Even the most sophisticated estate planners may be missing the point of grantor trusts. It's a risk-free, transfer-tax free, effortless wealth transfer tool that is much more powerful than most advisors realize. It amplifies the benefit of any other wealth transfer tool. In fact, grantor trusts are so effective, it could be malpractice to fail to suggest to a client that an irrevocable trust be structured as one.

A “grantor trust” is a trust of which all the income is taxable to the grantor under Internal Revenue Code Sections 671 through 679, irrespective of whether any income is distributed to the grantor. A grantor trust has no independent existence from the grantor for income tax purposes, and as a result, IRC Section 671 requires the grantor to report on his personal income tax return all items of income, loss, deduction and credit attributable to the trust.

The power of an irrevocable grantor trust is harnessed when it's used as a vehicle to transfer wealth to children and other beneficiaries. The grantor's payment of income tax on behalf of the trust reduces the value of the grantor's estate (which ultimately will be subject to estate tax) and increases — on a dollar-for-dollar basis — the value of trust property held for the benefit of his beneficiaries (which will not be subject to estate tax at the grantor's death). The trust's assets are able to grow undiminished by income taxes.

An individual retirement account (IRA) or other tax-deferred retirement plan provides a similar benefit: tax-free growth. But the benefits of a grantor trust are even greater because the tax is not just deferred until the funds are withdrawn, it's actually eliminated for the trust. A grantor trust never pays tax on the income and gains realized by the trust.

BENEFITS

In effect, the income tax paid by the grantor on behalf of the trust constitutes a tax-free gift to the trust. However, in Revenue Ruling 2004-64 (issued July 6, 2004), the Internal Revenue Service held that, when the grantor of a grantor trust pays the income tax attributable to the trust's income, he is not making a gift to the trust beneficiaries. Under the IRC, the tax is a legal obligation of the grantor and not of the trust, and the trust is not enriched by the grantor's payment of the tax. This ruling confirmed that the Service's view was the same as most practitioners'.

Prior to Rev. Rul. 2004-64, the IRS had hinted in Private Letter Ruling 9444033 (Aug. 5, 1994) that when the grantor of a grantor trust pays the income tax attributable to the trust's income, such payment might in some circumstances be treated as a gift to the trust beneficiaries. Commentators criticized the language in this ruling, noting that subpart E of subchapter J of the IRC imposes the tax liability of a grantor trust on the grantor, and that the grantor's satisfaction of his own liability cannot be a gift. A year later, in PLR 9543049 (Aug. 3, 1995), the IRS, without explanation, withdrew the offending language in the 1994 ruling. That left the Service's official position on this issue a mystery to estate-planning practitioners until Rev. Rul. 2004-64. And now that the decade of uncertainty is firmly in the past, it's time for advisors not only to embrace grantor trusts in plans they're formulating today, but also to revisit plans drafted yesteryear and see whether the grantor trust would suit them.

BENEFITS ILLUSTRATED

The benefits of a grantor trust can be demonstrated with a simple example: John Dough transfers $1 million in stocks and bonds to an irrevocable non-grantor trust for the benefit of his children. The trust's investments achieve a 10 percent annual rate of return, and, (to keep it simple) pay an income tax equal to 20 percent of the annual return (based on the trust's income tax rate and the amount of income and gains actually realized). Over the course of 20 years, the trust assets would grow to $4.6 million, assuming no distributions are made to the beneficiaries. The trust would have paid a total of $915,000 in taxes. (See “See How They Grow,” p. 27.)

On the other hand, if that trust were a grantor trust, the grantor would pay the income tax and the trust would have $6.7 million after 20 years, $2.1 million (or 44 percent) more than the non-grantor trust. The benefits of the grantor trust were magnified by the fact that the $915,000 that remained in the trust remained invested and compounded. The return is based on an ever-larger amount of trust assets compared to a non-grantor trust, increasing the disparity over time.

The greater the assets, return and amount of time involved, the more significant the difference. At a 15 percent rate of return over 25 years, the non-grantor trust would have $17 million while the grantor trust would have nearly $33 million, almost double the amount in the non-grantor trust.

