How an Intentionally Defective Grantor Trust Can Benefit You
Usually when we hear the word “defective,” we think about an umbrella that doesn’t open, a dangerous children’s toy, or perhaps our last car. And these are generally never defective by design. But inserting a carefully chosen defect in a trust agreement can bring big tax benefits when the trust assets involved are large enough.
What is a Grantor Trust?
A grantor is generally the party who funds the trust for future distribution to beneficiaries. Sometimes the grantor continues to control the trust assets even after putting them into the trust. This situation gives rise to a “grantor trust,” where the party funding the trust also has to pay tax on the trust as well as include those assets in his/her estate.
Recall that one major reason high net-worth families use trust is to reduce the estate tax their heirs may face once they pass on. The US tax code currently allows you to pass on to heirs up to $11.4 million per individual or $22.8 million per married couple without incurring an “estate tax,” which can chop up to 40% off your estate’s value over those amounts when you die.
When you make an irrevocable gift to a trust for someone else’s benefit, the amount given directly reduces your taxable estate. So if a married couple had a $25 million estate, for example, and puts $3 million into an irrevocable trust, the remaining assets fall below the $22.8 million thresholds and thus below the level that would incur estate tax. Of course, a gift is a gift. That money now belongs to heirs rather than the grantors.
Trusts Don’t Necessarily Save Taxes
Usually, an irrevocable trust has to pay its own taxes on any income it earns yearly, including a tax on capital gains. And trust tax rates are far from generous. In fact, a trust only has to earn $12,500 in regular income (2019 rates) to incur the highest US federal marginal tax rate of 37%. Compare that to a married couple filing jointly, who do not hit 37% until their regular income reaches $612,350.
What?! Yes, the tax code is far more favorable toward individual income than trust income. On the other hand, if a trust is revocable and thus stays in the grantor’s estate, income is taxed as if it had been earned by the grantor. What if you could have the best of both worlds? Now we get to the main thrust of this article.
An IDGT Can Separate Estate Tax from Income Tax
Recall that to complete a gift to a trust, you have to let go of all control. You can’t take the assets back later if you change your mind or direct the investments toward your own benefit. But if you retain control over the assets in the trust, the IRS may consider the assets still to be part of your estate. And they will certainly consider the trust taxable to you.
Here is where you have an advantage, though: the rules that determine whether assets form part of your estate differ from those that determine who must pay taxes on the income. An intentionally defective grantor trust document includes a minor instance of grantor control that triggers the income tax rules without also triggering the estate tax rules. In other words, you can cause the IRS to tax all income to the trust at your grantor tax rates and still reduce your taxable estate by the amount of your gift.
Why Would a Grantor Want to Keep Paying Taxes?
The obvious reason to use an IDGT is the difference between personal income tax rates and trust tax rates mentioned above. If you want to leave more money to heirs after maximizing your transfer tax exclusions, reducing the tax bite can really help them over time.
But there is an even more popular use of IDGTs that ultra-high-net-worth families take advantage of when they have a closely held business. And it may permit you to give beyond the transfer tax maximum through a sort of “back door,” provided you expect your business to continue growing in value. In other words, the grantor desires the ability to transfer potential appreciation to younger family members at a reduced federal gift tax cost.
Transferring a Closely Held Business to an IDGT
Say you as grantor owns a closely held business and that it is your intention to transfer partial ownership to beneficiaries. You can use an IDGT to reduce your estate’s ownership of the business as well as avoid taxes on this transaction, even if you exceed the excludable amount.
Remember that as long as the trust is still considered a grantor trust, you are paying the taxes. So any “taxable” transaction is from you, to you. So you don’t end up incurring an additional tax liability on transactions with yourself.
To transfer partial business ownership to the IDGT, you’d start by giving the trust some “seed money” (up to the maximum exclusion amount). Then you would “sell” part of your business to the trust for cash, writing a promissory note for any additional amount beyond the available cash. This note would have repayment terms and a market rate of interest, paid to you, and thus not taxable.
Because the above transaction forms a sale, the only true “gift” so far is the seed money, so the additional value given is not in excess of the exclusion amount. As long as the business grows its cash flow faster than your interest rate, the trust benefits from the differential, and if the company’s value increases, tax on that growth is deferred until sale.
Selling Shares at a Discount
There is another benefit available if you sell less than a controlling interest to the IDGT in the above scenario. When a closely held business sells a so-called “minority interest,” there is a customary value reduction applied for estate tax purposes. In theory, 30% of a business is worth less than 30% of the total company because it carries no rights to direct management and because it cannot be sold easily.
This paper reduction in value helps reduce the amount of the cash/promissory note required to transfer the ownership interest to heirs. If the business is sold at full value, however, the entire amount of cash goes into the IDGT. The sale takes place after the transfer, though, so any excess avoids the exclusion limitations.
Is an IDGT Right for Me?
The above-simplified discussion of IDGT benefits and tax consequences is not meant to be a complete guide. You will need the help of a qualified estate attorney and probably also a tax advisor to structure the trust and build your asset transfer effectively. For example, the IRS may contest your discount on a business sale. So you need to proceed carefully.
Alpha Fiduciary has an estate attorney, trust company, and CPA contacts if an IDGT is of interest to you. We’d also like the chance to discuss how an IDGT fits within your overall family wealth management picture. We serve our clients as a fiduciary advisor and take pride in our fee-based, independent approach. To schedule a no-obligation call today, just click on the link.