There is a type of trust that is currently popular among people who are interested in wealth preservation called the intentionally defective grantor trust. While the name may sound a bit strange, these trusts actually yield quite positive results when they are properly constructed.
The federal estate tax carries a $11.4 million exclusion in 2019. If your assets exceed this amount, you are logically going to be interested in the implementation of tax efficiency strategies. This is where the intentionally defective grantor trust comes in.
Assets that have been conveyed into the trust are leaving your estate, so its taxable value is being reduced. You name a beneficiary or beneficiaries who will receive distributions from the trust in accordance with the terms.
Though the assets are no longer part of your estate in the eyes of the Internal Revenue Service, you are not free of all tax responsibility. The trust is invariably going to earn income, and this income is taxable. The flaw that is inherent in these trusts makes you as the grantor responsible for the payment of these taxes.
This is actually good for the beneficiaries of the trust, because it will grow without being encumbered by recurring tax expenses. In addition, the money that you spend paying the income tax bills would otherwise be a part of your estate. As a result, it would be subject to the federal estate tax and its 40 percent maximum rate.
Family Limited Partnerships
People who are engaged in long-term financial planning are going to have to consider how they will be shifting their assets to their heirs as they age and eventually pass away. Those who have significant means have to concern themselves with the ravages of the federal estate tax and the gift tax with which it is unified.
At present the top rate of the estate tax is 40 percent. This is some significant potential asset erosion, so it is important to take action if your estate is in taxable territory.
There are a number of different strategies that can be implemented to provide tax efficiency, and one of them involves the creation of an FLP or family limited partnership.
As the name implies, these partnerships exist among family members. They are managed by a general partner or partners, and the GP will transfer interests in the partnership to limited partners. The general partner controls the assets and any distributions that may be made to the limited partners. The limited partners have no rights of control or marketability.
So to provide a very simple example, let’s say you create an FLP and fund it with $2 million. You give your two daughters each a 25 percent limited interest share. This equates to $500,000 each, and of course in liquid form half a million dollars is worth just that. So if you gave this amount to each of your daughters as a gift, the taxable value of each gift would be $500,000.
However, the taxable value of a 25 percent limited interest share in the family limited partnership is worth less than $500,000 due to the fact that the limited partner has no control over when distributions will be made or how the partnership will be managed.
These partnerships also provide asset protection, and transferred shares within the partnership can be eligible for tax discounts.
There are a number of different trusts other than the intentionally defective grantor trust that can be created to mitigate your estate tax exposure, and the optimal way to proceed will vary depending on the exact nature of your assets. For example, if removing the value of your home from your estate is a concern you could consider the creation of a qualified personal residence trust.
You can avoid multi-generational rounds of taxation by utilizing a generation-skipping trust. Tax-free asset transfers can sometimes be achieved through the utilization of the zeroed out GRAT (grantor retained annuity trust) strategy if you have highly appreciable assets and the federal midterm rate is favorable at the time you create the trust.
These are just a few of the options that are available to you. To explore the value of trusts in depth, send us a message through this page to schedule a no obligation consultation. You can also download our free estate planning worksheet to build on your knowledge.