A “Defective” Trust That Saves You Money

Sometimes when Congress closes one tax loophole it creates another. This is especially likely when Congress doesn’t coordinate the income and estate tax sections of the law. That’s how complicated the tax law is. And it opens up an opportunity for you with “grantor trusts.”

A grantor trust in the income tax law is one in which the grantor, or creator, of the trust retains enough powers over it to be considered the owner. And the owner of the trust is taxed on its income, regardless of who receives it. The grantor trust rules were set up to end an income tax strategy in which a high tax bracket person shifted income to someone in a lower bracket but still managed to retain control over, and most of the benefits from, the trust.

Under the estate tax, if you set up a trust and retain too much control over or benefit from it, then all the property in the trust is included in your estate.

But here’s the little glitch. “Control” is defined differently in the estate tax and income tax laws. That means you can set up a grantor trust in which you are taxed on the income but the property in the trust is out of your estate. Believe it or not, that can create benefits, saving your family a lot of money.

Here’s how it works. You set up an Irrevocable Trust that qualifies as a grantor trust and move property into it. Since it is a grantor trust, you pay taxes on the income and capital gains. But you write the trust so that you don’t have enough control for the property to be included in your estate.

What kind of provision makes you taxable on the income without including the property in your estate? A number of simple provisions work. The trust can provide that your spouse is eligible at some future time to receive income or principal, even if that never happens. Or you can borrow $1 from the trust each year. Those simple “defects” make you taxable on the trust income but keep the property and its future appreciation out of your estate.

That allows the income and gains to accumulate and compound in the trust without being diluted by taxes. In effect this is another way for you to make a gift to the trust’s beneficiaries equal to the amount of the taxes. But since the taxes are your legal obligation, paying them is not considered a gift under the tax law. That means no gift taxes, and the payment doesn’t count against your $10,000 annual gift tax exclusion. You have found another way to make a tax-free gift.

You want to give appreciating assets to a grantor trust, because the real benefit is to get the future appreciation out of your estate.

Setting up the trust is subject to gift taxes. But you can make the trust even better by giving assets that qualify for gift tax discounts. For example, you can put shares of a family business or real estate into a family limited partnership. If you set up the partnership properly, you can take a discount of 20% or more when you make gifts of the partnership interests to the trust.

A way to really enhance the trust is to sell assets to the trust.

You start by giving money or property to the trust equal to about 10% of the value of the property that you intend to sell to the trust. This is a gift subject to gift taxes.

Later, the trust buys property from you by issuing a promissory note. The cash or property you initially put into the trust and income that is generated by the purchased property are used to make the note payments. The note often requires interest-only payments for five years or more, with a balloon payment at the end.

Because you effectively are dealing with yourself when selling property to a grantor trust, there are no capital gains taxes to pay on the sale. You also don’t pay taxes on the interest payments received.

The note and any payments on it eventually are included in your estate. But the appreciation of the property is out of your estate, you should have been able to sell the property at a discount, and the trust value compounds free of income taxes. If for some reason the trust doesn’t generate enough income to make the balloon payment, it can return assets to you equal to the unpaid balance.

You can increase tax benefits further by naming your grandchildren, instead of your children, as beneficiaries of the trust. Skipping a generation like that saves a layer of estate taxes. Be sure your estate planner structures things to avoid the generation skipping tax.

The main drawback to the defective grantor trust is that the trust and its beneficiaries get the same tax basis in the asset that you had. There is no step-up in basis because it was not included in your estate.

The intentionally defective trust is a great way to increase the after-tax amount of assets left to your heirs. It won’t do anything to enhance your current standard of living. It is for assets you no longer need to maintain your standard of living and that you eventually want to benefit your loved ones.

Intentionally defective grantor trusts are very flexible. You can combine them with other strategies, such as a family limited partnership. But you do need to get all the details right. You need to work closely with an estate planner who knows the law in this area well and who will help get the results you want.