How lifetime business gifts and trust sales work
Key takeaway
Lifetime business interests can be transferred through gifts, grantor retained annuity trusts or sales to wholly grantor owned trusts, with separate rules for gift completion, valuation, income tax, basis and estate inclusion.
A completed gift, a qualified retained annuity and a sale disregarded for income tax purposes answer different tax questions. Gift completion does not establish annual exclusion eligibility, and income tax treatment does not establish adequate gift tax consideration or estate exclusion.
Research notice: Federal tax authorities appear in the collapsed Sources block, including the effective date conditions referenced below. Review the proposed transfer with an estate attorney and CPA before acting.
Outright gifts: completion, valuation and basis
Gift completion and annual exclusion eligibility are separate tests. A gift is complete when the donor relinquishes dominion and control so that the donor cannot change its disposition for anyone's benefit. Reserved disposition powers may leave a gift wholly or partly incomplete.
A present interest requires unrestricted immediate use, possession or enjoyment of the property or its income. Future interests generally receive no annual exclusion, subject to a separate exception for certain gifts to minors. An irrevocable trust label alone establishes neither gift completion nor annual exclusion eligibility.
Gifted business interests generally carry over the donor's basis for determining gain. For gifts made after the gift date cutoff listed in Sources, the basis increase is the gift tax paid multiplied by net appreciation divided by the gift amount. Net appreciation is fair market value at the gift minus the donor's adjusted basis immediately before the gift. The increase cannot exceed the gift tax paid or raise basis above fair market value at the gift.
For determining loss, basis is fair market value at the gift if that value is lower than the donor's adjusted basis. Spouse transfers covered by Section 1041 follow its separate basis rule.
Section 1014 may apply to gifted property only if the donor died after the death date cutoff listed in Sources, the property was included in the donor's gross estate, and the recipient had not sold, exchanged or otherwise disposed of it before the donor's death. Neither a low original basis nor a basis adjustment at death should be assumed for every business gift.
Value the interest and document the reporting
A business gift is valued at fair market value on the transfer date. The Form 709 adequate disclosure instructions call for a complete return, descriptions of the property and consideration, and the parties' identities and relationships. For a transfer in trust, include the trust's employer identification number and a description of its terms or a copy of the instrument.
The disclosure must include either a qualified appraisal or a detailed description of the valuation method. Explain the basis and amount of claimed discounts, and satisfy the additional detailed disclosure requirements applicable to special valuation transactions. These instructions establish no automatic valuation discount.
Review retained equity rights separately
Retaining voting rights alone does not justify a blanket statement that a retained interest has zero value. Section 2701's transfer rule does not apply to a transferred interest with readily available quotations on an established securities market as of the transfer date.
The retained interest exceptions cover interests with readily available quotations on an established securities market as of the transfer date, interests of the same class as the transferred interest, and proportionally identical interests. For the proportional exception, nonlapsing voting differences are ignored. For partnerships, the permitted differences concern nonlapsing management rights and liability limits.
The proportional partnership exception fails if the transferor or an applicable family member can alter the transferee's liability. Unless the Secretary provides otherwise, the specified differences that lapse under federal or state law are treated as nonlapsing for this exception.
The business valuation guide covers the broader appraisal discussion.
GRAT annuity and remainder
A grantor retained annuity trust, or GRAT, retains an annuity for the owner and transfers a remainder interest. The gift value is the transferred fair market value minus the value of the qualified retained annuity.
Section 7520 generally uses prescribed tables and 120% of the valuation month's federal midterm rate, rounded to the nearest 0.2 percentage point. An election to use either of the preceding two months is available only when an income, estate or gift tax charitable contribution is allowable for part of the transferred property. The chosen permitted rate must be used consistently for interests in the same property. No particular remainder amount is promised.
Read the payment provisions before signing
A qualified GRAT annuity must be payable at least annually. Any increase in its stated amount or percentage of initial value is limited to 20% over the preceding year.
The instrument must prohibit additional contributions, distributions to or for the benefit of anyone other than the annuity holder during the retained term, and prepayment of the retained interest. The term must be fixed at creation as the holder's life, a specified term of years or the shorter of those periods. An annuity stated as a percentage of initial fair market value also requires an incorrect valuation adjustment clause.
For anniversary arrangements, payment is due within 105 days after the anniversary. Proration is required for the final period if it is shorter than 12 months.
For arrangements based on the taxable year, payment is due by the trust's income tax return deadline without extensions. Under alternative grantor trust reporting, use the corresponding deadline that would have applied if the trustee had filed the trust return. Every short taxable year during the retained term requires proration.
The prorated amount is the annual annuity multiplied by the number of days in the short period divided by 365. Use 366 instead when the short period includes leap day.
A qualified annuity is an irrevocable right to a fixed amount, payable from income or principal. A right limited to the lesser of that amount and trust income does not qualify. Issuing a note, debt instrument, option or similar financial arrangement directly or indirectly to satisfy the obligation does not constitute payment.
For trusts created on or after the GRAT creation date cutoff listed in Sources, the instrument must prohibit the trustee from issuing a note, other debt instrument, option or similar financial arrangement to satisfy the annuity or unitrust payment obligation.
Understand death during the retained term
Death during the retained GRAT term can cause estate inclusion of the trust property needed to support the annuity. Section 2036 applies to interests retained for life, for a period not ascertainable without reference to death, or for a period that does not actually end before death, except for a bona fide sale for adequate and full consideration in money or money's worth.