In fairness, the amount that will be inherited by the trust beneficiaries from the grantor's estate (should he leave it to them) would be greater in the case of a non-grantor trust because the estate would not have been diminished by the income taxes. But those extra funds will be cut roughly in half by estate taxes before they pass to the beneficiaries.

A grantor trust can accelerate the wealth transfer process, helping a client reach the point when he feels the children have “enough.” If that objective is attained, the client can simplify his estate plan and leave the balance to a surviving spouse and to charity (perhaps even a family foundation), eliminating all estate taxes in the process. The chances of an audit — and the risk that such an audit could have any adverse consequences — dramatically decrease in such a plan because no tax would be due.

OTHER BENEFITS

By using a grantor trust, the beneficiaries may not only receive more assets, but also those assets are available for distribution sooner than if they had to wait until the grantor's death to inherit. This is a significant benefit, considering that our clients' life spans have stretched into the 80s and 90s — and they tend to leave their assets to a marital trust to defer estate taxes and their children's inheritances even longer.

Moreover, as with all lifetime transfers, the grantor has an opportunity to see how the trust beneficiaries react to, and use the distributions made to them. They can assist the beneficiaries in adjusting to the opportunities and pitfalls great wealth can bring. The beneficiaries' actions may even cause the grantor to revisit the overall disposition of his estate.

TAX-BASIS PLANNING

A grantor trust ceases to exist upon the grantor's death. At that point, the trust (and the beneficiaries, under the distributable net income (DNI) rules), becomes liable for its own income taxes. The basis of the assets held by an irrevocable trust that are not included in the grantor's gross estate will not be stepped up to their fair market value at the grantor's death. IRC Section 1014 increases, or “steps up” the basis of “property acquired from a decedent” to its fair market value. Property acquired from a decedent would include property acquired by bequest, devise, or inheritance, and other property included in the decedent's gross estate.

From a transfer-tax standpoint, it is therefore best to realize as much of the trust's gains while the trust is still a grantor trust. If the grantor is on his deathbed, the trustee should consider realizing gains. In addition, the trustee should consider selling low basis assets to the grantor in exchange for cash or other high basis assets. No gain would be realized in such a sale because under Rev. Rul. 85-13, a transaction between a grantor trust and its grantor are ignored for income tax purposes.1

This way, upon the grantor's death, the trust will have little or no unrealized gains on which it will have to pay tax and the low basis assets will receive a step-up in the grantor's estate, eliminating the tax on unrealized gains. Because the grantor was considered the owner of the trust assets, the one-year-rule of IRC Section 1014(e) will not apply to deny a step-up in basis if those assets pass back to the trust or the beneficiaries thereof.

Instead of relying on the trustee to take action, the grantor (or if the grantor is incapacitated, his legal representative) could substitute low-basis trust property for high-basis property to achieve the same result. The grantor may have retained the power to substitute trust property for other property of equivalent value in the trust agreement. Such a power is frequently included in trust agreements in order to make the trust a grantor trust. IRC Section 675(4) provides that such a power, when held by a person in a nonfiduciary capacity, will cause the grantor to be treated as the owner of the trust property.

RISKS AND ESCAPES

While there is no gift tax risk associated with a grantor trust, such a trust can create financial risks to the grantor. If the trust income and gains are significant, the grantor could be bankrupted by the tax liability. For example, if the trust owns zero-basis stock in a closely held corporation that it sells for $50 million, the $7.5 million plus capital gains tax could be more than the grantor is willing or able to pay. Moreover, the tax on the annual income and gains from the trust's reinvestment of the $50 million could be more than the grantor can bear without impinging his lifestyle or pushing him into bankruptcy. That's why it's critical that every grantor trust have an escape hatch.

One such escape is to include the grantor's spouse as a beneficiary. As long as the spouse is living (and married to the grantor — assuming the trust contains a divorce clause that would cut out the spouse in the event of divorce), the trustee could distribute funds to the spouse that the couple could use to pay some or all of the income taxes attributable to the trust. The trust might even have a flexible definition of the grantor's spouse so that it includes any person to whom the grantor is married.

Note, though, that if the grantor's spouse is a beneficiary of the trust, the grantor cannot make a gift utilizing both his and the spouse's $1 million gift tax exemption that they elect to split on a gift tax return.2 To preserve the ability to split such gifts, the trust could give the trustee the power to add the grantor's spouse as a beneficiary in the future. The power could be exercised only if the income tax burden becomes too great in the future, allowing distributions to the spouse to pay part or all of the tax.

