Flood: For large gifts, straight transfer not always best
Lifetime gifts of assets, including closely held stock, real estate, or marketable securities, from parents to children transfers those assets to the next generation while minimizing estate taxes. For large gifts, an outright transfer, although simple and straightforward, may not be the most effective type of transfer. Not including tax considerations, straightforward gifts may not be in the child’s best interest depending on age, financial astuteness and asset protection considerations. A method that may be in the best interest of the child is a gift, or a gift and sale, of assets to an Intentionally Defective Grantor Trust, or IDGT.
In an IDGT, the grantor (the person who creates the trust) makes an irrevocable gift of property into a trust, usually set up for the grantor’s children, and names someone else as trustee. It is defective for income tax purposes, but effective for estate tax purposes. In other words, the income is taxable to the grantor, but the value of the trust is not included in his or her gross estate.
An IDGT has a number of advantages:
1. The income tax liability for the trust assets may be lower if taxed at the grantor’s, rather than the trust’s tax rates. Estates and trusts have a very compressed income tax rate structure, and therefore the grantor being taxed on the trust income may create tax savings.
2. By having the grantor be taxed on the trust income, the value of the trust assets is not reduced by the taxes and thus will allow a greater value to pass to the remainder beneficiaries. This effectively results in a tax-free gift of the income tax to the trust’s remainder beneficiaries. The IRS has indicated the grantor’s payment of the income tax of an irrevocable grantor trust is not a taxable gift to the remainder beneficiary.
3. The grantor’s gross estate is reduced by the amount of the income taxes paid on behalf of the trust income.
4. The trust assets and the appreciation of the trust assets after the date of the transfer to the trust are removed from the grantor’s gross estate. As a result, appreciation on assets transferred to the trust can be shifted to younger generations with minimal transfer tax.
5. Transactions between the grantor and trust are ignored for income tax purposes. Thus, the grantor can sell assets to or buy assets from the trust without recognizing gain or loss on the transaction.
Only certain select powers will achieve the two-prong test of taxing the trust income to the grantor but excluding the trust assets from the grantor’s gross estate. To ensure grantor trust treatment, more than one of the following powers will often be included in the trust document:
1. Power to reacquire trust property by substituting other property of equivalent value is the most commonly included power in a trust instrument to create an intentionally defective grantor trust.
2. Power that gives a nonbeneficiary but related-party (e.g. spouse, parent, sibling) trustee the discretion to distribute income and principal among a class of beneficiaries causes grantor trust status.
3. Power to add beneficiaries to the trust other than children born or adopted after the original trust document was create will cause grantor trust status.
4. Grantor’s right to borrow from the trust without adequate security causes grantor trust status.
5. Power to distribute or accumulate income for the grantor’s spouse will cause grantor trust status. However, if the grantor’s spouse dies first, the trust will lose its grantor trust status. Also, if the trust instrument allows trust income to be used to “support” a spouse whom a grantor is obligated to support, trust assets will be included in the grantor’s estate.
6. Power to use trust income to pay life insurance premiums on the life of the grantor or the grantor’s spouse will cause grantor trust status.
This is only a brief overview of some important considerations associated with intentionally defective grantor trusts and is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.
• Michael J. Flood, CPA, MST, is a partner with Caufield & Flood in Crystal Lake. He can be reached at 815-455-9538, email@example.com or through cfcpas.com.