written by Brenda Logsdon
A GRAT is an estate planning technique that minimizes the tax liability existing when inter-generational transfers of estate assets occur. Under these plans, an irrevocable trust is created for a certain term or period of time. Assets are placed under the trust and then an annuity is paid out every year. When the trust expires the beneficiary receives the assets tax free. Definition found here at Investopedia.
A taxpayer can sell assets to an intentionally defective grantor trust (IDGT) so that any future appreciation of the asset will avoid estate taxes. This is typically done as an installment sale and the trust must pay interest on the note at the applicable federal interest rate. The taxpayer can sell any kind of assets, but are typically S-corporation stock or an interest in an LLC. The IDGT is an irrevocable trust for estate purposes, but for income tax purposes, the grantor is treated as the owner and pays tax on any income earned in the trust.
There are no gift taxes since it is an asset sale, but for income tax purposes, any gain realized on the sale is not taxable to the grantor. The taxpayer must make a significant gift to the trust, typically 20%, so that the IRS will not challenge the transaction and will have initial funding in order to pay the interest on the note. The note is usually interest only with a balloon note at the end of nine years.
Estate freezing with an IDGT occurs because any appreciation of the asset and accumulation of income earned inside the trust will be excluded from the taxpayer’s estate. The estate will also be reduced because the taxpayer will pay the income taxes on the income and capital gains earned inside the trust from the asset, which is a double estate tax benefit. Since the transaction is not treated as a sale for income tax purposes, the taxpayer also does not report the interest payment on the note.
The IDGT is similar to a GRAT, but does not have any mortality risk as with a GRAT. The disadvantage to the IDGT is that the beneficiaries will not receive a stepped-up basis equal to the value after the taxpayer’s date of death, but will only receive carryover basis.
Again, to maximize the benefits of any estate planning technique, whether a GRAT or otherwise, one must take into account the age and health of the grantor, the value of the assets involved, current interest rates and overall tax and financial position, and consult a tax professional prior to implementing any plan. Additional tips from Forbes.
If you have any questions about this estate planning technique, please contact us at 417-881-0145 or www.whitlockco.com.