Irrevocable Grantor Trust can reduce Tax exposure

March 16, 2023

Forbes’ recent article entitled “How To Pass On Business Assets While Paying As Little In Taxes As Possible” says that one of the first steps you’ll likely undertake in an estate plan is gifting assets so they’re not part of your estate. By gifting assets expected to appreciate over time—like company stock and real estate—into an irrevocable grantor trust and having those assets appreciate outside of your estate, you can reduce your estate tax exposure. Remember: the amount you can gift is restricted to you and your spouse’s combined lifetime federal estate and gift tax exemption ($25,840,000 in 2023).

As the grantor of the irrevocable grantor trust, you’ll be taxed on all income in the trust despite not receiving any of it. However, the payment of taxes from your estate reduces the value of your estate proportionately. Therefore, the assets in the trust can grow unburdened by taxation.

A drawback of gifting appreciating assets into a grantor trust is that the assets will retain the tax basis you, as the grantor, had when you gifted the assets. As the assets are no longer a part of your estate when you die, the assets you transferred to the grantor trust won’t get a step-up in basis to what their value is at that time. Capital gains taxation occurs when the trustee or beneficiary sells the appreciated assets.

Assuming that one of your goals for establishing the trust is to pay as little tax as possible, there are a few ways to avoid capital gains taxes inside a grantor trust.

As the grantor, you have the power to take trust assets back by buying them with cash or replacing them with other assets—low-appreciation ones are ideal. Therefore, if you get a large amount of your employer’s publicly traded stock, you might swap these shares for other publicly traded securities of equal value that have appreciated.

Since the assets traded must be equal in value, there shouldn’t be a change to your estate’s value used for calculating estate taxes. After the trade, you’ll own the highly appreciated stock. However, there won’t be a taxable gain when you pass away because you’ll get a step-up on the basis.

Likewise, for grantor trusts with appreciated real estate, an IRC §1031 exchange allows for capital gains taxes to be deferred when swapping one real estate investment property for another. Discuss with your estate planning attorney how an irrevocable grantor trust can reduce your estate tax exposure. If you would like to learn more about trusts and tax planning, please visit our previous posts.

Reference: Forbes (Dec. 22, 2022) “How To Pass On Business Assets While Paying As Little In Taxes As Possible”

What Is a Tax Reimbursement Clause?

February 13, 2023

What Is a Tax Reimbursement Clause? To understand a tax reimbursement clause, you must first understand what a grantor trust is, and how it works. A grantor trust means the person creating the trust, also called a trustor or grantor, is responsible to pay the income tax on income earned by the trust.

According to the article “Tax Reimbursement Clauses: What They Are And Why You Need To Know” from Forbes, these clauses were established when marginal income tax rates were much higher than they are today and taxpayers tried to save taxes by shifting income to a trust which paid a much lower income tax. Congress reacted by creating rules to cause the income of some trusts to be taxed to the grantor. However, tax experts reimagined the new laws and found a way to use the clause to benefit estate plans.

In 1986, when non-grantor trusts were taxed in a harsher way, grantor trusts were used for estate tax planning purposes. When assets were shifted into a trust, the goal is to have them grow rapidly and be protected by the trust. An increase in value of assets in the trust means less value in your taxable estate and outside the reach of creditors.

If you pay the income tax on the income earned by the trust, it grows faster because the value of the trust is compounding on a tax-free basis. Tax free compounding growth is considered one of the most powerful ways to build wealth.

As you pay income taxes on trust income, the trust grows faster and the assets in and value of the remaining estate is reduced. This also reduces the assets subject to the estate tax.

The purpose of the clause is to provide funds to the grantor to pay the income tax on the income earned by the grantor trust. What if the grantor trust tax becomes too much of a good thing, or if you don’t want to keep paying the income tax on the trust’s income?

If the trust can reimburse you for the income tax, it may help with cash flow concerns.

