Most everyone is familiar with a Revocable Living Trust. This estate planning vehicle allows you to transfer your assets to the trust, retain control over the assets and avoid a probate process at your death. The trust rather easily transfers the assets without the need for court action to your beneficiaries.
Because the trust is revocable, you can freely change the trust terms, including who would act as your trustee if you should become incapacitated or die, as well as who the trust beneficiaries will be, and in what amounts and percentages.
Revocable trusts therefore are grantor trusts for income tax purposes. In other words, the Revocable Trust uses your social security number as its tax identification number. It doesn’t file any separate tax returns during your lifetime. Your revocable trust is effectively you. It is just another form of ownership.
Consequently, when you die the assets titled in the trust are included in your estate for federal estate tax purposes. Remember that unlike the income tax, which is a tax on your “income statement,” the estate tax is a tax on your wealth. It’s a “balance sheet” tax.
But grantor trusts can be so much more than revocable trusts. They can be used to save both income taxes and estate taxes. But to do so requires a complete understanding of how the counterintuitive interaction of income and the estate tax laws create planning opportunities.
The opportunities arise not from the use of revocable rusts, but from irrevocable trusts.
Once you create an irrevocable trust, you can’t change it. With an irrevocable trust, we can create a trust that for estate tax purposes removes the assets from your estate, but for income tax purposes the income and capital gains are taxed to you.
Using the tax law, we can manipulate outcomes to both eliminate capital gains taxes and remove assets from our estate for estate tax purposes. Most of us are familiar with how income taxes work. Estate taxes, however, are not a tax on our income, rather they are a tax on our balance sheet.
One strategy to accomplish this goal is to use a technique known as a “sale to an Intentionally Defective Grantor Trust” (an “IDGT”).
Under the tax code, if you create a trust and you retain certain rights, then for income tax purposes, the trust is still deemed to be you. But for estate tax purposes, completed transfers to this type of irrevocable trust can exclude the transferred assets from your estate.
A “swap power” right, for example, is a right that will result in an irrevocable trust being taxed to you as the grantor for income tax purposes despite the trust assets being excluded from your estate for estate tax purposes. As it sounds, a swap power is one where as grantor, you have the right to substitute assets of the trust, so long as the swap is of equal value, and no beneficiary income rights are compromised.
To illustrate, assume that Grantor (G) creates an irrevocable trust naming his spouse (W) as trustee and his child (A) as beneficiary for A’s life and at A’s death the trust terminates to B. G retains the right to substitute assets of equal value. This is known as an Intentionally Defective Grantor Trust (IDGT).
G then transfers stock to the IDGT valued at $1 million but assume G’s tax cost basis in this stock is only $100,000. If G were to sell the assets G would realize a $900,000 capital gain and pay a large capital gains tax of approximately $214,200. Let’s also assume that the stock is appreciating at 10% per year.
When G transfers the $1 million of stock, the IDGT writes a promissory note back to G for $1 million. G effectively “sold” the stock to the IDGT. Because the IDGT is considered a grantor trust for income tax purposes (because of the swap power makes it a grantor trust for income tax purposes), no capital gain is realized. G does not pay capital gain tax.
Several years later the stock value grows to $1.5 million. G then uses his swap power to take the stock back, substituting cash into the IDGT for the stock. Why does G do this? Because if G owns the stock when he dies, his estate gets a step-up in tax cost basis.
Assume that G dies, and the stock is still worth $1.5 million. G’s estate is now free to sell the stock for $1.5 million and not realize any capital gains tax.
The IDGT, however, owns $1.5 million of cash but also still owes G’s estate the $1 million promissory note. The IDGT pays back the promissory note leaving it with $500,000 of cash. The result is the elimination of capital gain on the stock, and $500,000 is distributed to the IDGT beneficiary tax free.
I simplified this illustration to make it understandable. I didn’t point out, for example, that another benefit to this strategy is that with the promissory note G can continue indirectly receiving income from an asset that he irrevocably gave away. Yet, at the end of the day he did get the asset (stock) back, eliminated the capital gain, enjoyed indirect income from it, and transferred $500,000 tax free to his heirs.
Usually, if G retains the right to income then the asset is included in his estate for estate tax purposes. This strategy circumvented that rule.
Beware, as there are many nuances to the proper creation of an IDGT, as well as the structure of the sale and swap transaction. Failure to fully understand the nuances in the tax law could result in the strategy’s failure.
Nevertheless, you can see how the tax code might be used to achieve estate planning goals. In future columns I’ll explore additional estate planning grantor trust
© 2020 Craig R. Hersch. Originally published in the Sanibel Island Sun