate gift tax consequences, since the grantor is treated as having made a completed gift at the time the GRAT is established equal to the value of the property transferred less the value of the retained annuity interest.

Both the sale to the grantor trust and the GRAT are "circular," in the sense that the grantor is advancing appreciating assets in exchange for something.

In the case of the installment sale, that "something" is principal and interest; in a GRAT, it's annuity payments.

Because a grantor trust is not recognized as a separate taxpayer from its grantor, neither transaction generates any income taxes.

In both transactions, if the transferred asset outperforms the "hurdle rate" (i.e., the interest rate in a sale or the annuity rate in a GRAT), you're removing appreciation from the reach of the U.S. transfer tax system.

These transactions are effective from an estate tax perspective but intentionally defective (i.e., disregarded) from an income point of view.

Who can help clients set up installment sale transactions?

An installment sale to a grantor trust is a sophisticated transaction that combines an installment sale and a trust arrangement that entails the sale of assets by the grantor to a trust established for the benefit of designated beneficiaries.

An experienced estate planning attorney needs to draft the agreements.

However, in my experience and observation, few law firms provide the financial models to go with the documents.

Modeling the transaction mathematically is crucial to good decision-making.

How can advisors determine which clients will benefit from an installment sale strategy?

It's crucial to model the strategy from multiple perspectives.

The plan should be demonstrated visually as a flow chart and mathematically to confirm it can accomplish the client's goals.

Moreover, detailed modeling with explanations in everyday language is critical to ensure the client understands the transaction.

In my career, I have worked with wealthy families that didn't want to engage in high-level wealth transfer techniques because it was too complicated for them.

I refer to this as running up against their "complexity ceiling." When I hit a family's complexity ceiling, I emphasize approaches they may be more comfortable with, such as insurance planning, strategic gifts, valuation discounts, etc.

What kinds of operational challenges should installment sale designers consider?

I categorize the concerns into two buckets: controllable and uncontrollable.

The controllable problems are related to plan establishment and administration.

An installment sale must have all the trappings of an arm's length transaction.

What interest rate is charged?

Is the trust/purchaser appropriately capitalized?

Were the sold assets valued correctly?

Is there a demonstrable intent to pay the debt?

The client's advisors should plan for the controllables at the outset.

Failure to adequately address and administer these elements would lead to an undesirable outcome.

These pitfalls are within the planning team's control, but there is concern outside their control, too.

The success of the strategy lies in the incongruity between the income and transfer tax laws.

A growing number of policymakers question whether these tax savings are appropriate, which is leading to a push from specific segments for a change to the grantor trust tax laws to eliminate the incongruence between the income and estate tax rules.

How often do problems with installment sale transactions come up, and how easy are any problems to address?

Fortunately, the families I have worked with that engage in this level of planning have kept their plans on track.

Planners can remedy most mistakes that do occur.

Most errors occur when the trust and grantor fail to account for interest payments.

I want to emphasize my earlier point: The transaction must have all the trappings of an arm's length sale.

If an essential component — transaction documentation, how interest is handled, whether the trust is appropriately capitalized, any valuation issues, intent to pay principal, etc. — is missing, it weakens the position that the transaction is an installment sale.

At this point, the transfer stops looking like an installment sale and starts looking like a gift.

Jack Elder. Credit: CBS Brokerage

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