What are tax rates going to be in 20 years? What will estate taxes look like in 30 years? How can you protect your family’s wealth for generations to come? While we can’t predict the future, we can introduce you to a strategy that exists today: Installment Sales To Grantor Trusts.
What are installment sales to grantor trusts?
This allows you to freeze the value of your assets to determine the “transferor’s” transfer tax base. By doing so, it may provide asset protection, wealth preservation, credit protection, avoidance of probate, and estate protection.
How does this work?
- As mentioned above, this technique freezes the value of the transferred assets at their current fair market value. The grantor receives interest payments on the note, with an interest rate that is hopefully less than the growth rate in the value of the transferred assets.
- This results in no tax consequence! The sale is disregarded as a sale to oneself since the grantor is treated as owning the trust assets for tax purposes.
- This also allows the trust to make principal payments over an extended period using the earnings from the transferred assets.
Role of the Grantor
- The assets in a grantor trust are treated as owned by someone other than the trustee. In most cases, the owner is considered the person who transferred the assets to the trust.
- Because the grantor is treated as the trust owner, they report the income generated by the trust assets on their tax return.
- To maintain this treatment, the grantor must:
- Retain the right to enjoy the income or principal or revoke the trust;
- Retain certain administrative rights or powers over the transferred assets; or
- Utilize the income to satisfy the grantor’s support obligations or pay life insurance premiums on their life.
- A person may be treated as owning the trust assets for income tax purposes, but not estate purposes. This is because the transaction is considered either a completed gift or a sale for adequate compensation.
- To maintain this treatment, the grantor must:
How is this created?
- Give the grantor a substitution power, such as the power to reacquire the trust assets by substituting assets with the same value. For example, transfer high basis assets into the trust in exchange for low basis assets. In this way, when he or she dies, the low basis assets get a step-up in basis.
- Give a non-adverse party the right to add beneficiaries such as a charity or spouses of existing younger generation beneficiaries.
- The payment of tax on the income by the grantor is not a taxable gift, but it does result in a tax-free transfer of wealth to the beneficiaries. This gets tricky if the trust reimburses the grantor for the tax on the trust’s income, as the assets may get included in the grantor’s estate.
- The grantor does not recognize taxable income due to the sale to the trust.
- Interest payments will not be taxable to the grantor nor deductible by the trust.
- The sale removes the trust assets from the grantor’s estate if he or she does not retain the right of ownership over the trust assets.
- The generation-skipping transfer tax will not apply to the trust assets if:
- The GST exemption has been allocated to gifts made to the trust.
- The installment note received by the grantor is equal to the fair market value of the sold assets.
- The interest rate on the note is the applicable federal rate.
- This technique can be used for a business owner who wants to transfer the business to some, but not all, children but still wishes to treat all children equally.
- For the non-ownership beneficiaries, if the grantor passes before the note is paid, a note is left to these children. Therefore, installment payments will increase the value of the grantor’s estate that can be used to equalize all children.
Funding the trust
- The trust should likely hold assets having a value equal to at least 10% of the value of the installment note the grantor will receive in exchange for the asset to be sold to the trust by the grantor.
- This avoids an argument that the grantor has retained enjoyment of the income.
Income tax consequences
- There is no recognition of income on the sale of assets to the trust.
- This is not considered a gift if the sale of assets to the trust is for full and adequate consideration.
- Interest must be charged at the applicable federal rate, and the note must be equal to the fair market value of the transferred assets.
- The grantor’s payment of the tax on the trust’s income is not a taxable gift to the beneficiaries.
Termination of the grantor trust
- The grantor will recognize a taxable gain equal to the unrealized appreciation in the unpaid principal at death.
- After death, much depends on the proper drafting of the documents and subsequent IRS rulings.
- The basis of the assets transferred to the trust will be the same as the grantor, plus any gift or GST tax attributed to the unrealized appreciation of assets.
- Remember, there is no step-up in basis as the grantor is not considered the owner for estate purposes.
- This may prove to be an effective way to transfer assets to younger family members at their current value vs. their appreciated value at the date of death.
- A disadvantage is that the beneficiaries receive a carryover in basis in the assets when they receive them.
- It’s imperative to have a properly drafted trust agreement, installment note, and other documents required under state law to transfer ownership of the assets to the trust.
- The Build Back Better Act would have eliminated the tax advantages by:
- Including the value of the grantor’s trust in the grantor’s gross estate.
- Treating distribution from such trust assets during the grantor’s lifetimes as taxable gifts.
- Treating sales between the grantor and a grantor trust as a taxable event.
- These proposals could resurface in subsequent legislation!
Are you still with us? If so, that was a challenging read – kudos to you! If you need help figuring out if this makes sense for you, schedule a call with us today. We’d be happy to work with your estate planning attorney to initiate the conversation.