The SCIN-GRAT: Combining a Bet-to-die Technique with a Bet-to-live Technique

Some estate planning techniques work better the shorter a person lives and others work better the longer a person lives.  An interesting twist is to combine a bet-to-die technique with a bet-to-live technique.  With the ideal combination, each competing technique acts as a hedge against the other technique so that no matter when the person dies, the combination of techniques produces a favorable result.

One popular technique involves an installment sale of discounted assets to a dynasty trust.  Specifically, the person makes a gift to a dynasty trust which is a long-term irrevocable trust that continues for as long as applicable state law allows without any estate taxes and without its assets being subject to the creditors of the trust beneficiaries.  

The gift is followed by an installment sale of discounted assets, such as minority or non-voting interests in a limited liability company, corporation or limited partnership, to the dynasty trust.  The minority or non-voting interests are appraised by a business valuation appraiser at a discount from pro rata value of the underlying assets to reflect a lack of voting control and to reflect that there is little market for an interest in a closely-held business entity.  The installment sale is income-tax free since the dynasty trust is drafted as a grantor trust for income tax purposes.

Rather than use a traditional installment note, another option is to use a SCIN.  A SCIN is just like a regular installment note except that it includes a self-cancellation feature that cancels all remaining interest and principal owed if the seller dies before the end of the term of the SCIN.  This possibility of a "home run" for the family if the seller dies before the end of the term of years of the SCIN requires the note to carry either an interest rate premium or a principal premium to "pay" for the self-cancellation feature.  Since the premium is paid by the dynasty trust to the seller, the family doesn't pay this to a third-party financial institution.

The older the person, the larger the interest rate premium or principal premium must be.  If the person outlives the term of the SCIN, the family would have been better off using a traditional promissory note rather than a SCIN since less would have been paid back to the individual's estate.  Thus, a SCIN is a bet-to-die technique.  How can we hedge the risk that the person will outlive the term of the SCIN?

We can hedge the SCIN sale by combining it with a GRAT.  A GRAT is an irrevocable trust in which the grantor makes a gift and retains a stream of annuity payments generally for a term of years.  If the grantor survives the term of years, then the entire trust is outside of the grantor's taxable estate.  Thus, a GRAT is a bet-to-live technique.

Specifically, sometime after making the gift and SCIN sale described above, the individual will transfer the SCIN and some additional assets to a limited liability company ("LLC") taxed as a disregarded entity.  Since it's taxed as a disregarded entity, the transfer of the SCIN to the LLC won't trigger a taxable event on the SCIN sale.  

The LLC is structured with 1% voting shares and 99% non-voting shares.  The individual will gift the 99% non-voting shares to a GRAT.  A business valuation appraiser will appraise the gift and apply an appropriate valuation discount to reflect that the gift is of a non-controlling interest in a closely-held entity.  The trustee of the GRAT will use the distributions from 99% of the LLC (that owns the SCIN and other assets) to make its annuity payments to the Grantor.

Regardless of whether the individual dies young or lives a long life, the series of transactions works well to move significant wealth out of the individual's estate.  If the individual dies young, the SCIN sale works well and the failure of the GRAT doesn't matter much.  If the individual lives a long life, the SCIN generally works fairly well and the GRAT works very well.

Whether the individual is young or old, the SCIN-GRAT is a technique that should be considered in many circumstances.  In fact, it is often so effective that the estate planner needs to be extremely carefully not to overdo it and leave too little wealth in the individual's estate.  Rather, the careful planner will make sure that the individual has sufficient wealth outside of the wealth used in the SCIN-GRAT transaction to sustain his or her lifestyle after the term of the GRAT.  Thus, sufficient care must be taken in implementing this powerful technique.