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.

Nah.

"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'être. 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.

Now comes the actual sale. The IDGT gives an installment note to the client for the property's appraised value, adjusted for any appropriate discounts. There is no capital gains tax on the sale, Keebler says, because the trust is the grantor's alter ego for income tax purposes and transactions with oneself are not taxed. Likewise, although the trust must pay the grantor interest on the note at the applicable federal rate (AFR), there is no tax on the interest income.

Suppose a defective trust sale was completed in October, when the AFR for notes maturing between three and nine years was approximately 3.6%. Further imagine the trust property earning 200 basis points more than that, or 5.6%, in the first year. The trust has to pay 3.6% interest to the grantor, so her estate grows by that amount, minus the trust taxes she pays. Meanwhile, the 200 basis point excess return remains in the IDGT, where it bypasses transfer tax. So does any appreciation in the trust assets.

Selling assets to an IDGT for a private annuity, rather than an installment note, helps clients get assets out of their gross estate immediately, says Gerald Townsend, president of Townsend Asset Management in Raleigh, N.C. The client must have a life expectancy of at least one year and can't be terminally ill. Yet, if she does not survive the life expectancy shown in IRS tables, this type of transaction can lop off a big chunk of an estate. It's best to use income-producing property intended to be held long term.

Here's how it works: After priming the IDGT with cash and having the property appraised, the client sells it to the IDGT, which issues the private annuity-an unsecured promise to pay the client a fixed amount regularly, typically for life. (That's why income-producing property is recommended. Its cash flow makes it easier for the trust to pay the annuity.) In order to avoid gift tax consequences, the value of the transferred property must equal the present value of the payment stream.

The annuity payments obviously flow back into the grantor's estate, but consider the case of a 90-year-old nursing-home resident that Townsend is currently working on. He has recommended that the elderly man transfer $500,000 of real estate to a defective trust in exchange for a private annuity. Based on a five-year life expectancy, 4.4% Section 7520 interest rate and other factors, the client's annual nontaxable payment from the trust would be about $132,000. Therefore, if he dies after receiving two annual checks, the transaction will have sliced his estate by roughly $236,000-$500,000 property transferred out, minus $264,000 received from the annuity. The estate is further lowered by any taxes paid on the trust income.

The major downside, ghoulish as it may seem, is that the client could live a long time. All those annuity payments would fatten the estate, which would then have to be trimmed again via other strategies. "A private annuity is like taking a pill to lose five pounds right now and worrying about improving your diet later," Townsend says.

It's also important to note that the trust beneficiaries inherit the grantor's basis in the property. There is no step-up. In effect, then, the strategy saves the grantor estate tax but costs inheritors capital gains tax. But the latter is much cheaper and isn't triggered until the asset is sold-if it's sold. Townsend says, "Because the asset in this case is real estate, the heirs should be able to do a Section 1031 like-kind exchange. So potentially you've got some extremely long-term deferral on the income tax side."

While the certainty rendered by Rev. Rul. 2004-64 obviously makes the present a good time for transactions such as these, low interest rates do, too. For current IRS money rates, go to www.irs.gov/taxpros/lists/0,,id=98042,00.html.

When the Annual Exclusion Just Isn't Enough

Suppose your clients want to give their recently married daughter $80,000 for the down payment on a home-without gift tax consequence. One individual can give another $11,000 gift tax-free per year under the so-called annual exclusion. So married clients can transfer $44,000 to another couple each year.

The $36,000 gap?

Lend it and forgive it, says advisor Robert E. Maloney of Annapolis, Md. After Mom and Dad each write $11,000 checks to their daughter and son-in-law for the current year's annual exclusion gifts, they separately lend each $9,000. "Come January, the parents write letters to the children saying the notes have been canceled and converted to gifts" covered by the new year's exclusion, Maloney says.

To do it right, you need bona fide, interest-bearing I.O.U.s, he adds.