By Drew Grey, CPA, Partner

In a previous blog we discussed how grantor trusts – which are ignored for income tax purposes – are powerful gift and estate tax planning tools.  The IRS unsuccessfully argued that they were gift tax loopholes.  Grantor trusts are so powerful that, combined with a promissory note, they are an attractive alternative to the most sophisticated gift and estate tax planning techniques including self-cancelling installment notes (“SCINs”), grantor retained annuity trusts (“GRATs”) and private annuity trusts (“PATs”).

There are several reasons why a grantor trust is so attractive.  First, you must like the simplicity.  You start with a grantor trust, which is true of the three other techniques mentioned above.  All you add is a promissory note.  That is certainly less complicated than the documents and calculations required for SCINs, GRATs and PATs.  Second, the “hurdle” rate (the rate the assets should appreciate faster than) is lower than with the other three techniques.  With a sale to a grantor trust, you pick the “applicable federal rate” (the interest rate required by the IRS) depending upon the term of the note.  For September, 2011, the rates are the lowest in history: 0.21% short term (3 years or less); 0.84% mid-term (9 years or less); and 2.18% long-term (more than 9 years (all three are for annual payments; the long-term rate is slightly less when payments are made monthly).  Usually in these transactions we want to use the long-term rate?  Why, on the surviving parent’s death that parent’s estate will include a note with 10 or 20 years remaining at what we believe, by then, will be a very low rate compared to the then-prevailing market rate of interest.  If that is true, then the note will be severely discounted in the surviving parent’s estate.  Let’s try an example.

Assume Mom and Dad are 70 and 75.  According to the life expectancy tables, they have a survivor life expectancy of 20 years.  They sell an asset worth $1,000,000, with a basis of zero, to the grantor trust for their children.  Assume the asset generates $50,000 per year.  The children’s trust pays with an interest only 30 year note at 2.18%.  The survivor of Mom and Dad dies in 20 years when the comparable interest rate is 6%.  What is the value of a $1,000,000 note, with 10 years remaining, accruing interest at 2.18%?  The answer is, of course, for an appraiser to determine.  However, we can guess that it will be worth about $436,000.  Meanwhile, if the building has appreciated by 5%, at the end of the 20th year, $1,600,000 of value has already been shifted to the children.

This type of transaction is also attractive to the parents because they can, at any time, through their influence over the trustee of the children’s trust, increase the amount of payments they are receiving.  Therefore, if the parents need more money from the children’s trust than interest only, the trustee can start paying principal on the note.

A sale to a grantor trust is an attractive way to shift value from the parents to their children.  It gives the parents great flexibility on the level of income they receive in the future from the transferred asset.  Though it is not for every family, if you are interested in gift and estate tax planning, we will help you analyze whether it is right for you.

The above is not tax advice for any client or matter; it is provided as a topic of general interest to our readers and should not be used for tax planning purposes.  Each client’s situation contains unique facts.

If you are interested in exploring how these rules could benefit you, please contact Drew Grey at (818) 995-0090 or at to receive advice on your specific matter.




September 26, 2012 Posted in Estate Tax Planning, Tax