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A tax-advantage grantor trust can be a wonderful estate planning tool to transfer wealth from one generation to the next. Outright gifts to beneficiaries can be a great way to remove assets from the taxable estate while allowing current enjoyment of the property given away. Many clients, however, are uncomfortable making substantial outright gifts, perhaps because the recipient of the gift is a minor, not financially astute, has creditor problems, or is otherwise incapable of handling a large sum of money or other property. Under these circumstances, it may make sense to take advantage of the tax benefits afforded by an irrevocable grantor trust.
A grantor trust is a trust that is treated as owned by the grantor (the creator of the trust who transfers money or property to the trust) for income tax purposes. That is, any income earned on the trust property is taxed to the grantor. Payment of these income taxes by the grantor further reduces the size of the grantor’s taxable estate, and allows the assets in the trust to grow and appreciate, to the benefit of the ultimate trust beneficiaries. The grantor retains a right to receive income back from the trust for a fixed term of years. If the grantor fails to survive this term, the assets are included in his/her estate, and the grantor is therefore left in the same tax position as if the trust had never been formed.
Upon transfer of property to a grantor trust, the grantor has made a gift for gift tax purposes. Grantors may avoid incurring gift tax on this transfer, however, by using the $1,000,000.00 lifetime federal gift tax credit, and may also use annual exclusion gifting of up to $12,000.00 per year.
The most common types of grantor trusts include: Grantor Retained Annuity Trusts (GRATs), Grantor Retained Unitrusts (GRUTs), Grantor Retained Income Trusts (GRITs), and Qualified Personal Residence Trusts (QPRTs). Collectively, these estate planning tools are known as “Grantor Retained Interest Trusts.” As the name indicates, these trusts allow a grantor to keep an interest (such as the receipt of income) in the grantor trust, and transfer the remaining trust property to beneficiaries at the time the grantor’s interest in the trust terminates (the termination of the stated trust term).
The primary purpose of these tax-advantage trusts is to transfer property to younger generation family members in the future, and at a reduced gift tax value. The objective is to obtain a gift tax value for the trust property that is lower than both the fair market value at the time the grantor gifts the property to the trust, and at a fair market value that is lower than the property’s value at the time the grantor’s retained interest terminates. In other words, the value of the trust property is “frozen” at the time the property is transferred to the irrevocable trust – and the value of the property received by beneficiaries, for tax purposes, is this “freeze” value minus the present value of the retained right of the grantor to receive an annual amount of income from the trust. Therefore, the transfer of property by the grantor to the trust results in minimal gift tax consequences, as well as a reduction in the size of the grantor’s taxable estate.
Proper structuring of a tax-advantage grantor trust requires proper planning, consideration, and a thorough knowledge of federal tax laws. The following is a brief explanation of the most commonly-used grantor retained interest trusts:
Grantor Retained Annuity Trusts (GRATs):
A grantor transfers assets into an irrevocable trust, for the benefit of noncharitable beneficiaries, and for a stated term. During the stated term the grantor retains the right to receive a set dollar amount from the trust each year. Upon termination of the trust term, the assets of the trust are transferred to the trust beneficiaries.
The original transfer of assets into the trust is made with the expectation that the assets of the trust will grow at a rate which exceeds the federal interest rate set forth in the Internal Revenue Code. This appreciation is therefore transferred to the trust beneficiaries free of estate and gift tax. A GRAT is commonly structured so that the actuarially determined value of the grantor’s right to receive the annuity amount each year is substantially equal to the value of the trust property at the time it is transferred to the trust. This results in a transfer of assets to beneficiaries with little to no gift tax consequences.
Grantor Retained Unitrusts (GRUTs):
A GRUT is set up in the same fashion as a GRAT. In a GRUT, however, the grantor retains the right to receive a specific percentage of the trust value each year (the trust is re-valued each year for this purpose), rather than a set dollar amount. Once again, the grantor transfers property to an irrevocable trust, therefore “freezing” the value of the assets for tax purposes. For a stated term, the grantor retains the right to receive the annual unitrust amount. Upon termination of the trust term, the assets pass to the named beneficiaries of the trust. The value of the property passing to the beneficiaries, for gift tax purposes, is the “frozen” value of the assets at the time they were transferred into the trust, minus the grantor’s retained right to receive the unitrust amount. This value may be close to zero, despite an actual value that is much greater, as the assets in the trust may have appreciated or received an investment return exceeding the federal interest rate set by the Internal Revenue Code.
Grantor Retained Income Trusts (GRITs):
In a GRIT, the grantor establishes an irrevocable trust, retaining the right to receive all of the net income from the trust assets for a fixed term of years. Upon termination of the trust term, the assets remaining in the trust transfer to the named beneficiaries, in the same fashion as a GRAT or a GRUT.
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