Getting the biggest bang for your buck from your grantor trust
By Cheryl Kehoe Schaul, Esq., and Kathryn Kaler, Esq., Neal Gerber EisenbergJANUARY 13, 2023
Irrevocable grantor trusts (also known as “intentionally defective grantor trusts” or “IDGTs”) are one of the most effective and popular estate planning tools for families to shift wealth to lower generations. An IDGT is a trust in which the grantor retains certain “grantor trust powers,” resulting in the treatment of the grantor as the owner of the IDGT for federal income tax purposes. Thus, the grantor (and not the IDGT) remains responsible for income taxes incurred in connection with income earned by the IDGT during the calendar year.
appreciation of gifted assets from the grantor’s taxable estate, a gift to an IDGT of highly appreciated assets can increase the family’s overall income tax burden.
One of the nuances of gift and estate tax planning is that assets gifted during lifetime retain the same basis in the hands of the donee (in this case, the IDGT) as in the hands of the donor, while assets received from the estate of a decedent are entitled to a basis step-up to the fair market value at the grantor’s death. The basis of appreciated assets held in an IDGT is not stepped-up upon the death of the grantor, notwithstanding the fact that the grantor is treated as the owner of those assets for income tax purposes. As such, the sale of an appreciated trust asset could trigger significant capital gains tax.
Although the grantor is responsible for the payment of taxes on the income of the IDGT, transfers to the IDGT will be treated as completed gifts for federal gift and estate tax purposes, assuming the retained “grantor trust powers” do not constitute retained powers for gift and estate tax purposes. Therefore, assets owned by such an IDGT are generally excluded from the grantor’s taxable estate and not subject to federal estate tax at the grantor’s death. In other words, the grantor is treated as the owner of the IDGT assets for income tax purposes, but not for gift and estate tax purposes.
The paradigm created by this different treatment for income tax purposes versus gift and estate tax purposes effectively allows assets owned by the IDGT to grow both income tax-free and estate tax-free for the benefit of the trust beneficiaries, while enabling the grantor to further reduce the size of his or her taxable estate (which would otherwise be subject to estate tax at the grantor’s death) by paying income taxes on behalf of the IDGT. Typically, the IRS would consider the payment of income tax on behalf of another taxpayer a gift. However, under current law, the grantor’s payment of the IDGT’s income taxes is not deemed a gift (and accordingly does not affect the grantor’s remaining estate tax exemption).
While an IDGT can be quite effective at reducing a grantor’s estate tax burden by removing the current value and all post-gift
Consider, for example, an asset with a basis of $10 and a fair market value of $100. If the asset is gifted to an IDGT during the lifetime of the grantor, it retains a basis of $10. After the death of the grantor, the asset still retains its original basis of $10. If, however, that same asset is owned by the grantor at the time of her death, the basis of the asset is stepped-up to $100. So, on the sale of the asset for $100, the IDGT will have a gain of $90 — whether the sale occurs before or after the death of the grantor — while the grantor’s estate and its beneficiaries will have zero gain.
The “swap power,” one of the retained “grantor trust powers” mentioned above, can be highly effective at reducing the income tax burden associated with appreciated assets held in an IDGT. The swap power enables the grantor to substitute, or “swap,” assets owned by an IDGT with assets of equal value owned by the grantor.
A grantor of an IDGT can exercise the swap power to pull highly appreciated, low basis assets back into his or her individual name and substitute an equivalent amount of high basis assets (such as cash). If the grantor retains the highly appreciated, low basis assets
The swap power enables the grantor to substitute, or “swap,” assets owned by an IDGT with assets of equal value owned by the grantor.
While IDGTs can be extremely impactful as a part of a client’s estate plan, they are not always simply “set it and forget it” planning vehicles.
in his or her name until death, then the assets will receive a step-up in basis to date of death fair market value, thus reducing the capital gains tax incurred when those assets are eventually sold.
What if the grantor does not have sufficient cash or liquid assets to engage in an asset swap? A beneficial alternative may be for the IDGT to sell the appreciated asset during the grantor’s lifetime. Remember that the grantor is responsible for the payment of income taxes incurred by the IDGT, and this includes capital gains taxes. Current federal capital gains tax rates (20%, or 23.8% if the net investment income tax applies) are lower than federal estate tax rates (40%).
The grantor’s payment of capital gains tax incurred in connection with a sale of assets by the IDGT further reduces the grantor’s taxable estate for estate tax purposes, thereby minimizing the
overall tax burden. This impact may be amplified for grantors residing in states that still impose an estate tax, as the effective estate tax rate could be in excess of 50%.
While IDGTs can be extremely impactful as a part of a client’s estate plan, they are not always simply “set it and forget it” planning vehicles. Fortunately, the swap power and the timing of asset sales can provide clients with valuable tools to minimize taxes to which trust assets, and the client’s estate, will ultimately be subject. Prior IDGT planning should be reviewed to confirm that the existing planning still satisfies a client’s objectives, particularly in light of the increased federal estate tax exemptions and the expected sunset of the current federal estate tax exemption at the end of 2025, and to ascertain whether further planning in connection with the prior IDGT planning would enhance a client’s overall objectives.
About the authors
Cheryl Kehoe Schaul (L) is a partner in Neal Gerber Eisenberg’s private wealth services practice. She concentrates her practice on estate and business succession planning and wealth preservation, and has extensive experience in formulating and implementing sophisticated estate plans for high net worth individuals and families. She can be reached at cschaul@nge.com.
Kathryn Kaler (R) is a partner in the firm’s private wealth services practice group. She focuses her practice on estate planning, charitable planning, and the formation and operation of nonprofit entities. She can be reached at kkaler@nge.com. The firm is located in Chicago.
