When the Internal Revenue Service announced in July that paying your grantor trust's income tax bill does not trigger gift tax, few estate planning pros were surprised. After all, the tax code clearly reads that the person establishing a grantor trust-a type of trust that meets certain criteria spelled out in Sections 671 through 678-must pay its taxes. How could doing what the law mandates create additional liability? Still, there was speculation that paying the tax on income generated by property destined for heirs somehow involved a gift element.


"Revenue Ruling 2004-64 has given us the full go-ahead that grantor-trust planning works," says estate planning attorney Jonathan D. Eisner, a Piper Rudnick partner in Baltimore and chair of the law firm's Private Client Services Practice Group. For years, high-net-worth individuals have been using grantor trusts to remove assets and their growth from the taxable estate. "We're saying to clients with these trusts, 'Remember how we used to worry about the small possibility of a gift tax issue? Now the IRS agrees with us that there isn't (any),'" Eisner says. He's also revisited the topic with a few superconservative clients who previously avoided the trusts. "We're pushing ahead with them now," he says.

Why all the fuss? Because when a grantor pays her trust's taxes, not only does that lower the estate, it effectively allows the trust income to compound tax free, creating greater wealth for the trust beneficiaries (read: heirs). Consider, for example, a $3 million trust that earns 4%, or $120,000. Were the trust to pay its own taxes, at a rate of say 40%, its value at year end would be $3,072,000-the initial amount plus 60% of $120,000. On the other hand, if the grantor pays the tax, the trust is worth $3,120,000. Moreover, the grantor's estate falls by $48,000 (40% tax paid on $120,000 trust earnings), potentially slashing the federal death tax by more than $23,000 under current rules. Talk about win-win!

New Rule For New Trusts

The Service's edict also introduced a deal-killer of a new rule for grantor trusts created on or after October 4, 2004: If the trust document or local applicable law requires the trustee to reimburse the grantor for taxes she paid on the trust income, then the trust is part of her estate. "Required reimbursement is considered a retained interest in the trust, which makes it includible in the estate under code Section 2036," virtually negating the benefit of the vehicle, says Michael Kitces, director of financial planning at Pinnacle Advisory Group, Columbia, Md. Advisors should make sure the estate planning attorneys they work with have updated their boilerplate document language to accommodate the new proviso, he says.

The ruling goes on to say reimbursement may be permitted without triggering estate tax inclusion, provided there is no express or tacit arrangement that the trustee will follow the grantor's wishes. "The trustee must truly have discretion not to reimburse," Kitces says, adding that drafting new documents to allow reimbursement offers maximum planning flexibility. That way, the grantor can request a reimbursement if needed. "Ostensibly it's just a cashflow question for her."

Pre-October 4 trusts are not explicitly affected by the new rule. But, says Kitces, you may want to clean up existing trusts that currently must reimburse their grantors (and therefore aren't deriving the maximal benefits described earlier). "Depending on how the trust is structured, it may be possible to restate the trust, if allowable under its terms and applicable state law, so that the trustee has the option to reimburse but is no longer required to. Then the grantor can start reducing her estate by paying the taxes out of pocket and the trust can (compound)," Kitces says.

Techniques that involve intentionally defective grantor trusts (IDGTs) are the big winners under the new protocol, experts agree. Advisors, therefore, must be familiar with these babies. The sketchy moniker indicates that the grantor owns the trust for income tax purposes (it's actually considered her alter ego) but not for estate tax purposes, assuming proper document drafting.

A common strategy involves selling to the IDGT income-producing property that has appreciation potential, such as rental real estate or S-corporation stock. The objective is to pass the growth transfer-tax-free to heirs. You start by transferring cash to the IDGT to give it operating capital and-this is important-a raison d'ĂȘtre. Many professionals recommend putting in about 10% of the value of the property that will be sold to the trust.

However, the IRS has not commented on the amount, if any, that is sufficient. "Substance versus form is the only remaining Achilles' heel with the defective trust technique" now that the gift tax issue has been clarified, says Robert Keebler, a partner in the Green Bay, Wisc., accounting firm Virchow, Krause & Company LLP. The cash transfer to the trust is a gift, taxable if it is greater than the $11,000 annual exclusion and the client has consumed the $1 million lifetime gift tax exemption. But that may be a modest toll considering the potential savings.

First « 1 2 3 » Next