Sales to Defective Grantor Trusts

Viewpoints on Financial Planning

One of the best tools to reduce future transfer tax liability for wealthy families is a sale of appreciating assets to a defective grantor trust (DGT) that is ultimately designed to benefit the grantor’s intended heirs. The utilization of a sale to a DGT freezes the value of the asset sold for transfer tax purposes in the grantor’s estate and results in all appreciation above the value of the note received in exchange for the property from inclusion in his or her estate. A DGT is structured to be a grantor trust for income tax purposes and designed to remove the property sold, but not the note receivable from future transfer tax exposure. This results in the grantor being treated as the owner of the property for income tax purposes (all trust income, deductions and income tax credits, if any, pass through to the grantor’s individual income tax return and taxes are paid at his or her rate), but the appreciating property sold would not be includable in the grantor’s estate.

A defective grantor trust can be beneficial your heirs.

A sale to a DGT is usually structured as an installment sale in exchange for an interest-only balloon note maturing several years hence. The trust needs to be funded with either existing capital or a gift from the grantor (general guideline – minimum equity capital of 10% to be treated as a commercially reasonable transaction) to lessen the risk of an IRS challenge as a sham transaction. Some commentators believe that 10% of the note value is sufficient to fund the trust; others take a more conservative tax position and postulate that the gift should equal 10% of the total trust property. If the DGT funding is a gift, federal gift tax consequences should generally be sheltered by either or both the annual gift exclusion ($14,000 in 2014) and $5.34 million lifetime gift exemption (2014) if not previously utilized. The interest rate on the note must be equal to or greater than the applicable federal rate in the month of the transaction for the applicable trust term. This rate is set on a monthly basis by the IRS (see FAQ #1). When completed, the property gifted and sold is removed from the grantor’s estate and replaced by the outstanding note. Because the trust is treated as a grantor trust for income tax purposes, there is no recognized gain on the initial sale. In this way, there are significant and immediate estate tax savings to the grantor.

Example: Mary has a significant net worth and wishes to pass about $3 million of it to her three children but is not willing to give up her principal on a long-term basis. So, she establishes a DGT trust and arranges a sale in exchange for an interest-only 9-year balloon note. To satisfy the 10% equity interest, Mary would have to make a gift to the trust of $333,333 (based on total trust value) to meet the 10% target equity requirement (10% of 3,333,333 is equal to $333,333). In January 2014, the minimum interest rate with annual compounding on a 9-year note according to the IRS is 1.75%. For 9 years, Mary would receive annual deemed “interest” payments of $52,500 with a final balloon payment of $3 million. Thus, she would end up with payments totaling $3,472,500 with any appreciation above that amount passing to her three children with no further transfer tax consequences. Assuming that the underlying property appreciates to $6.5 million over the 9-year note term, the $3.5 million of appreciation would inure to the benefit of her three children with no additional gift or estate tax consequences.

FREQUENTLY ASKED QUESTIONS

1. When should one use a sale to a DGT?

A sale to a DGT is an effective estate freeze technique and is most applicable with taxable estates that would exceed the applicable exclusion ($5.34 million in 2014). It is a tax efficient means for a grantor with an appreciating estate and potential significant tax exposure to maximize his or her family wealth transfer desires. It works best in a low interest rate as the deemed “interest” payments from the trust back to the grantor are smaller in a lower interest rate environment. The interest rate used is called the applicable federal rate (AFR) for the note term: short–term (3 years or less), mid–term (more than 3 years up to 9 years) and long–term (more than 9 years). This interest rate is generally lower than that used for a grantor retained annuity trust (GRAT) that is equal to 120% of the mid–term rate. Other elements make a sale to a DGT beneficial:

  • The grantor is motivated to make transfers to intended heirs and can afford to do so
  • Trust property is expected to out-perform the AFR during the note term
  • Gift tax valuation discounts may be available which can increase leverage and reduce required note payments
  • The grantor is willing to tolerate some tax risk due to unsettled tax issues associated with the sale of property to a DGT

2. What are the income tax consequences associated with a sale to a DGT?

A DGT is deemed to be a grantor trust for income tax purposes. Thus, the initial sale to the trust does not generate any capital gains tax consequences to the grantor. However, future trust income, deductions and credits pass through to the grantor’s individual income tax return and taxes are paid at his or her rate just as if the asset remained in the grantor’s name. This would be the case even in situations where the income tax liability exceeds the annual deemed “interest” payable to the grantor. From a wealth transfer perspective, the payment of taxes by the grantor on property that will ultimately inure to the benefit of his or her remainder beneficiaries can be viewed as an additional tax-free gift to those beneficiaries.

In order to be treated as a grantor trust for income tax purposes but not for transfer tax purposes, the grantor or his or her spouse must retain certain powers under the trust document (e.g. power of substitution, power to borrow without adequate security, power to control beneficial enjoyment in the underlying property without an applicable standard or adverse party in place). At the same time, the trust assets are maintained outside of the grantor’s taxable estate.

Since a sale to a DGT has no current income tax consequences, the underlying property sold would not receive a step-up in basis at the grantor’s death. This could result in greater income tax consequences upon subsequent sale. However, the federal estate tax savings should far outweigh the future income tax cost but in any event should be part of the overall decision making process

3. What requirements must be met for favorable tax treatment of a sale to a DGT?

  • The transfer to the DGT must be irrevocable.
  • The interest rate on the note must be equal to or greater than the applicable federal rate in the month of sale.
  • The trust must be adequately funded to qualify as a solvent party. Most experts opine that this requires at least 10% equity.

4. What are the estate, gift and generation-skipping transfer tax implications associated with a sale of property to a DGT?

Because the property is deemed sold and not a gift, the only transfer tax consequences associated with the sale of property to a DGT is the initial seed gift if the DGT were not already funded. The grantor’s estate would only include the face amount of the note issued by the trust in payment for the property. Because the property is being sold to the DGT and not gifted, a sale to a DGT has tremendous generation-skipping transfer (GST) tax applicability (e.g. to grandchildren) since a sale for full and adequate consideration is neither treated as a gift nor subject to generation-skipping transfer taxes. Only the gift to establish trust equity might have GST tax implications where the trust would ultimately pass to a skip person. The impact on the GST tax can be lessened or eliminated were the grantor to allocate his or her GST tax exemption when the seed gift is made.

5. What are some examples of how a sale to a DGT could be enhanced from a transfer tax perspective?

  • Rapid appreciation during the note term (e.g., value of property transferred is temporarily depressed)
  • Trust property generates adequate cash flow to cover required annual note payments (e.g., using the DGT as an irrevocable life insurance trust and directing excess cash flow towards insurance policy premiums)
  • Gift tax valuation discounts on the property sold can reduce required note payments back to the grantor
  • DGT can be structured as a GST exempt dynasty trust
  • Sale to a previously funded trust such as a mature GRAT can eliminate the need to make a seed gift

SUMMARY

A sale to a DGT can be a strong estate freeze tool that can permit individuals with a desire and capability to pass on substantial wealth to their intended heirs. It is ideal for high income and growth assets and a superior tool for generation-skipping transfer tax planning.

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