Estate planning with trusts: Availability limited?

With the looming expiration of the $5 million estate and gift tax exemptions and the current favorable top tax rate of 35 percent, estate tax planning has become a significant area of focus among many tax advisers.

Possible expiration of these provisions has fueled the emphasis on the importance of addressing the impact on individuals and on the transfer of assets to future generations.

Many advisers have focused on employing grantor trusts to help meet clients’ objectives. Grantor trusts have been the target of legislators over the years, and current proposals would eliminate many of the benefits of using these trusts in estate planning.

Most commentators agree that it is highly unlikely that current proposals will be adopted. However, their approval would close the window on these estate tax planning opportunities, making it crucial to act now if you could benefit from these techniques.

To create a grantor trust, a donor transfers property to a trust but retains powers that cause the grantor to be treated as the trust owner under the grantor trust rules. The trust is disregarded as an entity under federal income tax law, and the grantor must account for all items of income and deduction attributable to the trust property.

Because the grantor is required to pay this tax, it is not treated as a gift to the trust, and the grantor effectively transfers additional wealth to trust beneficiaries without affecting the exemption amount or incurring additional gift tax.

In addition, due to differences in the grantor trust and the estate and gift tax rules, as long as the transfer is properly structured as a completed gift, the property will be excluded from the grantor’s estate for estate tax purposes.

When the trust document is drafted as a trust that purposely invokes the grantor trust rules, it is commonly referred to as an intentionally defective grantor irrevocable trust. Although this can be achieved in a number of ways, one of the more aggressive and complicated planning strategies involves structuring an installment sale to a grantor trust.

Using this strategy, the donor sets up a trust in which he retains the power to replace trust assets with assets of equal value. The transaction is structured as a combination gift and sale.

The grantor first makes a gift to the trust, usually cash, and then sells an appreciating asset to the trust in exchange for cash and a promissory note providing for installment payments over time. The interest is based upon the required minimum IRS interest rate.

Because the grantor is treated as the owner of the trust, no gain or loss is recognized on the sale of the asset to the trust or on the note’s interest.

A grantor retained annuity trust (GRAT) is another type of grantor trust. It can provide a unique estate planning opportunity because of the manner in which the remainder interest is valued for gift tax purposes.

To establish a GRAT, the grantor transfers appropriate property to an irrevocable trust. The grantor retains the right to receive an annual payment of a fixed amount for a specified term of years. Then the property passes to the remainder beneficiaries.

The creation of the GRAT is treated as a taxable gift to the extent of the present value of the remainder interest, which can often have de minimis, or minor, value. The trust property is assumed to appreciate at the federally established rate, while the property in the trust is expected to appreciate at a higher rate.

Proper planning should result in the value of the property received by the trust beneficiary substantially exceeding the value on which the donor was required to pay gift tax.

Although these trusts can be an effective planning tool for some taxpayers, they are not appropriate for everyone. If your estate is less than $10 million joint ($5 million single), you can likely accomplish your planning goals through lifetime gifts and less complicated trusts.

With the help of your CPA, you should assess your long-term objectives, personal and financial situation, and the assets that will be held by the trust to determine the most suitable approach. After this assessment, if you believe that a GRAT or grantor trust may be appropriate, you should consider the advantages and disadvantages of each.

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