The third element that enhances the effect of leverage and reduces risk is the survival in the code of the so-called "intentionally defective grantor trust." These trusts are a classic tax loophole, one the Treasury Department has sought to close, but only by Congress enacting legislation.
Intentionally defective grantor trusts are trusts that, for federal income-tax purposes, do not even exist. The "grantor" generally, but not always, the person who contributed assets to the trust is treated as the owner (and taxpayer) of all the trust property for income-tax purposes, even if he or she has no interest in its economics. At the same time, for gift and estate tax purposes, the trust is recognized, and a transfer to the trust constitutes a completed transaction that removes any assets transferred to the trust from the transferor's estate. A properly drafted grantor trust allows the trust beneficiaries to earn whatever return the trust assets generate without paying taxes on that return, notwithstanding that the asset was valued on a taxable basis.
What's also important is that the trust's grantor pays federal taxes on the trust income, but under a long-standing administrative ruling those payments are not treated as gifts for purposes of the gift tax, even if they free up the trust cash flow for distribution to beneficiaries. Over time, paying those taxes significantly expands the grantor's gifting capacity.
Intentionally defective grantor trusts can be used in a number of ways: as the recipient of leveraged gifts, or even as the purchaser of assets from the grantor, often with seller financing (at the favorable federal rate). The grantor does not recognize taxable income from such a sale, because the transaction is disregarded for federal income-tax purposes. (The same is not true for Pennsylvania personal income taxes, however.) Such purchase transactions are powerful estate planning tools, but require adequate equity in the grantor trust and regular cash payments of debt service.
A specialized form of grantor trust is the "grantor retained annuity trust," or GRAT. A GRAT resembles the sale to a grantor trust, but without the need for cash payments of debt service or an equity contribution from the trust. The grantor contributes assets to the trust in return for an annuity obligation that represents a portion (up to 100 percent) of the value of the assets contributed, and for gift-tax purposes is only charged with the difference between the value of the assets and the imputed value of the annuity. If the trust does not have sufficient cash to make the annuity payment, it can pay the annuity in kind, returning a portion of the assets contributed at their then-current value. Properly structured, GRATs are one of the safest techniques of estate planning, because they have specific statutory and regulatory authority. Unfortunately, if the grantor dies before the GRAT annuity period ends, the GRAT property is included in the grantor's taxable estate, and the estate-planning tax benefits of the transaction are lost completely. For that reason, people often choose very short-term GRATs, two or three years, with large annuities, usually exceeding the available cash flow. If the return on investment exceeds the federal 1.2 percent annuity rate, the actual value transferred in a GRAT will exceed the amount reported as a gift for gift-tax purposes. If the investment loses money, the grantor will simply get the assets back ... and will likely try again with a new GRAT. If the GRAT has a $0 gift value at the outset, the grantor will not even use any gift-tax exemption if the investments are not successful.
(One of the Treasury's loophole-closing proposals has been to require GRATs to have a term of at least 10 years and to ban $0 gift value GRATs. So if a GRAT seems attractive, it is worth exploring now, before Congress' next opportunity to pass tax legislation.)
For the moment, at least, wealthy families that can afford to give more to the next generation than they have already given have many ways to transfer wealth, without subjecting themselves to current gift tax.
Actual estate-planning transactions are complicated, however. Each type of technique discussed here (and those not discussed here) has technical requirements and limitations that competent counsel must address. The law could change at any time, including as part of the "tax reform" bargain both Democrats and Republicans claim to favor. It is also vitally important to recognize that all of these transactions involve actual transfers of wealth and should be undertaken only by people who are absolutely certain they will not need access to the assets transferred to support their own lifestyles and health.
John H. Schapiro, a partner in Kleinbard Bell & Brecker's business and finance department, is the practice leader of the firm's taxation group and a member of the trusts and estates group. He has counseled middle-market businesses, their executives and their families for more than 25 years. He combines extensive experience as a transactional business attorney with expertise in federal and state income taxes, and estate and inhertance taxes.