Learn more about Craig on NerdWallet’s Ask an Advisor
In estate planning, the goal is to remove as many taxable assets from a taxpayer’s estate as possible to go under the $5.35 million exclusion in 2014. You can accomplish this through a variety of means. One way would be to gift a portion of your estate to your heirs now instead of waiting until death. The problem with gifting is that you can only give someone $14,000 per year ($28,000 if married and electing gift splitting). Typically taxpayers that fall into the estate tax realm could never gift away their assets before death. There are a variety of other methods used to, in effect, gift away your estate. However the problem in gifting away your estate can come up with small business owners that own S-Corporation stock. Typically, the family business is the largest asset of the estate, and must be dealt with in a way whereby the shareholder gives the business away, but retains control over the assets until death. One popular method of doing this is with a Grantor Retained Annuity Trust (GRAT). However, GRATs have their own problems.
A GRAT is a trust created by a person (the grantor), who retains the right to receive fixed annual payments for a specified term of years. At the end of the specified term the property of the GRAT is either distributed outright to the designated beneficiaries or retained in trust for their benefit. The transfer of property to a GRAT may involve a gift to the remainderman (a person eligible to receive property in the future) for gift tax purposes. Whether there is a gift is determined by deducting the actuarially determined value of the grantor’s retained term interest from the total value of the property transferred to the trust. The difference, if any, is a gift to the remaindermen. The method of determining whether a gift is involved allows GRATs to be planned so the gift to the remaindermen is greatly reduced or entirely eliminated. The gift element is entirely eliminated if the gift is “zeroed-out.” The problem is that if you die in the middle of these payments, then the remaining value of the GRAT is then added to your taxable estate. In short, you have accomplished nothing.
I am licensed to represent taxpayers before the Internal Revenue Service. I am a tax specialist. In addition, I have a specialty as a Certified Estate Planner™. I do about 20 to 30 estate plans per year, and last year I ran into a problem with a client. His taxable estate was $8.98 million and $6.75 million of that was his Subchapter S-Corporation. He was 79 years old. At first I thought, we will do a 15-year GRAT, and get the S-Corporation out of the taxable estate that way. However, due to the client’s age it would have been a risky strategy. Instead, I used a strategy called an Intentionally Defective Grantor Trust.
A “Grantor Trust” is a trust that runs “afoul” of the rules contained in IRC§§ 671-679. Traditionally, running afoul of Grantor Trust Rules was viewed negatively in that the Grantor (the Trustor or creator) of the trust was, for income tax purposes, the owner of the trust assets, and therefore personally responsible for all items of income (ordinary income and capital gains) attributable to the assets held in the trust. This personal responsibility existed whether the income and/or principal was distributed to the Grantor or not.
Even though the Grantor is treated as the owner of a Grantor Trust for income tax purposes, he or she is not necessarily treated as the owner for estate tax purposes. The estate tax inclusion rules are applied separately to make the latter determination.
In some cases, a beneficiary can be treated as a Grantor (and therefore, the owner, for income tax purposes) of a Grantor Trust, thus allowing the beneficiary to utilize any tax benefits (or detriments) that would otherwise be attributable to the Grantor Trust.
An “Intentionally Defective Grantor Trust” (“IDGT”) is a term used for a trust that is purposely drafted to invoke the Grantor Trust Rules.
An IDGT can be created in one or more of the following ways:
- The Trustor or his or her spouse retains the power to recover the trust assets (e.g., the Trustor retains the right to reacquire property out of the trust in exchange for property of equal value);
- The Trustor or his or her spouse can or does benefit from the trust income (e.g., the Trustor and/or a nonadverse Trustee can sprinkle income for the benefit of the Trustor’s spouse);
- The Trustor or his or her spouse possesses a reversionary interest worth more than 5% of the value of the trust upon its creation;
- The Trustor or his or her spouse controls to whom and when trust income and principal is to be distributed, or possesses certain administrative powers that may benefit the Trustor or his or her spouse (e.g., a nonadverse Trustee may add beneficiaries of the trust income and/or principal).
An IDGT is an essential component for many estate planning techniques. For example, the most basic plan includes a revocable living trust (to avoid probate and allow for full use of the Applicable Exclusion Amount for estate tax), which is an IDGT. Irrevocable trusts, held for the benefit of the Grantor’s beneficiaries, can be IDGTs also. Because the Grantor pays the income taxes incurred by the IDGT, the assets held in the IDGT can grow unreduced by such income taxes. This, in turn, increases the value of the assets available for the trust beneficiaries. In essence, the payment of taxes by a Grantor is a gift to the trust beneficiaries that is not subject to transfer tax.