Talk with your estate planning attorney about the pros and cons of including a tax reimbursement clause in your trust. Some estate planning attorneys insist that a tax reimbursement clause must be included in every grantor trust, while others never use them. They are concerned that they may increase the risk of all trust assets being included in your estate as a result of the tax reimbursement clause being viewed as a retained right in the trust, or you as a beneficiary of the trust.

The decision depends upon your situation and your state laws. The improper use of a tax reimbursement clause might cause estate inclusion, in which case great care needs to be used before including this provision. However, there have been so many cases of taxpayers misusing tax reimbursement clauses that not including them may also make sense.

Every trust has its own language and the exercise of any tax reimbursement clause must comply with the terms of the trust.

Talk with your estate planning attorney about understanding what a tax reimbursement clause is and if it is appropriate for you. If you would like to learn more about taxes and estate planning, please visit our previous posts.

Reference: Forbes (Jan. 8, 2023) “Tax Reimbursement Clauses: What They Are And Why You Need To Know”

Steps to Ensure a Smooth Probate

December 7, 2022

What can you do to help heirs have a smooth transition when settling your estate? Probate can be a costly and time consuming process. There are steps you can take to ensure a smooth probate. A recent article from The Community Voice, “Managing probate when setting up your estate,” provides some recommendations.

Joint accounts. Married couples can own property as joint tenancy, which includes a right of survivorship. When one of the spouses dies, the other becomes the owner and the asset doesn’t have to go through probate. In some states, this is called tenancy by the entirety, in which married spouses each own an undivided interest in the whole property with the right of survivorship. They need content from the other spouse to transfer their ownership interest in the property. Some states allow community property with right of survivorship.

There are some vulnerabilities to joint ownership. A potential heir could claim the account is not a “true” joint account, but a “convenience” account whereby the second account owner was added solely for financial expediency. The joint account arrangement with right of survivorship may also not align with the estate plan.

Payment on Death (POD) and Transfer on Death (TOD) accounts. These types of accounts allow for easy transfer of bank accounts and securities. If the original owner lives, the named beneficiary has no right to claim account funds. When the original owner dies, all the named beneficiary need do is bring proper identification and proof of the owner’s death to claim the assets. This also needs to align with the estate plan to ensure that it achieves the testator’s wishes.

Gifting strategies. In 2022, taxpayers may gift up to $16,000 to as many people as you wish before owing taxes. This is a straight-forward way to reduce the taxable estate. Gifts over $ 16,000 may be subject to federal gift tax and count against your lifetime gift tax exclusion. The lifetime individual gift tax exemption is currently at $12.06 million, although few Americans need worry about this level.

Revocable living trusts. Trusts are used to take assets out of the taxable estate and place them in a separate legal entity having specific directions for asset distributions. A living trust, established during your lifetime, can hold whatever assets you want. A “pour-over will” may be used to add additional assets to the trust at death, although the assets “poured over” into the trust at death are still subject to probate.

The trust owns the assets. However, with a revocable living trust, the grantor (the person who created the trust) has full control of the assets. When the grantor dies, the trust becomes an irrevocable trust and assets are distributed by a successor trustee without being probated. This provides privacy for the beneficiary and saves on court costs.

Trusts are not for do-it-yourselfers. An experienced estate planning attorney is needed to create the trust and ensure that it follows complex tax rules and regulations. Taking the steps needed to ensure you have a smooth probate process will give you peace of mind. If you would like to learn more about the probate process, please visit our previous posts.

Reference: The Community Voice (Nov. 11, 2022) “Managing probate when setting up your estate”

Photo by Ksenia Chernaya

Protect the Family Business for the Next Generation

December 6, 2022

The reality and finality of death is uncomfortable to think about. However, people need to plan for death, unless they want to leave their families a mess instead of a blessing. In a family-owned business, this is especially vital, according to a recent article, “All in the Family—Transition Strategies for Family Businesses” from Bloomberg Law. There are strategies you can use to protect the family business for the next generation.

The family business is often the family’s largest financial asset. The business owner typically doesn’t have much liquidity outside of the business itself. Federal estate taxes upon death need special consideration. Every person has an estate, gift, and generation-skipping transfer tax exemption of $12.06 million, although these historically high levels may revert to prior levels in 2026. The amount exceeding the exemption may be taxed at 40%, making planning critical.

