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.