IDGTs also are beneficial because the trust is taxed as a “grantor trust.” IRC §671, provides that all the trust income tax attributes are taxed to the grantor. As a grantor trust, there is no income tax to the grantor on the sale of assets to the IDGT. The trust income also is taxed to the grantor, thereby resulting indirectly in greater tax-free gifts to the trust beneficiaries. Transfers to such a trust are said to be “effective” for estate tax purposes, but “defective” for income tax purposes. The provisions set forth in IRC §671-679 determine whether a trust is taxed for income tax purposes as a grantor trust. These income tax provisions do not dovetail with estate and gift tax provisions. This inconsistency between the estate and income tax provisions creates the planning opportunities.
Assets can be transferred to an IDGT by a few methods. The first is by gift or by a part gift and part sale. If the assets transferred are $5.35 million or less ($10.7 for a husband and wife) and the transferor has his or her full exemption available, a simple gift can be made to the IDGT. However, often the assets are both given as gifts and sold to the IDGT to leverage the amount of assets that can be transferred, preserve the exemption amount, or retain income.
So let’s back up for a second. The estate tax is a tax on your right to pass property along at death. For 2014, you do not have a taxable estate if your assets are less than $5.35 million. You also can gift these assets away during your lifetime. You have a lifetime gift tax exemption of $5.35 million. You can give away $5.35 million in increments of $14,000 per year without filing a gift tax return. Oh yes. There is a tax on gifts.
If you are married you have something called portability. What that means is that any estate exemption that you don’t use, will pass to your spouse. That is kind of neat. Now back to IDGTs.
Now I don’t want something to be lost on you. You can structure this as a partial gift and sale. In that scenario, the gift acts as the down payment, sort of like a down payment in a third party sale. So I like to follow rules that are really not rules, but they are Tax Court Rulings, or other factors the Code and Regs are silent on. So, the value of this “seed” gift should be at least 10% of the value of all assets transferred to the trust, including assets transferred by both gift and sale. When the gift is made, the transferor would use his or her lifetime gift exemption to avoid paying gift taxes. So, if you are keeping up that would be $5.35 million in an exemption.
Next, the transferor sells assets to the IDGT. This is typically things such as company stock, LLC interests, or real estate, in exchange for an installment note. This technique uses IRC § 453. The note would bear interest at the applicable federal rate (AFR) required under IRC § 1274(d). This rate is set for the life of the loan. The incredibly low AFR rate for a nine-year note for this year is right around 0.92% – 1%. Because the IDGT is a grantor trust for income tax purposes, the sale of the asset would not result in any taxable gain to the grantor (for income tax purposes, the grantor is considered to be selling an asset to him or herself). There also is no interest income reported by the grantor or interest deduction to the IDGT. The grantor is my client.
Now I want my client to retain control of the business until his death, but in an S-Corporation you can only have one class of stock, which is common stock. All shareholders of common stock have the same rights, and no one other than the majority shareholder can out trump any other shareholder. What I did was separate his stock holdings into two categories, voting stock, and non-voting stock. The shares of stock are still common shares, but now we have a class called voting. My client held all of the voting shares in this transaction.
For example, my client Tom could transfer $7.65 million of Company’s stock to an IDGT for his wife Julie, the children, and future generations and remove the value and its appreciation from his estate. This is accomplished by doing the following:
- Give $765,000 in stock as a gift to the IDGT.
- Sell $6.885 million in stock to the IDGT. The promissory note is annual interest-only, 0.92%, with a nine-year term balloon payment. The annual interest payment would be $633,420 ($6.885 million principal times 0.92% AFR interest rate).
- If the dividend on the $6.885 million of stock is 7% each year, the IDGT income would be $479,850.
- After the payment of interest, the balance of the IDGT income may be accumulated and reinvested by the IDGT, used to pay down principal, or disbursed to the IDGT beneficiaries.
My client did this:
- Retained the 100% of the voting stock of the S-Corporation which was 1% of the overall stock.
- Gifted $757,350 of the non-voting stock to the IDGT.
- Sold the remaining $6,816,150 in non-voting stock to the S-Corporation on an interest only note with a 15-year balloon payment at 0.92%, giving him income of $627,086 per year until what would presumably be his death. This income is taxable to my client as interest
- The income from the S-Corporation was $2.5 million per year. After the interest was paid, my client had the option of receiving additional principle on the note or taking a distribution of the profit. Because he did not materially participate in the S-Corporation activity the income to him was considered passive, and he was not required to take a salary.
What was accomplished was this, he actually sold his S-Corporation to the beneficiaries of the IDGT, which were his four children. The income from operations was used to pay the interest to the client, so there was no additional strain on the company’s finances or undue hardship on the children that inherited the business. My client used the income from the interest to live on, and the company paid him a small distribution. He removed the business from his taxable estate, and his rights to the promissory note are owned by his Revocable Living Trust and passed to his wife at death. Using portability of the Estate Tax, neither the husband nor the wife will owe any estate tax on the passing of the S-Corporation.
The client was ecstatic, and he will be a client for life.
With tax planning there are always some neat little tricks you can do. This is just one of them.