Reducing Exposure to the Estate Tax: Defective Grantor Trusts

Long-term complete repeal of the estate tax is highly unlikely, so techniques designed to minimize estate and gift tax exposure remain very attractive for clients of substantial wealth who are prepared to make irrevocable transfers to family members or other beneficiaries.

Intentionally Defective Grantor Trust (DGT)

In this technique, the irrevocable trust is deliberately structured so that the creator of the trust retains powers causing it to be “defective” for income tax purposes (i.e., any income earned by the trust is taxable to the creator or grantor rather than to the trust or the trust beneficiaries). Nevertheless, the trust is structured so that transfers to this trust are completed transfers for estate and gift tax purposes. This discrepancy between the two tax systems (income tax and transfer tax) creates many great opportunities for super-charged wealth transfer.

The traditional use of this technique involves the transfer of income producing property, or property likely to appreciate to the trust in exchange for a promissory note of “equal” value. As a result, the grantor “freezes” the value of the property transferred to the trust and allows the majority of the income and any subsequent appreciation on the property to eventually pass to the trust beneficiaries without gift or estate tax on those incremental values. Further, to the extent the assets being contributed are held in an entity such as a family limited partnership, the transfer of the entity interests likely garner minority and marketability discounts that immediately reduce the value of the assets transferred. The total taxable estate is even further reduced since the trust rules require the grantor to pay the income tax liability of the trust, effectively allowing additional gift tax-free transfers annually.

As an example, assume you created a family limited partnership to hold a $5,000,000 investment portfolio and retained the limited partnership interests. While you had planned to give small interests to your children annually, the value of the portfolio is rising too quickly and simply increasing your estate. Therefore, you would first create an irrevocable grantor trust for the benefit of your heirs and “seed” the trust with a small gift of property (say, 10% of the total amount expected to be contributed). While tax rules do not permit you to retain complete discretion over those trust assets, you do have the ability to maintain some indirect control and still achieve the estate tax benefits. You could just make a gift of the partnership assets to the trust, but this would come at a very large gift tax cost. Instead, you could sell the limited partnership interests to the trust in exchange for a promissory note bearing interest at the minimum prescribed rate (i.e., currently 3.58% for loans up to 9 years in term). Due to minority and marketability discounts on the limited partnership interests, the promissory note might reflect a 25% or greater reduction so the amount of the note might be $3,750,000 or less. As a result, the underlying property need only produce a 2.7% pre-tax return (i.e., 75% of 3.58%) to cover the interest and any excess return passes tax-free to your beneficiaries. If the total pre-tax return on the portfolio were 10% per year, the excess accumulating in the trust for later distribution could be as much as $345,000 per year – tax-free. To the extent the excess grows at the same 10% per year, the estate and Generation Skipping tax (GST) tax savings through compounding can be very substantial.

One of the additional benefits to the structure is its flexibility. To the extent the assets do so well that the trust contains more than you originally planned to transfer, the grantor trust nature of the trust can be relinquished and all future income taxes would be borne by the trust itself. In contrast, if the return on the investments is less than expected in any given year, the payments from the trust can be reduced to interest only. Alternatively, if you later decide that you would like to get back the specific assets originally transferred to the trust, you can freely exchange the asset with other property of equivalent value. All of these transactions, as well as the original sale and note repayment, would not create any income tax consequences for the grantor as long as the trust is a grantor trust, since the income tax law treats the trust and the grantor as identical.

Comparing a DGT Sale with a Grantor Retained Annuity Trust (GRAT)

Another technique often considered along with the DGT sale is a Grantor Retained Annuity Trust or GRAT. The reason for the comparison is that the technique is very similar to the DGT sale except that the grantor transfers property to the trust in exchange for an “annuity” as opposed to a note. There are key differences that might lead you to choose one over the other. First, the rules for the GRAT are taken explicitly from the Internal Revenue Code and therefore are legislatively sanctioned whereas the DGT sale is the product of cases and IRS rulings. The DGT sale, however, has been readily used for more than 20 years and has seen few successful challenges. Second, the DGT sale requires that a separate gift be made to seed the trust and it is often suggested that the amount of the gift need be as much as 10% of the sale amount. In contrast, the GRAT annuity value can be increased enough to effectively reduce the taxable gift amount to zero. Third, the GRAT contains an automatic adjustment clause wherein the retained interest adjusts to the extent the value is incorrectly determined. With a DGT sale, if the valuation of the assets sold is successfully challenged, some additional gift tax may be created. While the DGT sale documents might employ a similar type of adjustment clause, the effectiveness of those clauses has not been determined.

However, the DGT sale has its own unique benefits. First, since the property is sold and no annuity retained, the grantor may allocate the generation-skipping transfer tax exemption to the original gift. As a result, unlike a GRAT, the DGT sale is an excellent technique to pass wealth not only to children but also to grandchildren. Often, the terms of the trust provide that the assets are made available to the children but, to the extent undistributed, pass down to successive generations without tax. Second, unlike the GRAT, the payments under the DGT sale are flexible such that as little as the interest owed…or as a much as the entire promissory note…can be paid in any year. Third, the GRAT rules require the grantor to survive the term of the retained interest for the assets to be completely excluded from the grantor’s estate. With a DGT sale, the grantor need not meet any survival requirement and only the unpaid note is included in the grantor’s estate upon death. Fourth, the GRAT does not permit the trust beneficiary to receive any of the trust assets until the conclusion of the retained term whereas the DGT trust beneficiary can have more immediate access.

As always, the chief factors in selecting among these techniques are your goals and the type of asset being contributed. If your goal is to have assets remain in trust for multiple generations, the DGT sale likely is a better option due to the generation-skipping potential. If the asset is difficult to value or subject to substantial valuation discounts, the GRAT, with its statutory adjustment clause, probably is preferable. If instead, the income from the asset is variable or the beneficiaries need more immediate access to the trust assets, the flexibility of the DGT sale makes it the best alternative. In either situation, however, you can save substantial transfer taxes through proper design and implementation of these techniques. As we continue to assist you in your overall financial affairs, we welcome the opportunity to address these techniques in detail.

Clay Stevens, Los Angeles