Another possible escape hatch would be to have the trust contain provisions giving the trustee and the grantor the right to release their powers that cause the trust to be a grantor trust. In the case of trustee powers, language should be included acknowledging that terminating grantor trust status may not be in the best interest of the beneficiaries, and that the trustee is released and exonerated from any liability for doing so. The trustee also may want to obtain written releases from the beneficiaries.

The release does not need to affect the entire trust. If the grantor is willing to pay half of the tax attributable to the trust, the trust could be divided into two trusts or shares, and the grantor trust powers could be released over only one of the trusts or shares. Such a power to divide the trust may be granted in the trust instrument or under state law.

In some cases, merely changing the identity of the trustee will be enough to terminate grantor trust status. For example, IRC Sections 674, 675 and 677 require certain powers of the trustee to be held by a “non-adverse” trustee in order for such powers to result in grantor trust status. Thus, non-grantor trust status can be achieved by a trustee resigning or, the grantor removing the trustee and appointing a new trustee who is adverse.3

A last escape hatch would be to authorize the trustee to reimburse the grantor for all or any part of the income taxes attributable to the trust. In Rev. Rul. 2004-64, the IRS discussed the effect of a tax reimbursement clause in a grantor trust. The good news is that the ruling held that if the trust agreement or applicable local law gives the trustee the discretion to reimburse the grantor for his income tax liability attributable to the trust, the existence of that discretion will not cause the trust property to be includible in the grantor's gross estate. Such reimbursement also will not be treated as a gift to the grantor by the trust beneficiaries. However, if pursuant to the trust agreement or local law, the grantor is required to be reimbursed for such income taxes, all of the trust property is includible in the grantor's gross estate under IRC Section 2036(a)(1).

Before practitioners routinely add discretionary tax reimbursement clauses to grantor trusts, though, they should consider whether such a provision makes the grantor a beneficiary of the trust. If it does, state law may allow the grantor's creditors to reach the trust assets for settlement of their claims, which in turn makes the grantor's gift to the trust incomplete for gift tax purposes. As an incomplete gift, the trust property would remain subject to estate tax in the grantor's estate.4 Some states, such as New York, have statutes that prevent this result with respect to discretionary tax reimbursement clauses.

STRUCTURE

Once the decision has been made to utilize a grantor trust as part of a wealth transfer plan, careful consideration should be given to the design and terms of the trust in order to maximize the benefits.

Trusts for children, grandchildren and others should not have termination dates. That is, they should not automatically terminate when the beneficiaries attain certain ages or gradually distribute the trust assets as they attain certain ages. The reasons: (1) the wealth transfer benefits afforded by grantor trust status will end; (2) the creditors of the beneficiaries (including divorcing spouses) will not forgive the grantor's children's debts and liabilities because it is their birthday; rather, they will be thrilled that the trust is terminating and putting the assets in the beneficiaries' hands where they can be seized; and (3) terminating a generation skipping transfer (GST) tax exempt trust prevents the assets from passing transfer-tax free to future generations. Even terminating a non-GST exempt trust can cause unnecessary estate taxes: If a beneficiary of a non-GST exempt trust dies without children and his trust passes to his siblings, the trust assets will not be subject to estate tax, if properly drafted.

BENEFICIARIES

It is advisable to consider including the grantor's spouse as a beneficiary, or giving the trustee the power to add the spouse as a beneficiary. The trustee would have the ability to shift assets into the hands of the spouse (who presumably would share it with the grantor) if required to maintain their lifestyle as a result of a change in their financial condition.

If the trust eventually holds more assets than the grantor wishes to be available to his children, the trustee could be given the power to add the grantor's spouse and/or specific charities as beneficiaries. The trustee then could decant some of the trust assets in favor of the spouse or charity. Amounts distributed to charity would entitle the grantor to an income tax deduction, as the grantor is considered to be the owner and transferor of such assets to charity. Of course, the trustee must carefully navigate his fiduciary obligations and duties before taking such actions.