Assuming an estate tax liability is created upon the death of the business owner, how will the family pay the tax? If the spouse survives the business owner, they can use the unlimited marital deduction to defer federal estate tax liabilities, until the survivor dies. If no advance planning has been done prior to the death of the first spouse to die, it would be wise to address it while the surviving spouse is still living.

Certain provisions in the tax code may mitigate or prevent the need to sell the business to raise funds to pay the estate tax. One law allows the executor to pay part or all of the estate tax due over 15 years (Section 6166), provided certain conditions are met. This may be appropriate. However, it is a weighty burden for an extended period of time. Planning in advance would be better.

Business owners with a charitable inclination could use charitable trusts or entities as part of a tax-efficient business transition plan. This includes the Charitable Remainder Trust, or CRT. If the business owner transfers equity interest in the business to a CRT before a liquidity event, no capital gains would be generated on the sale of the business, since the CRT is generally exempt from federal income tax. Income from the sale would be deferred and recognized, since the CRT made distributions to the business owner according to the terms of the trust.

At the end of the term, the CRT’s remaining assets would pass to the selected charitable remainderman, which might be a family-established and managed private foundation.

Family businesses usually appreciate over time, so owners need to plan to shift equity out of the taxable estate. One option is to use a combination of gifting and selling business interests to an intentionally defective grantor trust. Any appreciation after the date of transfer may be excluded from the taxable estate upon death for purposes of determining federal estate tax liabilities.

For some business owners, establishing their business as a family limited partnership or limited liability company makes the most sense. Over time, they may sell or gift part of the interest to the next generation, subject to the discounts available for a transfer. An appraiser will need to be hired to issue a valuation report on the transferred interests in order to claim any possible discounts after recapitalizing the ownership interest.

The ultimate disposition of the family business is one of the biggest decisions a business owner must make, and there’s only one chance to get it right. Consult with an experienced estate planning attorney and don’t procrastinate in protecting the family business for the next generation. Succession planning takes time, so the sooner the process begins, the better. If you would like to learn more about succession planning, please visit our previous posts.

Reference: Bloomberg Law (Nov. 9, 2022) “All in the Family—Transition Strategies for Family Businesses”

Photo by Amina Filkins

GRATs are good Estate Planning Strategy

November 14, 2022

The first thing to know—GRATs are not just for the uber-wealthy, despite the title of the article “Here’s how uber-rich pass wealth to heirs tax-free when markets are down” from CNBC. “Regular” people and their families may benefit from using Grantor Retained Annuity Trusts. The second thing to know–GRATs work well when stocks are down in value and are expected to rebound relatively quickly. While no one knows what the markets will do today or six months from today, GRATs are good estate planning strategy for many people.

The GRAT works like this: assets like stocks in a privately-held business are placed into the trust for a specific amount of time—maybe two, five or ten years. Any investment growth passes to heirs and the original owner gets the principal back. This is, of course, a highly simplified description.

The family can avoid or reduce estate taxes at death by shifting future appreciation out of the estate. The investment growth is the tax-free gift to heirs. If there’s no growth, the asset passes back to the owners. Lowered assets likely to return in value over the life of the trust are the most likely to make this strategy work best.

The S&P 500, a commonly used barometer for U.S. stock markets, is down by about 24% as of this writing, making now an excellent time to consider a GRAT.

The GRAT makes the most sense for families who are subject to the federal estate tax. While the federal estate tax is applied to estates is now valued at more than $12.06 million, the federal estate tax is expected to drop precipitously when the Tax Cuts and Jobs Act of 2017 expires on December 31, 2025.

GRATs are said to have been used by some of the nation’s wealthiest people, including Michael Bloomberg, Mark Zuckerberg, the Walton family (of Walmart fame), Charles Koch and his late brother David Koch, Laurene Powell Jobs (the widow of Apple-founder Steve Jobs), Oprah Winfrey and others. However, a GRAT can work for people who are not among the top wealthiest in the country.

