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Chris Jones

For most people, estate planning includes transferring assets to their children or grandchildren without paying any taxes.  The problem is that these transfers are typically subject to federal taxes.  The transfers are either treated as gifts for which gift taxes are owed, or sales for which capital gains taxes are owed.  But there is a solution to this dilemma.  Because of discrepancies in the Internal Revenue Code, it is possible to transfer the appreciation of assets to other generations without having to pay either tax.  This technique is through the use of what is known as Intentionally Defective Grantor Trusts.

How Intentially Defective Grantor Trusts Work

A person creates a trust for the benefit of their children or grandchildren but retains specific limited administrative powers, such as the power to substitute the trust assets with other property of equivalent value.  The Grantor “sells” assets at fair market value to the trust in exchange for a long-term installment note. Because of provisions in the Internal Revenue Code, the Grantor is treated as the trust owner for income tax purposes, but not for estate tax purposes.  This allows the sale of the assets to the trust to avoid capital gains taxes and the note interest received by the Grantor to avoid being subjected to income taxes.  If the Grantor dies before the note is paid off, only the unpaid balance due on the note is included in the Grantor’s estate.

The only gift tax element is the requirement that the trust be capitalized with sufficient funds, usually ten percent of the value of the installment note, so that there is a debt equity ratio of not more than 10:1.  This prevents the trust assets from being included in the Grantor’s estate.

Income-Generating Trusts

As the Grantor pays income tax on the trust income, his or her own taxable estate is reduced by the amount of the tax paid.  The trust’s income accumulates and compounds over time.  Over a period of years, this is a dramatic benefit that will increase the value of the trust assets before they are distributed.

The taxpayer can allow funds to pass for the benefit of the trust beneficiaries free of gift tax by paying the income tax on the trust income.  All payments of taxes by the Grantor are, in essence, tax-free gifts to the beneficiaries.

Sale of Assets to Defective Grantor Trusts

Transactions between the trust and the Grantor are disregarded for income tax purposes.  When a person sells an asset to him or herself, the sale does not create any income tax consequences.  For example, the Grantor can sell appreciated real estate, or an operating business, to the trust.  The growth in value passes to the beneficiaries.  The sale of the assets to the trust by the Grantor in exchange for an installment note is a non-taxable event for the Grantor for income tax purposes.  Moreover, the payment of interest by the trust to the Grantor is a non-taxable event for income tax purposes.  It results in neither income to the Grantor nor any deduction by the trust.  The Grantor only pays income tax on the income generated by the trust property.  Since the Grantor, and not the trust, pays the income tax, the value of the trust assets is not reduced.  The trust is thus allowed to grow as a result of retaining the income as a result of the income tax savings and such growth is for the benefit of the trust beneficiaries, not the Grantor.

For Grantors with a taxable estate, this technique is very appealing in that it does not require the use of the Grantor’s estate and gift tax exemptions, nor does it require that the Grantor have to pay capital gains taxes.  With a goal of putting as many assets into the hands of beneficiaries as possible, this is a very useful tool in preserving the estate and even increasing the amount received by the beneficiaries.



- The Estate Planning Law Team
  Rogers Sheffield & Campbell, LLP


This article is not intended to provide legal advice. For legal advice on any of the information in this post, please contact us directly, use the form to the right or contact us by phone at 805-963-9721.

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