In typical estate planning parlance, a “grantor trust” refers to a trust the assets of which are deemed owned by an individual (rather than the trust itself) for income tax purposes, but owned by the trust for estate and gift tax purposes. Grantor trusts highlight the complexity that arises when different tax rules (in this case, income taxes compared to estate and gift taxes) overlap with inconsistent treatment.
A trust is treated as a grantor trust if the trust contains any one of a number of elements detailed in Tax Code provisions commonly referred to as the “grantor trust rules”. An analysis of the grantor trust rules is too voluminous for this summary, but it is important to know that it is possible to intentionally cause grantor trust status to take advantage of the overlap between the income tax rules and the estate and gift tax rules tax rules.
For the balance of this post, I refer to the individual that is deemed to be the owner of a trust’s assets for income tax purposes as the “trust owner”. Income attributes of a grantor trust (i.e., income, expenses, etc..) become part of the trust owner’s individual income attributes. In many cases, the trust owner is the grantor/settlor of the trust, but in other circumstances another individual (e.g., a beneficiary of the grantor trust) can be treated as the trust owner.
Commonly used revocable (living) trusts are grantor trusts, but the assets of revocable trusts are deemed owned by the grantor/settlor both for income tax purposes as well as for estate and gift tax purposes. While revocable trusts have many benefits, reduction of estate and gift taxes is not one of them. Other trusts can be created in a manner where the assets are considered owned by the trust for income tax purposes, but deemed owned by an individual for estate and gift tax purposes. These trusts are typically designed to reduce State income taxes, but do not have estate tax benefits. Neither of these types of trusts are the subject of this summary.
This summary describes irrevocable grantor trusts that are used to provide significant estate and gift tax benefits.
What are the Benefits of Grantor Trusts?
Grantor trusts are one of the most important tools in estate planning. As with many provisions in the Tax Code, the grantor trust rules mentioned above were developed to prevent tax abuses, but the rules have ended up being used to design estate planning transactions that have tremendous estate and gift tax benefits. Some of these benefits are:
Estate Freeze Transactions. One common use of a grantor trust is to engage in “estate freeze” transactions where a trust owner can create a grantor trust and sell assets to the grantor trust. The “estate freeze” sale effectively locks in estate tax exposure by exchanging appreciating assets for a fixed purchase price (typically paid under a promissory note). As the assets continue to appreciate after the sale, the appreciation will remain outside of the seller’s estate for estate and gift tax purposes.
The above type of estate freeze transaction can be accomplished without triggering income tax recognition at the time of the sale since the assets in the trust, both before and after the sale, are deemed owned by the trust owner for income tax purposes – basically, the estate freeze sale is ignored for income tax purposes, but respected for estate and gift tax purposes.
For a simple illustration of an estate freeze transaction, assume that an individual sells an asset for $500,000 to a grantor trust of which the individual is the trust owner and, over ten years, the asset appreciates to a value of $1,200,000. If the trust owner died in the 10th year, only the $500,000 of the purchase price from the sale would be included in the individual’s estate while all of the appreciation following the date of the sale ($700,000 = $1,200,000 – $500,000) escapes estate taxation. The value of the asset at the time of the sale of $500,000 has been “frozen” in the taxable estate.
A downside of this type of estate free transaction is the potential loss of the step up in basis of assets held by a decedent at death. This area of the tax law is not yet settled, but the potential risk of losing the step up in basis is something to consider in weighing the benefits of an estate freeze transaction. Given that the estate tax rate is currently 40% applied on total value of assets while the capital gains rate is 20% applied on an asset’s appreciation, an estate freeze transaction is beneficial in most cases even if the step up in basis was lost (some would argue that a step up in basis will still occur upon a trust owner’s death, but it is not a certainty under the current state of the law).
Tax Free Gifts In The Form Of Income Tax Payments; The “Tax Burn” Benefit. As mentioned above, using grantor trusts in an “estate freeze” transaction allows assets to appreciate outside of a trust owner’s estate for estate and gift tax purposes without triggering income tax recognition. In and of itself, this is a valuable benefit, but a favorable Revenue Ruling solidified a benefit that, in many circumstances, proves to be even more valuable than the “freeze” component of an estate freeze transaction.
Specifically, Revenue Ruling 2004-64 provides that when a trust owner pays income taxes attributable to earnings/ gains on a grantor trust’s assets, there is no gift for estate and gift tax purposes from the trust owner to the grantor trust and/or its beneficiaries.
To illustrate this benefit, assume that: (i) a 50% interest in a partnership is owned by a grantor trust; (ii) the partnership makes $500,000 of ordinary income each year; and, (iii) the partnership makes distributions sufficient to satisfy the taxes on an annual basis. Under this circumstance, the trust owner of the grantor trust is allocated $250,000 (50% of the $500,000 total) of income which results in taxation of approximately $100,000 ($250,000 * 40%). The partnership makes a distribution sufficient to satisfy the tax liability of $100,000 to the grantor trust since the grantor trust is the owner of the partnership interest even though the trust owner of the grantor trust (rather than the trust itself) is actually liable for the taxes. When the trust owner of the grantor trust pays the $100,000 of taxes due: (i) the trust owner uses funds otherwise included in his or her estate for estate tax purposes to satisfy the income tax liability (sometimes referred to as a “tax burn”) of $100,000 (i.e., the owner reduces his or her estate tax exposure by $40,000 [the estate tax rate of 40% * $100,000]); and, (ii) the grantor trust (and effectively its beneficiaries) has received an additional benefit of $100,000 without there being a taxable gift to the trust.
