April 20, 2020
This is the fourth in a six-part series that focuses on proactive planning strategies in a volatile market.
Despite the current uncertainty and continuing impact of the COVID-19 pandemic, there still may be opportunities for wealth planning. The current unfortunate circumstances have created a prime environment for certain wealth transfer strategies—such as sales to grantor trusts—which can help position individuals with transfer tax concerns to take advantage of the current financial conditions.
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A grantor trust is a type of trust where the grantor is treated as the “owner” of the trust assets for income tax purposes and, as a result, the grantor is responsible for paying taxes on the trust’s income.
When a grantor trust is structured as an irrevocable trust for the benefit of the grantor’s spouse, descendants and/or other beneficiaries, it is treated differently for transfer tax purposes than it is for income tax purposes. Those different treatments can result in multiple benefits. From a transfer tax perspective, properly structuring a trust as an irrevocable grantor trust can remove the transferred assets and their appreciation from the grantor’s taxable estate. From an income tax perspective, the assets of the trust can grow without the burden of income taxes because the income tax liability flows back to the grantor individually.
Selling assets to a grantor trust can further leverage the benefits of a grantor trust. The effectiveness of the strategy lies in the trust’s ability to take advantage of the differences between the income tax treatment and transfer tax treatment of irrevocable grantor trusts. The two different tax treatments result in a sale to the trust that does not produce a capital gain to the grantor (because the grantor and the trust are the same taxpayer for income tax purposes), but produces an irrevocable transfer that removes the property and its appreciation from the grantor’s estate with minimal transfer tax consequences.
Typically, in a sale to a grantor trust, the grantor sells assets to the trust in exchange for a promissory note. The promissory note carries a market rate of interest and requires repayment of principal—usually in the form of a balloon payment at the end of the note’s term. The market rate of interest is often based upon the applicable federal rate (AFR) at the time of the transaction. A balloon payment allows the trust to take full advantage of the growth potential of the trust’s assets before having to return any of the principal to the grantor. When the note is repaid, the grantor has transferred the appreciation associated with the property in the trust with minimal transfer tax cost.
To support the trust’s ability to make payments back to the grantor after the sale, the purchasing trust should have assets already in the trust. This can be accomplished by using either a pre-existing trust or by the grantor making a gift to the trust before the sale. If the grantor makes a gift to the trust before the sale, then the grantor can shelter this gift with the grantor’s remaining gift tax exemption.
Another key feature of this strategy is that if the grantor should die during the term of the note, the trust’s underlying assets and appreciation remain excluded from the grantor’s estate. Only the remaining balance of the note held by the grantor is considered part of the grantor’s estate for transfer tax purposes.
Considering a sale to a grantor trust makes sense right now because many asset values have declined, the federal gift tax exemption is at an historical high at $11.58 million per person in 2020, and interest rates are among the lowest rates in history.
Gifting assets that have lost value can be an efficient way to leverage the current gift tax exemption. Because these increased limits are set to expire in 2026, there may be a limited window of opportunity to take advantage of the increased gift tax exemption. Selling depressed assets to a grantor trust will use less of the federal gift tax exemption and allow the grantor to potentially gift more in the future. Furthermore, if and when markets recover, any appreciation will occur outside of the grantor’s taxable estate.
Also, because the AFR is so low, sales to a grantor trust can produce substantial transfer tax savings if the trust’s assets grow more than the AFR associated with the promissory note.
As with many powerful estate planning tools, there are many factors—in addition to interest rates and the current financial climate—that go into making gifting decisions. Therefore, it is imperative that any individual interested in this technique speak with their legal, tax and financial advisors to determine whether a sale to a grantor trust is an appropriate option.
Learn more about Lifetime Gift Planning.
Proactive Planning During a Time of Uncertainty and Volatility
Part 1: Proactive Planning in Volatile Markets With Grantor Retained Annuity Trusts (GRATs)
Part 2: Proactive Planning in Volatile Markets with Roth Conversions
Part 3: Proactive planning with low market values using Spousal Lifetime Access Trusts
Part 5: Proactive planning with low interest rates using intra-family loan
Part 6: Proactive planning with low market values using gifts
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