GRANTOR TRUSTS: GIFT TAX LOOPHOLES

By Drew Grey, CPA, Partner
dgrey@srgcpas.com

An irrevocable trust can be treated in at least three different ways for Federal income tax purposes.  A simple trust requires all the income to be distributed every year, in which case the beneficiary is taxed on the income.  A complex trust permits the trustee to accumulate or distribute income, in which case the trust is taxed if the income is accumulated and the beneficiary is taxed if the income is distributed.  A grantor trust is taxed to the grantor – the person who established the trust.  The trust itself, and the beneficiary, are ignored.  This last type of trust is difficult for many professionals to understand and, yet, can be one of the most powerful tools of gift and estate tax planning.

Grantor trusts are all around us.  Virtually every family with any amount of wealth has one.  They are called “living” trusts, or “family” trusts, or “revocable” trusts, or even “inter vivos” trusts.  In short, they are the “Will substitutes” that, starting in the mid-1970s, replacing Wills as the way to dispose of assets in California.  It is not surprising that these trusts are “ignored” for income tax purposes.  After all, the people who create them can amend or revoke them at any time (as long as they are alive).  What is surprising to most people, and many professionals, is that it is possible to have a grantor trust – one that is ignored – that is irrevocable.  How can that be?  The answer is that the word “own” is different for purposes of the income tax laws that it is for our “transfer tax” laws (gift, estate tax, and generation skipping transfer tax laws).

For income tax purposes you are deemed to own a trust if you merely have the right to “reacquire trust corpus by substituting assets of equivalent value.”  Essentially that means you can buy the trust assets for fair market value.  However, the fact that you have the trust does not prevent the trust from being excluded from your taxable estate.  Also, you are deemed to own a trust if the trustee has the right to use trust income to pay the premiums on an insurance policy on your life.  However, that does not prevent the trust from being excluded from your taxable estate.

Why is it important to have a trust which you own for income tax purposes but which you do not own for estate tax purposes?  Here’s a simple example.  Assume you give an apartment building worth $1,000,000, which generates $50,000 per year of taxable income, to a trust for the benefit of your children which is ignored for income tax purposes.  Every year the $50,000 of taxable income causes a federal and state tax liability of $22,500.  If the children’s trust had to pay the tax, it would be left with $50,000 – $22,500 = $27,500.  Instead, since you pay the income tax the trust is left with $50,000.  Also, your estate has been reduced by $22,500.  The IRS used to view your payment of the tax as a taxable gift.  However, it lost all of the cases and, eventually, gave up the battle.  As a result, almost every irrevocable trust currently drafted is a grantor (ignored) trust.  Sometimes these trusts are referred to as “defective” reflecting the prejudice that people feel that trusts should be required to pay their own taxes.  For added zest, these trusts are often drafted so as to give the trustee the ability to “toggle” grantor trust status off, and even back on.

The above is provided as a topic of general interest to our readers and should not be used for tax planning purposes.  If you are interested in exploring how these rules could benefit you, please contact our office.

For more information about sophisticated income, gift and estate tax planning, please contact me for a complimentary consultation at 818-995-0090 or send me an email to dgrey@srgcpas.com.

September 17, 2012 Posted in Estate Tax Planning, Tax