Philanthropic Options for Promissory Notes used in Testamentary Wealth Transfers to Family Members


Last September, our CTAC eNewsletter Advisor Corner carried an article entitled, “Philanthropic Options for Transferring Wealth to Family Members.” Readers learned about the unusual Private Letter Ruling recently released by the IRS (PLR 201129049).

In the ruling, the IRS dealt with a private foundation’s receipt of a promissory note, that a closely-held corporation planned to give the foundation, in redemption of non-voting stock left to the foundation by a descendant's estate. Promissory notes are also widely used in family wealth transfer plans, and our focus here is to highlight where some careful vigilance may be required when incorporating these notes.

For example, a common estate freezing technique utilizes a promissory note in combination with the so-called Dynasty Trust, or the intentionally defective irrevocable trust (IDIT). After an individual creates and funds the IDIT, he or she typically takes back a promissory note. If your client is charitably minded, their estate plans may ultimately include the testamentary transfer of their promissory note to a charitable lead annuity trust (CLAT), or to a private foundation.

Professional advisors recommending the use of a testamentary CLAT or private foundation know that these vehicles are governed by the self-dealing rules. It is also important to remember that under the self-dealing rules, when a pre-existing note with a disqualified person drops into the CLAT or private foundation, you still have to go to court to swap the note out for a new, identical note, to avoid self-dealing problems longer term. 

Testamentary CLAT versus Private Foundation

Does a testamentary CLAT funded with a promissory note have any real benefit over a private foundation funded with a promissory note? If the client’s surviving children plan to use a promissory note to buy the estate assets, purchasing those assets from a private foundation with a promissory note means that the interest payable on the note will be the applicable federal rate (AFR) under IRC §1274(d). On the other hand, however, the CLAT uses the interest rate under IRC §7520, which is 120% of midterm AFR. The IRC §7520 rate is almost always higher than even the long-term AFR.

Typically, advisors design the testamentary CLAT to earn only the required AFR from the note, but the interest rate applicable to the charitable payout is the higher IRC §7520 rate. So, most CLATs funded with these notes would likely run out of money before the end of the CLAT term!

So, when your charitably-minded client is likely to leave an estate that includes a pre-existing promissory note, it is noteworthy to consider using a private foundation, instead of a CLAT, to handle the note. Why? The surviving children will have a better chance of sharing the same economic benefits that the private foundation enjoys.

By: Dan Rice, Co-founder of CTAC

Back to the December 2011 eNewsletter