OTHER STRATEGIES

Grantor trusts can be a means to an end in themselves, or they can be involved in other transactions to transfer wealth in a tax-efficient manner:

  • AFR loans. A grantor could lend money to a grantor trust without realizing taxable income for the interest. As long as the loan is documented by a promissory note bearing interest at the applicable federal rate (AFR), the loan will not result in an imputed gift due to insufficient interest.5 If the trust can earn more on the borrowed funds than the interest rate on the note, it will retain the difference, increasing the size of the trust and limiting the growth of the grantor's estate to the interest rate on the note. Because the trust does not pay taxes, only its pre-tax return needs to beat the interest rate on the note to come out ahead.

  • Sale to grantor trust. Similarly, the grantor could sell assets to the trust in exchange for a promissory note.6 As with AFR loans, the grantor does not recognize gain on such a sale under Rev. Rul. 85-13. If the trust's pre-tax return on the acquired assets is greater than the interest rate on the note, it will profit from the transaction.

  • Remainder from a QPRT. Structuring a qualified personal residence trust (QPRT) so that the remainder passes to a grantor trust, can provide many benefits. If the residence passes to a trust of which the grantor's spouse is a beneficiary, the spouse may continue to live in the residence rent-free, and the grantor may reside with him rent-free (just as the grantor's spouse was able to reside with the grantor rent-free before the end of the income term).7 However, upon the spouse's death or if the spouse is not a beneficiary, the grantor must pay rent to the trust in order to continue living in the residence.

    Using a grantor trust to own the residence after the QPRT term will make it easier for the grantor to lease the residence after the QPRT term, so he will need only to negotiate or contract with one trustee rather than several individuals or trustees. The grantor could enter into an agreement at the time the residence trust or QPRT is created, giving him an option to lease the residence for fair market rent after the QPRT term.8

    Alternately, the residence trust or QPRT agreement itself could give the grantor the option to lease the residence for fair market rent after the QPRT term. The rent payments by the grantor to the trust are, in effect, tax-free gifts to the beneficiaries, and the trust will not recognize rental income.

    If the residence is sold, the grantor will pay any capital gains tax. However, the QPRT must prohibit a sale of the residence to the grantor, the grantor's spouse or a grantor trust as to either of them.9 The purpose of this regulation is to prevent the grantor from repurchasing the residence in a non-taxable transaction that avoids capital gains tax and retaining it until death, at which time the residence's basis is stepped up to its fair market value.

  • Sale/leaseback of residence instead of QPRT. Instead of transferring a residence to a QPRT, one could sell a residence to a grantor trust for a promissory note. Unlike a QPRT in which the grantor's death during the term of retained interest causes the residence to be included in his estate, no such estate inclusion occurs if the grantor dies before the note is repaid. The grantor would lease the property back from the trust, and the trust would use part of the lease payments to pay down the note.

  • Remainder from a GRAT. Finally, similar to a QPRT, one could structure a grantor retained annuity trust (GRAT) so that the remainder passes to a grantor trust. Doing so allows the tax-free growth of the trust assets outside of the grantor's estate to continue.

In my view, the “nirvana of estate planning” is a GST-exempt grantor trust established in a state that abolished or permits election out of the rule against perpetuities. The trust assets are out of the transfer tax system forever, and grow undiminished by income taxes. While the grantor bears tax on the trust's income and gains, the trust is truly a tax-free entity.

Even if the estate tax is reduced or repealed, repeal of the gift tax is not being considered due to potential income tax losses. If clients want their children to benefit at a time when the assistance is most needed (for example starting a business or buying a first home) and while the client is able to provide guidance to the recipients and see the fruits of their wealth and generosity, lifetime transfers will remain relevant. Grantor trusts can accelerate and maximize such transfers.