The supporting corpus is determined using Section 7520 and applicable payment adjustments, without reducing or invading principal. Inclusion cannot exceed the fair market value of the trust corpus at death. For graduated annuities, the calculation includes the base amount plus the supporting corpus for subsequent payment increases, subject to the same cap.
Sales to grantor trusts: consideration and tax treatment
A transaction between a grantor and a purchasing trust is disregarded for federal income tax purposes when that grantor is treated as owning the entire trust for that tax. Income tax disregard establishes neither adequate gift tax consideration nor estate exclusion. The cited ruling supplies no conclusion about death or termination of grantor status.
A transfer for less than adequate and full consideration in money or money's worth can create a gift. Forgiving or failing to collect another person's indebtedness may also create a gift. Gift tax analysis therefore applies separately to the sale price and subsequent debt treatment.
For a trust portion treated as owned by the grantor, the grantor reports the attributable income, deductions and credits to the extent those items enter an individual's income tax computation. Payment of that personal income tax liability is not an additional gift to the beneficiaries. Any remaining trust portion remains subject to the ordinary trust tax provisions.
Review tax reimbursement before signing
Mandatory reimbursement of the grantor's trust income tax causes inclusion of the full value of the trust assets under the IRS reimbursement ruling, subject to its assumptions and transition limit. The rule applies whether the reimbursement requirement comes from the trust instrument or applicable local law.
The ruling assumes an otherwise completed gift, no other retained interest or power causing estate inclusion, and a trustee who is not related or subordinate to the grantor under Section 672(c). Discretion to reimburse, by itself, does not cause estate inclusion under those assumptions, whether or not exercised.
Discretion combined with other facts may cause inclusion. Those facts include a reimbursement understanding or arrangement, a retained power to remove the trustee and appoint the grantor as successor, or local law allowing the grantor's creditors to reach trust assets.
The IRS will not apply the mandatory reimbursement estate holding adversely to a grantor's estate for a trust created before the reimbursement transition cutoff listed in Sources.
Keeping control while transferring ownership in a family business
Retaining the right to vote stock of a controlled corporation counts as retained enjoyment under Section 2036(b). A corporation is controlled if, at any time after the transfer during the three years ending at death, the transferor owned, with Section 318 attribution, or had the right, alone or jointly with another person, to vote stock possessing at least 20% of the combined voting power of all classes of stock.
The retained interest periods under Section 2036 apply: retention for life, for a period not ascertainable without reference to death, or for a period that does not actually end before death. A bona fide sale for adequate and full consideration in money or money's worth is excepted. Relinquishment or cessation of the voting rights is treated as a property transfer for purposes of applying Section 2035.
The family LLC and partnership guide covers entity governance, operating control and family farm ownership structures.
S corporation shareholder rules for grantor trusts
A nonforeign trust wholly treated as owned by an individual United States citizen or resident can be a permitted S corporation shareholder under the specified grantor trust category. A trust qualifying immediately before that owner's death may continue under the corresponding category for two years beginning at death.
Differences solely in common stock voting rights do not create a second class of stock. These provisions do not resolve other trust categories, elections or all S corporation eligibility requirements.
The trust ownership guide covers other S corporation trust categories and elections.
Common questions
How does a GRAT differ from an outright gift?
A GRAT retains an annuity for the owner, while an outright gift transfers the interest without that retained annuity. Read the full GRAT section above for valuation conditions, document requirements and payment obligations before comparing proposals.
What happens if the owner dies during the GRAT term?
Death during the retained GRAT term can cause estate inclusion of the trust property needed to support the annuity. The calculation uses Section 7520 and applicable payment adjustments without reducing or invading principal, and inclusion cannot exceed the trust corpus's fair market value at death. Graduated annuities require the base amount plus the supporting corpus for subsequent increases, subject to that cap. The retained interest periods and bona fide sale exception are explained in the section on death during the retained term.
Do gifted business interests receive a basis step up at death?
No, not automatically: for a completed gift to an irrevocable grantor trust, grantor status alone does not adjust basis at death under the IRS ruling's facts. The ruling addresses assets outside the grantor's gross estate and outside the property categories in Section 1014(b). At death, trust liabilities did not exceed asset basis, and neither the trust nor the grantor held a note owed by the other. The ruling does not resolve an outstanding note scenario.
Section 1014 may apply to gifted property only if the donor died after the death date cutoff listed in Sources, the property was included in the donor's gross estate, and the recipient had not sold, exchanged or otherwise disposed of it before the donor's death.
Resources to check out
- IRS Instructions for Form 709: Reporting and valuation: Review reporting, valuation attachments and adequate disclosure instructions.
- Treasury rules for qualified GRAT interests: Annuity requirements: Check the annuity provisions, payment timing and valuation examples.
- Treasury rules for retained annuities at death: Estate inclusion: Review the supporting corpus computation and its limits.
- IRS Revenue Ruling: Grantor tax payments and reimbursement: Examine the reimbursement ruling, including its assumptions and transition limit.
- IRS Revenue Ruling: Basis of assets in a grantor trust at death: Read the basis holding with its factual limits.
- S corporation shareholder and trust eligibility: Permitted ownership: Review the specified trust category and common stock voting distinction.