In 2026, the estate-tax threshold will be cut in half, unless Congress extends the Act. Individuals with $6 million estates, or $12 million for married couples, should start considering how to transfer their wealth now.

Rising interest rates put another wrinkle in planning for the future. The complex inner workings of GRATs concern interest rates, which must technically exceed a certain threshold—the “7520 interest rate,” also known as the “hurdle” rate—to pass tax free from the estate. This rate is currently up by 4% from October 2021.

Here’s an example of how this applies to a grantor-retained annuity trust. If investments in a two-year trust grew by 6% over two years, a trust pegged to the hurdle rate of October 2021 would allow 5% of the overall growth pass to heirs, but this would fall to 2% for a trust established in October 2022.

GRATs are good estate planning strategy for a variety of people. Your estate planning attorney will be able to explain whether a GRAT is a good fit for your wealth strategy, considering your tax liabilities, the size of your estate and your comfort level with any strategies tied to interest rates and markets. If you would like to learn more about GRATs, please visit our previous posts.

Reference: CNBC (Oct. 10, 2022) “Here’s how uber-rich pass wealth to heirs tax-free when markets are down”

Photo by Askar Abayev

Business Interests are better Protected by Trusts

July 26, 2022

Once your business grows, so does the pressure to make good financial decisions in the short and long term. When you think about the future, estate and succession planning emerge as two major concerns. You’re not just considering balance sheets, profits and losses, but your family and what will happen to them and your business when you’re not around. This thinking leads to what seems like a great idea: transferring stock or LLC membership units to one or more of your adult children. There are benefits, especially the ability to avoid a 40% estate tax and other benefits. However, there are also lots of ways this can go sideways, fast. Your business interests are better protected by trusts established to benefit your family.

Executing due diligence and creating an exit plan to minimize taxes and successfully transfer the business takes planning and, even harder, removing emotions from the plan to make a good decision.

An outright transfer of stock or ownership units can expose you and your business to risk. Even if your children are Ivy-league MBA grads, with track records of great decision making and caring for you and your spouse, this transaction offers zero protection and all risk for you. What could go wrong?

An in-law (one you may not have even met yet) could try to place a claim on the business and move it away from the family.
Creditors could seize assets from the children, entirely likely if their future holds legal or financial problems—or if they have such problems now and haven’t shared them with you.
Assets could go into your children’s estates, which reintroduces exposure to estate taxes.

No family is immune from any of these situations, and if you ask your estate planning attorney, you’ll hear as many horror stories as you can tolerate.

Trusts are a solution. Thoughtfully crafted for your unique situation, a trust can help avoid exposure to some estate and other taxes, allocating effective ownership to your children, in a protected manner. Your ultimate goal: keeping ownership in the family and minimizing tax exposure.

A Beneficiary Defective Inheritance Trust (BDIT) may be appropriate for you. If you’ve already executed an outright transfer of the stock, it’s not too late to fix things. The BDIT is a grantor trust serving to enable protection of stock and eliminate any “residue” in your childrens’ estates.

If you haven’t yet transferred stock to children, don’t do it. The risk is very high. If you’ve already completed the transfer, speak with an experienced estate planning attorney about how to reverse the transfer and create a plan to protect the business and your family.

Bottom line: business interests are better protected when they are held not by individuals, but by trusts for the benefit of individuals. Your estate planning attorney can draft trusts to achieve goals, minimize estate taxes and, in some situations, even minimize state income taxes. If you would like to learn more about business succession planning, please visit our previous posts.

Reference: The Street (June 27, 2022) “Should I Transfer Company Stock to My Kids?”

Photo by Christina Morillo

Category: Grantor Trust

Irrevocable Grantor Trust can reduce Tax exposure

What Is a Tax Reimbursement Clause?

Steps to Ensure a Smooth Probate

Protect the Family Business for the Next Generation

GRATs are good Estate Planning Strategy

Business Interests are better Protected by Trusts

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