This article is the second installment of a three-part series by Erica Williams that will highlight specific topics contained in recent tax reform proposals that may impact your estate plan. The first installment discussed the proposed changes to the estate and gift tax exemptions. This second installment will discuss grantor trusts and how the use of such trusts may change if the proposals become law. The third installment will discuss the effect that the proposed changes to annual exclusion gifts would have on certain transfers.
The use of irrevocable trusts to transfer wealth out of an individual’s taxable estate has been a long-standing technique in estate planning. Typically, transferring assets to an irrevocable trust also relieves the creator of the trust (the “Grantor”) of tax liability on the income the trust assets generate because the irrevocable trust is a separate taxable entity. In recent years, however, practitioners have relied on exceptions to the general rule and have included specific provisions in the irrevocable trust that would permit the Grantor to be the owner of the trust assets for income tax purposes only and thereby reap additional benefits of essentially being able to make tax-free gifts to the trust by paying the income taxes generated and by being able to sell appreciated assets to the trust without recognizing any taxable income as a result of the sale. These benefits may soon have negative consequences if the tax reform legislation proposed by Senator Bernie Sanders (I-VT) or similar legislation becomes law.
When assets are transferred to an irrevocable trust, the Grantor relinquishes all legal rights of ownership to the assets, effectively removing those assets from the value of the Grantor’s taxable estate so that they are not subject to federal estate tax. Under current law, the trust could be structured so that the trust assets will still be considered as owned by the Grantor for income tax purposes. If the Grantor is treated as the owner for federal income tax purposes, the trust is considered a “grantor trust” and the trust’s income is taxed to the Grantor as if the Grantor received the trust income directly. As a result, the trust’s assets can continue to grow without the trust having to pay income tax out of the trust assets. This has become a widely used technique because the IRS has ruled that the payment of the income tax by the Grantor is not considered an additional transfer to the trust. Each payment of the income taxes by the Grantor is essentially a tax-free gift that the Grantor may make year after year to continue to reduce his or her taxable estate.
A vastly popular estate planning technique is to have the Grantor of a grantor trust sell appreciated assets to the grantor trust. Because the Grantor would be treated as selling the assets to himself or herself for income tax purposes, the Grantor will not recognize any taxable income as a result of the sale. Consequently, the Grantor is able to make a gift tax-free transfer of the appreciation to the trust beneficiaries.
The tax reform proposed by the Act would eliminate the effective use of irrevocable grantor trusts. The proposed new rules will require the assets of certain grantor trusts to be included in the estate of the Grantor, treat certain distributions to beneficiaries of the trust during the Grantor’s lifetime as gifts from the Grantor, and treat the entire trust as a gift from the Grantor if grantor trust status is terminated during the Grantor’s lifetime. The Act would apply to grantor trusts established post-enactment, as well as to existing grantor trusts to which additional assets are transferred post-enactment. It is important to note that the governing date for these proposed rules is the date of enactment. This is potentially a very different, and much earlier, date than December 31, 2021, which is the date that the federal exemption amount would be decreased from $11.7 million per person to $3.5 million per person1. Because of this, it is imperative that grantor trusts be fully created and funded prior to the enactment of any such legislation.
1 See discussion in the author’s first installment, “The Proposals for Estate and Gift Tax Reform Have Begun: Analysis and Considerations Regarding Lower Exemption Amounts.”
We invite you to read other articles in this Estate Planning Series:
This article provides an overview and summary of the matters described therein. It is not intended to be and should not be construed as legal advice on the particular subject.