grantor trust is a trust that you establish and for which you will remain liable for all income taxes. You, as the “grantor,” pay the income tax on trust earnings. At the heart of much sophisticated estate planning is an irrevocable (you cannot change it) grantor trust to which you make a completed gift (so that the future value of that gifted asset will not be included in your estate). Even though you remain liable for the income tax on income and gains generated from the assets held in that trust, the trust assets are removed from your estate. This is a rather incongruous result. It is treated as a completed gift for gift, estate, and GST tax purposes, but the gift is essentially ignored for income tax purposes (i.e., you as the grantor are still treated as owning the trust property for income tax purposes only).The benefits of making a completed gift to a grantor trust cannot be overstated. Grantor trust status is a keystone of much of modern estate and trust planning. For example:
•A trust’s status as a “grantor” trust for income tax purposes permits the much coveted “estate tax burn” in your estate. As you pay income taxon earnings accumulating inside an irrevocable trust, your estate is further diminished by the annual tax payments. For many taxpayers, the impact of this estate tax burn can far exceed the benefit of pushing the envelope on valuation discounts that many practitioners continue to focus on.
•With grantor trust characterization, highly appreciated assets can be sold to an irrevocable trust without triggering any capital gains tax. For wealthy taxpayers seeking to shift large asset values (e.g., well above the $5.12 million exemption amount) out of their taxable estates, and for those of more modest wealth seeking to shift assets into the protective envelope of a trust in order to protect them from potential claims of future creditors, including divorce or lawsuits, grantor trust status may be critical. See the discussions that follow concerning DAPTs and BDITs.
•Grantor trust status can often help to avoid some of the thorny income and estate tax issues associated with transfers of life insurance policies to and from trusts.
President Obama’s Greenbook proposal (the General Explanations of the Ad-ministration’s Fiscal Year 2013 Revenue Proposals, released February 13, 2012), if enacted, would undermine this critical component to many estate plans by requiring that assets held in any grantor trust (even an irrevocable completed gift trust) will be included in the grantor’s taxable estate. Distributions out of such grantor trusts will be treated in the future as completed gifts by the grantor at that time. If an irrevocable grantor trust is created and funded in 2012, it may be exempt from the provisions of the new law (i.e., grandfathered), at least as to transfers completed prior to any law change. This can have a tremendous planning benefit and is yet another reason you should plan before the end of 2012.
PLANNING NOTE: You might consider incorporating express language in your Trust Agreements so as to permit trustees to create separate sub-trusts for pre- and post-grantor trust law changes. This would allow the trust to be bifurcated as to any future component of the trust that either will be anon-grantor trust or would be included in the grantor’s estate at death under President Obama’s proposal.
Other grantor trust planning opportunities are discussed in later chapters.
Lock in Discounts
Favorable valuation discounts often provide the leverage that has imbued many estate planning techniques. Valuation discounts, in very simplistic terms, can be illustrated with an example. If a closely held business is worth $1 million, 30 percent of the business is worth less than $300,000 (30% x $1 million) because the owner of such a minority interest generally cannot control distributions to owners or make other important business decisions. Discounts have provided tremendous leverage to many tax-efficient wealth transfers.
There have been a host of proposals over recent years to restrict or eliminate valuation discounts on certain asset transfers among members of a family. If a gift is consummated before any such law changes, the favorable valuation discounts that are currently permitted should be locked in. Once the law changes, these favorable discounts may be lost on future transfers. Discounts can be more important than just adding leverage to a wealth transfer transaction (i.e., getting the biggest bang for the buck out of the donor’s available gift and GST exemptions). For instance, discounts may be critical to the transaction itself being viable in the first place. Discounts can be essential not only for certain estate plans, but for as-set protection as well. Asset protection planning as a separate motivation for 2012 transfers is discussed next.
EXAMPLE: A physician wishes to engage in asset protection planning. She owns interests in a number of real estate limited liability companies (LLCs) where her practice offices are based as well as in several surgical centers. The real estate alone is valued at $7 million. Relying on minority interest discounts on her ownership in the various LLCs, the physician can simply gift the LLC interests to a completed gift DAPT (explained later) without gift tax under the protection of the $5.12 million exemption and remove all future appreciation on this real estate from her estate. Perhaps, more important, the physician can also achieve meaningful asset protection planning. Without the discounts, the physician would have to gift one or more LLC interests to the DAPT and sell the remaining interests for a note in order to avoid gift tax. This would significantly increase the cost and complexity of the transaction and leave the note in her estate.
EXAMPLE: Entrepreneur A owns 50 percent of the interests in a real estate rental entity organized as an LLC. The business is valued at $40 million. Entrepreneur A wishes to gift $5 million worth of the LLC to a dynasty trust for his heirs to use his exemption. He also wishes to sell the balance of his interests in the LLC to the same trust. The goal is to shift all future appreciation in the value of the real estate business away from Entrepreneur A’s estate and to the dynastic trust while “freezing” the value of the business interests subject to the note sale.
Now is a perfect time to engage in this type of transaction because business valuations remain depressed due to the flailing economy, and the interest rate to be paid to Entrepreneur A on the note can be set at a historically low rate. While the LLC has always paid arm’s-length salaries, cash distributions to the members (owners) have been relatively modest compared to the revenues and earnings because most of the profits have historically been reinvested in the form of capital improvements to the real estate. Even with today’s historically low interest rate, the annual distributions that the real estate LLC could realistically make to the trust (as the new owner) would likely be insufficient to enable the trust to make current interest payments on the note. The attorney planning the transaction is of the opinion that interest on the note sale should be paid currently, not accrued, to bolster the likelihood of the IRS respecting the sale transaction. With an aggregate discount estimated by an appraiser at 40 percent, the value of the LLC membership interests sold (and given), the note sale portion of the transaction can be reduced to a level such that the annual distributions from the LLC may well be sufficient for the trust to make current interest payments on the note.
However, if the transaction is not completed in 2012, but in 2013 when these discounts may be restricted or eliminated, the annual distributions from the LLC would never suffice to make current interest payments. Thus, the discounts, apart from providing favorable leverage
