If you’re thinking of transferring assets to your children, grandchildren and distant descendants, you may want to consider using a grantor retained annuity trust (GRAT) or an intentionally defective grantor trust (IDGT). Both estate planning tools can be used to freeze the value of the assets you transfer.
Let’s look at the basics of each.
A GRAT is an irrevocable trust that allows you to transfer assets to the trust and retain the right to receive a fixed annuity payment for a term of years. Once the trust is established, you can’t contribute any additional property to it. At the end of the term, the remaining trust assets are distributed to your beneficiaries. In this way, you can pass a significant amount of your wealth to the next generation with little or no gift tax.
GRATs are useful if you face significant estate tax liability at death. A GRAT may be used to freeze your estate’s value by shifting part or all of its appreciation onto your heirs. Any appreciation of an asset can be transferred to your children tax-free using a GRAT. This is why GRATs are a popular fund for assets that the owner expects to appreciate quickly, such as shares in a promising startup or IPO. The nature of the fund keeps the money from appreciation from counting against your lifetime exemption from estate and gift taxes. The trust appreciates when the assets included in it grow faster than the minimum annuity interest rate.
GRATs help reduce estate taxes in intergenerational transfers, but Intentionally defective grantor trusts or IDGTs have their own advantages in certain circumstances, sometimes making them even more efficient than GRATs.
A sale to an IDGT is more complicated than one is to a GRAT, but it offers potentially greater transfer planning opportunities. An IDGT also is an irrevocable trust that is defective for income tax purposes but effective for estate tax purposes. You make a gift of either cash or assets to the trust and those assets are held for the benefit of your heirs.
You retain certain powers that cause the trust to be treated as a grantor trust for income tax purposes. These powers don’t cause the trust assets to be includable in your estate. You might retain the power to swap trust assets with other assets of equivalent value. You may be able to borrow from the trust without adequate interest or security. For income tax purposes, you would be treated as the owner of the trust.
You can sell assets to your grantor trust without recognizing a gain on the sale. After you’ve made a gift to the trust, you can sell appreciated assets to the trust in exchange for a promissory note. Since the IDGT is a grantor trust, the interest income on the note is not recognized. If the income and growth of the trust assets exceed the interest rate on the note, the excess is passed on to your heirs, free of any gift tax. For estate tax purposes, the trust assets aren’t part of your estate, but any outstanding balance on the note is part of the estate.
It’s advantageous from a transfer tax perspective to make the note taxable on your trust’s income because your payment of the trust’s taxes essentially allows you to make additional tax-free gifts to the trust with each payment of the trust’s tax liabilities, further depleting your estate.
When you make the initial gift to the IDGT to fund the down payment and capitalize the trust, you may use a portion of your lifetime gift tax exemption or may even have to pay gift tax. There’s no step-up basis for the underlying assets, just as there isn’t in a GRAT.
There are estate tax consequences if you die before the end of a GRAT’s term or before the IDGT note is paid off. All of a GRAT’s assets may be included in your estate if you die during the term of the contract. Conversely, only the outstanding note balance from the IDGT is included if you die before the note is paid.
Due to the structure of a GRAT, the generation-skipping transfer tax exemption cannot be allocated until the end of the GRAT term. That exemption should be allocated so distributions to grandchildren and more remote descendants don’t incur a tax. Since the exemption cannot be allocated until the end, it’s not possible to know how much will be needed, and the value of the trust might exceed the available exemption. It’s possible to allocate the generation-skipping tax exemption to the initial gift to an IDGT. That’s why you may see the IDGT as a better vehicle for transferring assets to your children and grandchildren.
Consult with your trusted local professional tax practitioner or wealth advisor such as Bott & Associates, Ltd., to answer your questions about multigenerational wealth transfer.