Donald M. Thompson - Wills, Trusts, and Estate Planning


Sale to an Irrevocable Grantor Trust

This technique applies only to irrevocable trusts.

A grantor trust is one that is treated as owned for tax purposes by the person who created it and transferred assets to it. This person is called the grantor. If the grantor owns the trust for income tax purposes all income of the trust (and deductions and other income tax items) is attributable to the grantor. If the grantor is treated as the owned for estate tax purposes all trust assets are in the grantor's estate for estate tax purposes. The rules for determining whether the grantor is the owner are different for income tax and estate and gift tax purposes. Because of this it is possible to structure a trust that is owned by the grantor for income tax purposes, but not estate and gift tax purposes. The income would be taxable to the grantor, but the assets would not be in the grantor's estate.

Grantor trust status is determined by a variety of rights retained by the grantor. One of course, is the right to the income of the trust. However, the grantor does not have to retain the income in order to be taxable on it under the income tax grantor trust rules. Therefore a grantor trust can provide that income be paid to the grantor's children or grandchildren.

An example of a retained power that could cause a trust to be a grantor trust for income tax purposes, is the power to substitute property of equal value for trust assets. Making the spouse of the grantor a beneficiary is another example (note that if the spouse dies before the grantor this no longer applies).

With a grantor trust that is treated as owned by the grantor for income tax purposes, but not estate and gift tax purposes:

1. A grantor can sell property to the trust in a transaction which is ignored for income tax purposes because the grantor is selling property to him or herself.

2. If the property has appreciated in the grantor's hands there will be no recognition of gain on the sale.

3. If the property produces income in the future that income can be paid to the grantor's children while the grantor pays tax on it. In effect this transfers future income to the children tax free and the grantor's estate becomes that much smaller without incurring estate or gift taxes.

4. All future appreciation in the value of the property is out of the grantor's estate.

The grantor does get something for the sale. Otherwise the grantor would be making a gift. The grantor cannot get cash from the trust unless the trust has other assets or borrows against the property the grantor transfers. The grantor usually gets an installment note providing for payments of interest only.

To avoid a gift, the interest rate on the note must be at least the applicable federal rate periodically set by the IRS. The note usually provides for a balloon payment of all principal far in the future - often 30 years. The sale must also be for the full fair market value of the property to avoid a gift.

In effect the grantor exchanges what may be appreciating property and all future income from it for a fixed value, fixed interest rate. This technique is said to "freeze" the value of the grantor's interest.

Often this technique is combined with a device which will discount the value of the property the grantor sells to the trust. Family limited partnership interests are sometimes used for this purpose. However, any discounted asset could be sold - such as minority interest stock in a family corporation. (If the corporation is an S corporation, the trust must be qualified to hold it.)

A sale of property to a grantor trust can backfire. The retained installment note can wind up being worth more than the property sold to the trust. This can happen if the trust property declines in value or if it produces less income than the interest payments on the note. No one can predict the future, but unless the grantor expects the property in question to appreciate in value and to pay more current income than the interest rate on the note, this technique should not be used.

Of course a gift can be made to the trust instead of a sale. This works even better, but it will be subject to the gift tax.

The trust the sale is made to is usually funded with a gift of substantial assets before the sale to avoid IRS arguing that the sale is illusory because the buyer (trust) has no assets.

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Donald M. Thompson * 55 W. Monroe #3950; Chicago, IL 60603
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