Using a "Defective" Grantor Trust in the Sale of Family Business
Problem:
The husband and wife owners of a family business wanted to sell it. At the same time, they wanted to begin implementing their estate plan by making lifetime asset transfers to their children. They wanted to do this with the minimum of gift tax liability, and at the same time make sure that the gifted assets are entirely removed from their own estate (to lower their own eventual estate tax liability).One method:
With the help of an estate planning attorney, this family might utilize a "defective" grantor trust, which is one type of irrevocable (unchangeable) trust, offering an opportunity to transfer family wealth to successor generations, using asset valuation discounting techniques to significantly reduce the current gift tax which will be paid when the parents "gift" their property into the grantor trust, for the benefit of their heirs.Normally, income of an irrevocable trust is taxable to the trust or to the beneficiaries of the trust (in this case, the children). In a grantor trust, however, the trust income is taxed to the creator of the trust (called the grantor or settlor).
This is how it might work: before completing the sale of a successful family business, the husband and wife transfer a gift of a minority ownership interest in the business (in the form of stock or a partnership interest) to a newly-created grantor trust. The trust is established for the benefit of the taxpayers’ children and possibly their grandchildren. These are the beneficiaries.
Upon the transfer of the minority ownership interest to the trust, the grantors / settlers (the parents) must pay gift tax, required because the transfer and the trust are irrevocable. But because certain discounts will be applied to the value of the transferred property (based on lack of marketability and lack of control), the taxable value of the gift will be discounted by approximately 35% to 50%, or more. So, while a gift to the trust is made of, say, $100, for purposes of assessing gift tax, the grantors will pay tax on a gift valued at $50 to $65. But they will have reduced their own taxable estate by the full $100.
After the gift is completed, the trust will act as one of the business owners/partners at the time the business is sold. The trust will receive its share of the proceeds and invest them for the benefit of the children and any other beneficiaries. Thereafter, the grantors are responsible for the payment of income taxes on trust income. The income tax paid by the grantors acts as an additional gift to the beneficiaries, because no income tax is charged against the trust, and it can re-invest its income, or distribute all or part of it to the beneficiaries.
If the grantor trust document is carefully drafted to be "defective," the assets in the trust which generate income will be excluded from the grantor’s estate. There are several ways to create a "defective" trust, all involving specificity as to the rights and restrictions on the grantor’s use and control over the trust assets.
Of interest to many is the option of creating within the trust the provision that the grantor may re-acquire trust assets in a fair trade. This provision, in and of itself, constitutes a "defect," and may be of value to the grantor in a business context, particularly where trust assets appreciate, since the grantor secures a new stepped-up cost basis in the acquired trust assets, and avoids capital gains liability for any appreciation that has occurred during the time the assets were owned by the trust.
