Financial Solutions

Financial Solutions

Financial Solutions

Financial Solutions

May 30, 2017

Utilizing Grantor Trusts

When properly drafted, grantor trusts can be a powerful tool for estate planning and wealth transfer.

A grantor trust is any trust for which the grantor retains certain powers to control or direct trust assets. As a result, the grantor is treated as the owner of trust property for income tax purposes and the income tax liability of the trust passes through to the grantor’s return. The term “grantor” refers to the person(s) who fund(s) a trust. In the context of grantor trusts, however, the grantor is also the “owner” of the trust for income tax purposes. The grantor trust rules, found in §§671-679 of the Internal Revenue Code, establish parameters for determining grantor trust status. These rules describe the controls that, if retained by a grantor, will incur grantor trust treatment. Estate planners can therefore draft trusts to incur or avoid such treatment.

Grantor trusts are not always suitable. Grantor trusts incur an often undesirable result—tax liability for an individual. There are times, however, when creating a grantor trust can be beneficial. Grantor trusts can be powerful tools for estate planning and wealth transfer. A grantor trust can allow the grantor to “gift” income tax payments on trust property, transact efficiently with the trust, claim trust losses or deductions on personal income returns, or transfer assets in a tax-efficient manner. Grantor trusts, therefore, can be highly effective when applied in the appropriate circumstance.

The grantor trust rules operate through two steps: §§ 673-679 identify parties as “owners” of trust portions for which they have retained interests or controls, while § 671 describes the consequences of ownership. When trusts are drafted carefully, these rules allow for an opportunity to shift income tax liability between parties while still accomplishing underlying legacy goals. This can be helpful for a few reasons. First, trusts are taxed at a compressed rate, reaching the highest income tax brackets at $12,000. Thus, benefits can stem from shifting income tax liability from a trust to an individual. Second, individual income tax liability for assets allocated to beneficiaries can be desirable for two reasons. The tax payments on trust property serve as a “gift” to beneficiaries, while these payments simultaneously reduce the taxable estate of the grantor. Additionally, techniques can allow for tax-efficient asset transfers while providing a level of flexibility to adapt as circumstances or tax laws change. In addition, thoughtful planning and attention to the grantor trust rules can provide asset protection benefits while ensuring tax neutrality as well.

An example of an estate planning tool that utilizes grantor trust status is the “Intentionally Defective Grantor Trust”. Despite its name, there is nothing defective about this trust. An IDGT is an irrevocable trust that intentionally runs afoul of the grantor trust rules, yet remains effective for estate and gift tax purposes. IDGTs can provide a flexible and efficient way to transfer closely-held business interests or other low-basis assets efficiently. Under the trust agreement, the grantor makes a gift while retaining powers to ensure both flexibility and grantor trust treatment. Such powers often include the ability to borrow or purchase assets from the trust. The grantor transfers assets out of his or her taxable estate while maintaining ownership for income tax purposes. The grantor is able to gift assets for the benefit of family members and reduce his or her taxable estate, while retaining the ability to utilize trust assets in a tax-efficient manner. For individuals looking to “freeze” the value of certain assets that are part of their estate, or for those who are in need of liquidity, the IDGT can be used to effectuate a sale or loan between the grantor and the trust in a tax-efficient way.

Grantor retained annuity trusts (GRATs) are another planning tool that can assist with transferring assets while minimizing estate and gift tax. In a GRAT, a grantor transfers assets to the trust and retains the right to receive a fixed annuity payment for a term of years. At the end of the term, remaining assets pass to designated beneficiaries. This strategy is a useful tool for efficient asset transfer, particularly when gift tax exemptions have been used or are of primary concern. A GRAT is a one-time gift of assets, calculated by formula as the present value of the remainder interest in those assets. An annuity stream is paid back to the grantor from the trust over a term of years. Any appreciation of the trust assets that exceeds federal interest rates over the term passes to the beneficiaries tax-free. The grantor must outlive the term of the trust to complete the gift. If the grantor survives the term, the assets are out of the grantor’s taxable estate. The grantor, meanwhile, receives a steady income stream while assisting asset appreciation by shouldering the income tax liability. 

GRATs and IDGTs are simply examples of the tools available through strategic use of the grantor trust rules in estate planning. Proper trust planning, with a focus on your unique family and goals, can provide a number of important benefits. Speak with your advisor and an attorney to ensure that your plan is effectively and efficiently meeting your family’s objectives and expectations, both now and in the future.

© Morningstar 2017. All Rights Reserved. Used with permission.

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