Looking at it another way, if the trust owner was to give the grantor trust (or the beneficiaries thereof) $100,000 to pay the grantor trust’s taxes, the $100,000 would be treated as a taxable gift (it would cost $40,000 in gift taxes to make that gift); but, if the owner pays $100,000 of taxes on income attributable to the trust (saving the trust from having that expense), no gift taxes are triggered. The contrast between the tax results in these two situations is created by a combination of the grantor trust rules and Revenue Ruling 2004-64.
The above benefit continues year over year and, by its nature, tends to grow each year as the funds inside of the grantor trust continue to accumulate and appreciate. This benefit would cease at such time that the trust is no longer considered to be a grantor trust. At the latest, this would occur upon the trust owner’s death, but grantor trust status can be terminated sooner under certain circumstances (including intentionally).
S Corporation Stock Planning With Grantor Trusts.
The most common type of entities designed to shield business owners from liabilities associated with their businesses are corporations and limited liability companies. The owners of most corporations elect for the corporations to be treated as “S corporations” (the “S” refers to an election under Subchapter S of the Tax Code).
S corporations, like most limited liability companies and partnerships, are treated as pass-through entities for income tax purposes meaning that all income tax attributes of the entities “pass through” to the owners of those entities without being subject to income taxation at the entity level. In contrast, owners of C corporations (e.g., publicly traded corporations) are subject to taxes on dividends after the C corporation pays corporate level taxes (essentially, a double taxation).
One drawback of S corporations (as compared to C corporations, limited liability companies and partnerships) are rules that specify who can own S corporation stock. If stock in an S corporation becomes owned by certain persons or entities (including trusts), then a corporation can lose its election to be an S corporation – meaning that the corporation would become a C corporation and subject to the regime of double taxation mentioned above.
The general rule is that trusts are not eligible stockholders of an S corporation. There are a few exceptions to this general rule and one such exception is for grantor trusts. The rationale behind this exception goes to a fundamental point mentioned above – a grantor trust is not distinct from its trust owner for income tax purposes. Thus, if the trust owner is an eligible S corporation stockholder (e.g., a United States citizen), then the grantor trust is an eligible S corporation stockholder.
Life Insurance Planning. You may have heard that life insurance proceeds are “tax free”; but that is somewhat of an over-generalization. Life insurance benefits, in most circumstances are tax free from an income tax perspective; but, proceeds from life insurance policies can be subject to Federal estate taxation in the estate of the policy owner and/or beneficiary.
I will illustrate this issue with an example that arises with surprising frequency. In considering the example, remember that the exemption from Federal estate taxes is $5,450,000 per person and $10,900,000 per married couple. Assume that husband and wife have accumulated $9,000,000 of assets, and that the wife’s life is insured for $6,000,000 (whether for replacement of the wife’s income or for some other reason) under a typical term life insurance policy. The wife is the owner of the insurance policy and the husband is named as the beneficiary. If the wife dies, the husband will receive the life insurance proceeds without paying Federal income taxes, but suddenly he will have $15,000,000 of assets compared to a $10,900,000 exemption. If the husband subsequently dies under those circumstances, estate taxes of $1,640,000 (($15,000,000 – $10,900,000) * 40% estate tax rate) would need to be paid.
The estate taxes in the above example could have been easily avoided from the start by using an irrevocable life insurance trust to own, and be the beneficiary of, the insurance policy; but, under certain circumstances, grantor trusts can be used as part of a plan to restructure ownership of the insurance policy in a manner that can allow the insurance proceeds to escape Federal estate taxation.
Specifically, using a grantor trust, the wife can gift or sell (there are benefits to selling the policy that go beyond this summary) the insurance policy to a grantor trust of which she is the trust owner in a manner that results in a Federal estate tax benefit without causing unintended income tax consequences. Upon the wife’s death, the insurance proceeds would be received by the trust and be available for the husband’s use without the proceeds being included in the husband’s estate for estate and gift tax purposes.
Any plan to change the ownership and/or beneficiaries of a life insurance policy must be implemented carefully so as not to run afoul of Tax Code provisions that can cause adverse tax consequences (both for income taxation and estate taxation).
When Should You Consider Incorporating A Grantor Trust Into Your Estate Plan?
Under the right circumstances, grantor trusts can provide tremendous tax benefits. Grantor trusts should be considered in estate planning under circumstances where it is reasonable to expect that an individual’s estate will exceed the exemption from Federal estate taxes.
The timing of establishing a grantor trust, and creating an estate freeze transaction, is important to maximizing the benefits. For example, using an estate freeze transaction with a grantor trust should be strongly considered when an individual owns assets that are expected to increase significantly in value. This allows for the “freeze” in value to occur prior to the anticipated appreciation.
Also, as mentioned above relating to problems with the structure of life insurance policies, use of a grantor trust and/or irrevocable life insurance trust should be strongly considered if an individual’s life insurance would bring his/her (or their respective spouse’s) estate over the Federal estate tax exemption.