Endnotes

  1. Revenue Ruling 85-13, 1985-1 C.B. 184.
  2. See David A. Handler and Kevin M. Chen, “Fresh Thinking About Gift Splitting,” Trusts & Estates (January 2002), at p. 36.
  3. Internal Revenue Code Section 672(a) defines an “adverse party” as any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust. A “non-adverse party” is defined as any person that is not an adverse party.
  4. See Commissioner. v. Vander Weele, 254 F.2d 895 (6th Cir. 1958); Outwin v. Comm'r., 76 T.C. 153 (1981); Paolozzi v. Comm'r., 23 T.C. 182 (1954), acq. 1962-1 C.B. 4.; and Rev. Rul. 76-103, 1976-1 C.B. 293.
  5. The applicable federal rate (AFR) is the minimum rate of interest that must be charged on a loan in order for the lender to avoid imputed interest income under IRC Section 7872 and to avoid making a taxable gift to the borrower by charging inadequate interest. The AFR is set monthly by the Treasury; it varies depending on the term of the loan (short-term, mid-term, or long-term) and how frequently interest compounds (annually, semiannually, quarterly, or monthly).
  6. For articles discussing sales to grantor trusts, see Michael D. Mulligan, “Sale to a Defective Grantor Trust: An Alternative to a GRAT,” Estate Planning (January 1996); Jerome M. Hesch, “Installment Sale, SCIN and Private Annuity Sales to a Grantor Trust: Income Tax and Transfer Tax Elements,” Tax Management Estates, Gifts and Trusts Journal, Vol. 23, No. 3 (May 14, 1998); Richard A. Oshins, “Defective Trusts Offer Unique Planning Opportunities,” CCH-Financial and Estate Planning (Aug. 20, 1998); Steven J. Oshins, “Sales to Grantor Trusts: Exponential Leverage Using Multiple Installment Sales,” Probate & Property (January/February 1999).
  7. See Private Letter Ruling 9827037 (Apr. 6, 1998).
  8. See PLRs 9425028 (Mar. 28, 1994), 199916030 (Jan. 22, 1999), 199931028 (May 10, 1999).
  9. Treasury Regulations Section 25.2702-5(c)(9).

SEE HOW THEY GROW

Grantor trusts do far better than non-grantor trusts

Assume a settlor transfers $1 million in stocks and bonds to both a grantor and a non-grantor trust; each receive a 10 percent annual rate of return; income tax is 20 percent of the annual return; and this continues for 20 years. Result: the grantor trust would have 44 percent more than than the non-grantor trust. A big difference.

Grantor Trust Non-Grantor Trust
Year Starting Balance (in millions) Growth Tax Paid Ending Balance (in millions) Year Starting Balance (in millions) Growth Tax Paid Ending Balance (in millions)
1 $1.0 $100,000 $0 $1.1 1 $1.0 $100,000 $20,000 $1.08
2 1.1 110,000 0 1.21 2 1.08 108,000 21,600 1.1664
3 1.21 121,000 0 1.331 3 1.1664 116,640 23,328 1.259712
4 1.331 133,100 0 1.4641 4 1.259712 125,971 25,194 1.360489
5 1.4641 146,410 0 1.61051 5 1.360489 136,049 27,210 1.469328
6 1.61051 161,051 0 1.771561 6 1.469328 146,933 29,387 1.586874
7 1.771561 177,156 0 1.948717 7 1.586874 158,687 31,73 1.713824
8 1.948717 194,872 0 2.143589 8 1.713824 171,382 34,276 1.850930
9 2.143589 214,359 0 2.357948 9 1.850930 185,093 37,019 1.999005
10 2.357948 235,795 0 2.593742 10 1.999005 199,900 39,980 2.158925
11 2.593742 259,374 0 2.853117 11 2.158925 215,892 43,178 2.331639
12 2.853117 285,312 0 3.138428 12 2.331639 233,164 46,633 2.518170
13 3.138428 313,843 0 3.452271 13 2.51817 251,817 50,363 2.719624
14 3.452271 345,227 0 3.797498 14 2.719624 271,962 54,392 2.937194
15 3.797498 379,750 0 4.177248 15 2.937194 293,719 58,744 3.172169
16 4.177248 417,725 0 4.594973 16 3.172169 317,217 63,443 3.425943
17 4.594973 459,497 0 5.054470 17 3.425943 342,594 68,519 3.700018
18 5.05447 505,447 0 5.559917 18 3.700018 370,002 74,000 3.996019
19 5.559917 555,992 0 6.115909 19 3.996019 399,602 79,920 4.315701
20 6.115909 611,591 0 6.727500 20 4.315701 431,570 86,314 4.660957
Total Tax $0 Total Tax $915,239
Source: David S. Handler

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