My clients have asked me why the proposed federal tax legislation wants to eliminate grantor trust strategies, so I thought I’d address that in today’s column. Let’s start with the definition of a grantor trust. Generally speaking, a grantor trust is one in which the individual who creates the trust is the owner of the assets for both income and estate tax purposes. Revocable trusts are grantor trusts. Revocable trusts are not the trusts that the proposed legislation addresses.
The proposed legislation instead addresses “Intentionally Defective Grantor Trusts (IDGT)” where the grantor isolates certain assets to segregate income tax from estate tax treatment. It is effectively a grantor trust with a purposeful flaw that ensures the individual (grantor) continues to pay the income taxes while removing them (and all future appreciation on them) from the individual’s estate for gift and estate tax purposes.
Knowledgeable estate planning attorneys have used IDGT strategies for years as there are several benefits. By continuing to be treated as the owner for income tax purposes, the grantor can “sell” assets to the trust, but because he or she is the taxpayer for both, there is no capital gains tax on the transaction.
As one over-simplified example, if Henry creates an IDGT for his children, and funds that IDGT with a minimum amount of assets or money, he can then sell an appreciated commercial property to the IDGT, taking back a promissory note. The capital gains are not recognized since for income tax purposes, the transaction is a sale to himself. Same with the interest payments on the note. The commercial property’s future appreciation is out of his estate, and the tenant’s lease payments are paid to his children, as they are the beneficiaries of the IDGT, but Henry continues to pay the income tax on the lease payments, an additional “tax free” gift to the children.
If Henry transfers his commercial property into an LLC, family partnership or corporate entity, the membership/partnership/shareholder interests subsequently transferred to his children can be discounted because they are not marketable on the open market, have a minority share interest and lack control over the entities’ dealings. Henry can control the income as the managing member/partner, and even take a reasonable manager’s salary if he wishes. These discounts allow Henry to move more assets out of his estate for estate tax purposes, as his exemption is leveraged. The proposed legislation seeks to remove discounts on transfers of passive investments as well as limit IDGT strategies.
Let’s put some numbers to this. Assume that Henry has 3 children, Andy, Betty and Claire. He owns a $3 million commercial property that generates $210,000 of net revenue. Henry transfers the property into an LLC. He then gifts 99% of the LLC interests into 3 IDGTs, 33.333% for each of his children. The appraiser discounts the interests by 40% for lack of marketability, control and minority share interests. Assume the LLC operating agreement and the IDGTs have been properly drafted to accomplish Henry’s goals.
What just happened? The value of the gift is only $600,000 for each of the IDGTs so Henry has only consumed $1.8 million of his exemption to transfer out the $3 million property from his estate. His children’s trusts distribute $70,000 of net revenue annually to each of them, but Henry pays the taxes on that income (assuming a 35% marginal tax bracket he pays a total of $73,500 of taxes annually, which are not considered a gift from Henry to his children.) This continues for Henry’s lifetime.
This is exactly the type of transaction that the proposed legislation attempts to thwart. The proposed legislation’s language eliminates these strategies upon the enactment of the legislation into law, so individuals who are looking to take advantage of the law should do so now, before the proposed legislation is passed into law. No one knows for certain whether the legislation will become law, but by the time that becomes evident it will be far too late to put together this type of planning, which takes careful consideration on the part of the client, as well as the coordination of various professionals.
My IDGT strategy example is but only one of several different ways that IDGTs can be used for gift, estate, and income tax planning. IDGTs can be used with insurance and stocks and bonds for example. If one can implement and fund the strategy prior to any legislation’s enactment date, it’s likely that the trust will be grandfathered in for the favorable treatment under current law. There are a variety of nuances, however, that could result in losing the grandfathered effect, which are too detailed to describe in this post.
Another factor spurring active planning is the proposed reduction of the federal estate tax exemption from it’s current $11.7 million down to $6 million, the exemption amount that will occur anyway on January 1, 2026 when the current law sunsets, assuming no further legislation is enacted between now and then.
©Craig R. Hersch learn more at floridaestateplanning.com