All posts in Grantor Trusts

08 Apr

What Do You Mean It’s Defective? How You Can Benefit From Intentionally Defective Grantor Trusts

In Grantor Trusts by admin / April 8, 2013 / 0 Comments

Estate Planner Jan-Feb 2001

Would you use a product or service that is intentionally defective? Probably not, but an increasingly popular estate planning technique uses an intentionally defective grantor trust. This is an irrevocable trust that you purposely create to be complete for federal transfer tax purposes but incomplete for federal income tax purposes, thus the term “intentionally defective.” The IRS treats you, the grantor, as the owner of the trust’s assets only for income tax purposes.

Use this trust as an effective estate-freezing device by selling assets to the trust in exchange for the trust’s installment note with a reasonable market rate of interest — currently between 8% and 10%. Typically, the subject assets are stock, membership or partnership interests in a closely held business, real estate, or marketable securities. The assets generally have significant growth potential. Let’s take a closer look at how intentionally defective grantor trusts work and then examine how the estate-freeze technique might benefit you.

How These Trusts Work 

When you acquire or retain certain powers or interests in a trust you create, the Internal Revenue Code treats you as the owner of the trust’s assets for income tax purposes. For this type of trust — known as a grantor trust — the IRS will attribute the trust’s income, deductions and credits to you — as the trust owner — even though the trust instrument distributes or accumulates trust income in the trust for the benefit of another person. So you are liable for tax on both the trust’s ordinary income and capital gains. If the trust is properly drafted, trust assets will be excluded from your estate for estate tax purposes.

The IRS will consider you the owner of trust property for income tax purposes if you or your spouse:

  • Has a reversionary interest in trust income or principal exceeding 5% of trust value,
  • Retains certain prohibited powers exercisable by you or a nonadverse party (or both you and a nonadverse party) that can affect the beneficial enjoyment without an adverse party’s approval or consent. An adverse party in this context is any person with a substantial interest in the trust who would be adversely affected by the exercise or nonexercise of this power,
  • Retains certain prohibited administrative powers or the right to revoke the trust, or
  • Can benefit from trust income.

You can create a defective grantor trust if:

  • You have the power in a nonfiduciary capacity to reacquire trust corpus by substituting property of equal value,
  • You retain the right in a nonfiduciary capacity to sell trust assets or change the nature of trust assets,
  • You are related or subordinate to more than half the trustees, and they have power to distribute income or corpus among the beneficiaries,
  • A nonadverse party, such as the trustee, has the right to add beneficiaries other than children born after the creation of the trust to the trust,
  • You may use the trust’s income to pay your life insurance premiums provided the trust owns such insurance,
  • You can pay the trust’s income to your spouse, or
  • You retain the power to borrow trust assets without adequate security.

The Estate-Freeze Technique In Action

The objective of an estate freeze is to place a ceiling on the current value of an asset in your estate and to shift all future appreciation to family members while paying a minimum gift tax. How do you do this? If you sell an asset to the grantor trust at fair market value, there is no gift tax and all future growth in value belongs to the trust.

For example, suppose Steve owns all stock in a business worth $2.5 million with a positive growth outlook. Steve creates a trust for the benefit of his children and grandchildren that is defective for income tax but not for estate and gift tax purposes. How? By including the power to reacquire the trust property by substituting assets of equivalent value or to borrow trust assets without providing adequate security.

Steve initially funds the trust with a cash gift of $250,000. The gift equals about 10% of his business’s stock value — the assets that are to be sold to the trust — and many estate planners recommend providing liquidity to the trust apart from its interest in the purchased stock. The contributed cash represents a taxable gift to the trust’s beneficiaries — a gift that may or may not be within Steve’s gift and estate tax applicable exclusion amount. Steve then sells his stock to the trust for full and adequate consideration, receiving a 10-year installment note for $2.5 million from the trust with interest at the applicable federal rate.

The sale of the stock generates no taxable gain to the trust in the estate-freeze technique. The IRS doesn’t recognize any gain or loss in transactions between you and a defective grantor trust because the trust is not an entity separate from you. If the sales price is fair, the transfer of stock to the trust isn’t subject to gift tax because fair and adequate consideration will have been paid. When you die, only the value of the note should be included in your estate. Any increase in stock value held by the trust and the income generated by it will escape estate tax. You can further reduce the value of your estate by the amount of tax you pay on trust income. And the tax payment is effectively a tax-free gift to beneficiaries because they receive the trust income but you — as the grantor — pay the tax.

