Selected Funding Mechanisms

The perpetual trust can be particularly effective when combined with wealth transfer strategies designed to leverage value, i.e., to transfer significant value at a reduced (or no) transfer tax cost.  We have selected three such strategies to highlight the possibilities offered by the perpetual trust, whether by itself or in conjunction with the DAPT.  

Grantor Retained Annuity Trust/Sale to Defective Grantor Trust

The grantor retained annuity trust, or GRAT, has become one of the favored planning tools.  This strategy, which is sanctioned by Section 2702 of the Internal Revenue Code and is well-understood by sophisticated planning counsel, enables a settlor to transfer appreciation (above the adjusted AFR, currently hovering at or near historic lows) to beneficiaries with little or no taxable gift. (Pending legislation in Congress would drastically curtail the tax-saving potential of GRATs).

Although these characteristics make the GRAT a particularly useful vehicle for funding inter vivos transfers, it has been disfavored for generation-skipping planning because of the "ETIP" rules, which effectively preclude allocation of generation-skipping transfer tax to a transfer of property that might be brought back into the transferor's estate, until that possibility ends.  Most practitioners have assumed that this prevents allocation of GST exemption to a GRAT until the end of the GRAT term, at which time the remainder interest may be well in excess of the settlor's GST exemption, if the strategy has worked particularly well.  Some respected practitioners have suggested that this may not be the case, particularly in the case of a younger settlor or a short-term GRAT, if the possibility of inclusion is "so remote as to be negligible" (i.e., less than 5%).21

Even if one resolves this difficulty, the GRAT may present other practical hurdles as well.  In particular, the GRAT requires payments back to the settlor annually.  If the assets contributed to the GRAT are illiquid and produce little or no income, this requirement necessitates paying the settlor back in the assets themselves, which reduces the strategy's effectiveness and often necessitates additional expenditures, for example for appraisal of the assets.

The sale to a defective grantor trust presents a functionally similar alternative, one that addresses both of the difficulties just discussed.  The ETIP rules will not apply to a typical defective grantor trust (i.e., one that is "seeded" with a completed gift and over which the settlor retains no interest or powers that would cause the assets to be included in his or her estate), and so GST exemption can be allocated when gifts are made to the trust.  The note can be structured as an interest-only note with a balloon payment of principal at the end of its term, thereby greatly reducing (although not eliminating) the problem of annual payments.  

The grantor trust strategy does present its own difficulties.  First, the consensus of most practitioners is that the trust must have sufficient substance prior to the sale that the settlor's interest in the assets is debt, and not equity, in order to avoid either having the sale characterized as a gift or risking estate tax inclusion of the assets on the basis of a retained income interest in the settlor.  Therefore, a taxable gift and, if the dollars involved are large enough, the payment of gift tax may be involved.  

Second, the income tax consequences if the grantor dies prior to completion of the sale are at best unclear.  A conservative approach would suggest that when the settlor dies and the trust is no longer a grantor trust for income tax purposes, the remaining taxable gain on the sale is recognized.  At a minimum, this is a risk inherent in the strategy, although one that under the right circumstances has a solution, as discussed below.

Life Insurance

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