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Posted: December 18, 2012

The hot new thing in wealth planning isn’t new

But it does give you flexibility and power

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.

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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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