Is a Defective Grantor Trust Right for You?

Using a defective grantor trust offers you the opportunity to transfer substantial assets at a reduced tax cost compared to continuing to hold appreciating assets. Defective grantor trusts also allow you to transfer the future appreciation in assets to your children or grandchildren at minimal transfer tax cost. If you have questions about the use of defective grantor trusts, please give us a call. We’d be happy to explain how a “defective product” can work in your favor.

The objective of an estate freeze is to place a ceiling on the current value of an asset in your estate and to shift all future appreciation to family members while paying a minimum gift tax.

08 Apr

If It Ain’t Broke, Break It! Intentionally Defective Grantor Trusts Can Lead to Tax Benefits

In Grantor Trusts by admin / April 8, 2013 / 0 Comments

Estate Planner Jul-Aug 1998

In creating a trust, it is desirable, or at least logical, to avoid being taxed on trust property or trust income. In certain situations, however, an individual may actually benefit from retaining the tax burden of the property. To realize these benefits, the trust agreement can be drafted as a grantor trust.

What Is a Grantor Trust?

If a grantor exercises or retains enough control over trust assets, he or she is treated as the owner for income tax purposes. This is a grantor trust. Since the grantor retains these limited controls, he or she also retains certain tax savings. For income tax purposes, it is as if the grantor never contributed the property to the trust. For estate tax purposes, though, the transfer of the property can be treated as a completed gift, thereby removing the property from the grantor’s estate.

Intentionally Defective Grantor Trust

When an individual sets up a grantor trust so that he or she is taxed on the income generated by trust property, it is called an intentionally defective grantor trust (IDGT). There are several income tax advantages that can justify employing an IDGT:

A lower tax rate may be imposed. The highest marginal tax rate for both trusts and individuals is 39.6%. However, a trust reaches that tax bracket at $8,350 of income, while a married individual filing a joint return is not taxed at that rate until income reaches $278,450. Therefore, if the grantor wishes to create a trust, but avoid the 39.6% tax rate on trust assets, an IDGT may be a good idea.

Trust income may be offset. If the grantor has substantial current net operating losses, the income generated from the trust can be absorbed. If net operating losses have been carried forward for a number of years, they can now be used. Similarly, the grantor may be able to use large charitable deductions to offset the trust income.

The grantor can make leveraged gifts to trust beneficiaries tax-free. Since the grantor is paying the income tax on trust income and capital gains, trust assets will grow and accumulate without being reduced by taxes, and distributions can be made to the beneficiaries free of income tax. However, the Internal Revenue Service may argue that the payment of taxes is a gift to the beneficiaries and subject to gift tax.

The grantor can engage in transactions with the trust tax-free. Why? Because the grantor is treated as the owner of the trust, and the grantor is — in substance — dealing with himself or herself. For example, the grantor may sell an appreciated asset to the trust in exchange for a promissory note. In doing so, the grantor removes the asset from his or her estate — including all future appreciation. The grantor’s estate will include the present value of any remaining payments on the note plus the payments received before the grantor’s death. However, the grantor reports no gain on the sale and no income from the payments, and the trust receives no interest deductions.

Consider Using an IDGT

The grantor trust is a viable tax planning tool. It can be used to remove property from the grantor’s estate while allowing him or her to maintain limited control over the property and use suspended losses and deductions to offset the trust income. Call us to see how a grantor trust might be effectively employed in your estate plan.


How To Create A Grantor Trust

You can create a grantor trust if you retain certain interests or powers over the trust that are more than merely administrative. For example, if the you retain the power to substitute trust assets for other assets of equivalent value, the trust will be deemed a grantor trust. You also can establish a grantor trust by retaining the power to add beneficiaries. In both cases, the property you transfer to the trust will not be included in your estate but will be taxed as income to you. A person other than the grantor can, under certain circumstances, be treated as the grantor, but only if the actual grantor is not treated as such.

Also, if you retain the power to revoke the trust and get back the property, creating what is known as a revocable or living trust, the trust will be considered a grantor trust for income tax purposes. If you transfer property to a revocable trust, however, the property will be included in your gross estate for tax purposes.