In addition to raising tax rates on certain individual taxpayers, small businesses, and corporations, the recent House Ways and Means Committee tax proposal makes planning more difficult for those transferring wealth to heirs. The proposal calls for reducing the lifetime exclusion for gifts and estates (from $11.7 million per person to roughly $6 million) beginning in 2022 and rolling back the use of grantor trusts.
The appeal of a grantor trust
A grantor trust is designed to allow the grantor (the individual transferring property to the trust) to retain certain powers over the trust property. These powers are referred by the tax code (IRC §§ 671 through 678) as the “grantor trust rules.” Examples of these rules include the power to change or add a beneficiary of the trust and the power to substitute property of equal value within the trust (known as “swap powers”).
The appeal of a grantor trust is two-fold:
- The sale or transfer of property from the grantor to the trust is not considered a taxable event for income tax purposes. The IRS does not consider the grantor and the trust to be separate tax-paying entities. One strategy employed by taxpayers is to sell appreciated property to a grantor trust in exchange for a long-term promissory note. Since the grantor and the trust are considered the same income tax-paying entities, there is no capital gains tax triggered on the transaction. Additionally, grantor trusts can be used to maximize the benefit of stepped-up cost basis at death. Low cost-basis property held within a grantor trust could be swapped for high cost-basis property held by the grantor. This can be an effective tax-planning strategy since low cost-basis property owned individually by the grantor could benefit from stepped-up cost basis treatment upon the death of the grantor. Property held within the grantor trust is not eligible for stepped-up cost basis treatment.
- While a grantor trust is not considered a separate entity for income tax purposes, it is considered a separate entity for estate tax purposes. Transferring property to a grantor trust removes assets from the grantor’s estate. Since the trust is not considered a separate entity for income tax purposes, the grantor is responsible for reporting trust income on their individual tax return. This allows the property within the trust to accumulate free of taxes and avoids the more compressed tax brackets associated with non-grantor trusts, which are considered separate taxable entities.
Lawmakers target grantor trusts in new tax proposal
The draft legislation proposed in the House would introduce two new sections of the tax code to restrict the use of grantor trusts in the future, defined as date of enactment (when legislation is signed into law).
IRC § 2901 – Considers grantor trusts to be included in the gross estate of the grantor
IRC § 1062 – Treats sales between grantor trusts and their deemed owner (i.e., the grantor) to be considered a sale to a third party
Consequently, this proposal would eliminate the current benefits of using a grantor trust by including trust property within the estate of the grantor, and treating transfers of property between a grantor and a grantor trust as a taxable transaction. If the provision survives debate in Congress and is eventually signed into law, this will pose challenges for estate planning attorneys since many trust structures – including Grantor Retained Annuity Trusts (GRATS), Intentionally Defective Grantor Trusts (IDGTs), Spousal Lifetime Access Trusts (SLATs), Qualified Personal Residence Trusts (QPRTs), Irrevocable Life Insurance Trusts (ILITs), and some Charitable Lead Trusts — are structured as grantor trusts.
Existing grantor trusts are exempt from new laws – sort of
Grantor trusts established and funded before the legislative date of enactment are exempt from following new laws, with a caveat. Some grantor trust structures, such as GRATs and ILITs, involve ongoing transactions either in or out of the trust. During the term of a GRAT, there are ongoing annuity payments from the GRAT to the grantor. After the date of enactment, future payments would presumably be considered transactions between third parties and potentially be considered a taxable event. This would undermine an objective of utilizing a GRAT in the first place.
Existing ILITs could pose similar issues. Many ILITs are designed to leverage annual gifts into the trust as a source of funds to pay annual insurance premiums. Following the date of enactment, these transfers into the trust could trigger taxes, and the portion of death benefit proceeds associated with premium payments post-date of enactment may cause inclusion within the decedent’s taxable estate. One consideration would be to fund several years’ worth of insurance premium payments into the ILIT ahead of the date of enactment. Of course, the tax proposal will likely change as debate among lawmakers continues, and there is no guarantee the grantor trust provision will be included in a final package signed into law. Or, there could be modifications to the provision that would mitigate some of these potential issues involving ongoing transactions with trusts that were previously exempt from new laws under the proposal.
Seek professional advice on current estate plans
Investors with existing grantor trusts or considering a strategy using grantor trusts may want to consult with a qualified estate planning professional to understand the potential implications of the proposed change. It’s important to proceed carefully to balance the risk of not acting before legislation is signed into law versus pursuing a strategy now that may have negative consequences in the future.