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Posted: July 23, 2012

The hot new thing in wealth planning

...isn't really new

Mira Finé

The recent IPO by Facebook founders led to their creation of grantor trusts to avoid paying taxes of at least $200 million. It underlined new uses of a technique that has been around for a long time. Grantor trusts, including defective trusts, are still the hot new thing.

The idea of trust law originated in the Middle Ages in the English legal system to protect landowners who went off to fight in the Crusades from losing their properties. The current treatment of trusts in the U.S. has been around since their recodification in 1954. Chances are good that if you have any kind of significant assets and beneficiaries in mind, you will use a grantor trust, a legal entity created by the grantor - usually you - with the intention of eventually transferring the assets to children and other beneficiaries. The grantor generally maintains control of the assets, and the income is taxed to the grantor.

Explore your options

A grantor trust can also be formed into what is called an intentionally defective grantor trust, which is designed to avoid paying estate taxes upon the grantor’s death.  

With this type of trust, the grantor irrevocably transfers an asset into the trust as a gift or sale in return for a note. The trust holds the asset based on the terms of the trust, and the asset held in the trust can be substituted for an asset of equal value. If this type of trust is done right, no estate tax is paid when the grantor dies. The grantor still reports and pays the current income in the trust; however, any transactions between the trust and the grantor do not result in a taxable event. Upon the grantor’s death, the trust is not included in the grantor’s estate because it is still deemed to be an irrevocable trust.

There is also a grantor trust called a grantor-retained annuity trust, used by the Facebook executives. These trusts are a perfect vehicle to transfer a great deal of wealth when you want to avoid estate and gift tax. The grantor sets up the trust and gives the yet unappreciated asset into the trust.

Over the time covered by the trust, the grantor receives the income from the trust based on an interest rate determined by the Internal Revenue Service. Right now, this rate is very low. If the asset increases in value, that growth is outside of the grantor’s estate and all the grantor has to do is to recognize the required low income.

If this annuity stream is set up correctly, there is no gift tax when it is set up. Bear in mind that the grantor is giving away assets, but usually to their named beneficiaries and they are avoiding estate tax and gift tax. If the asset fails to increase in value, the grantor is not in worse shape.


Reap the Benefits

Keep in mind that any asset transferred to a trust is not subject to regular estate taxes due upon the grantor’s passing, but anything left in the grantor’s regular estate will be subject to the usual and much higher, estate taxes. Here are some of the advantages of grantor trusts:

• Classification Flexibility. You can classify trusts in different ways. If a grantor does not have the powers over a trust and all the assets with it, then it’s a non-revocable trust. If the grantor has powers that go beyond normal, than it is deemed to be a grantor or revocable trust. When the grantor renounces powers, then it becomes a non-grantor trust.

Here is the twist: One can change the type of trust based on how you treat it on a year-to-year basis. In an irrevocable trust, if the grantor borrows principal or income and has not repaid it before the end of the year, the trust will be a grantor trust for that year. So, you could borrow on Dec. 31 and not repay it until Jan. 1 and the trust would be deemed to be a grantor trust. However, this will not occur if the loan provides for adequate interest and security assuming the loan was made by the trustee to her rather than the grantor or related parties.

• Lower Taxes. The federal income tax paid by the grantor is likely to be less because the trust tax brackets are higher than individual ones. For a trust, the 35 percent tax bracket starts at $11,000 of income. The personal income tax paid by the grantor does not hit 35 percent until it reaches $300,000. So you can pull the tax payment out of the trust and it is paid by the grantor.

• Asset Substitutions. Trust assets can be substituted with like-valued assets in either a grantor or defective trust. A non-fiduciary power to switch assets should not cause inclusion of trust assets in a grantor’s estate because there is not a diminishment of the assets. However, the values of the exchanged assets need to be identical; you cannot substitute a Chevy for a Mercedes. You also must have appraisals or some agreement providing that if the values do not work, there will be a make-up of the value. This often comes up when a grantor puts land into a trust and didn’t realize that titling and development issues would arise with consolidating land around the trust.

Real-World Case

Why and when would someone borrow from their own trust? Let’s look at a real-life example of a case I am familiar with. A mom sets up an irrevocable, or non-grantor trust that the mom doesn’t have control over. Her daughter is the beneficiary but doesn’t know about it. Mom is also the trustee of the trust, and develops a bad gambling habit. She spends all her money gambling and now doesn’t want to tell her daughter that the trust existed.

Mom borrows money from the trust, which she can approve because she herself is the trustee. The trusts still exist, however, and the daughter can sue her mom, preventing her from regaining control over the trust assets and to make her repay the loan from the trust. The daughter could argue that under normal rules, the trust would not have loaned mom the money unsecured. If you were in mom’s place, you’d argue that it was a grantor trust all the time. The case hasn’t been decided by the court yet.

This happens a lot; people thinking they will avoid estate problems and then everything falls apart on them. If the mom in our example had established a grantor trust, then she’d have had a better argument against the daughter’s lawsuit because in a grantor trust, she’d generally have control (under certain circumstances) of the assets as long as she paid the correct taxes, though she might not be able to avoid estate tax.

There is no right and wrong way to create a trust, or to designate what type of trust it is. The type of trust you choose depends on your situation. The positive is that you have a lot of flexibility and power.

Mira Finé, CPA, is the national director of tax operations for Hein & Associates LLP, a full-service public accounting and advisory firm with offices in Denver, Houston, Dallas, and Southern California. She specializes in succession planning and can be reached at mfine@heincpa.com or 303.298.9600.

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