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Grantor Trusts

Objective
Estate planning techniques generally involve the transfer of assets during a person’s lifetime, which then avoids estate taxation at death. The transfer may involve either a gift or sale, and may be made to individuals or to trusts. Certain trusts, known as "grantor trusts" (also referred to as defective grantor trusts or intentionally defective grantor trusts), are particularly beneficial for estate planning purposes. If a gift or sale is made to a grantor trust, the grantor (the person who contributed the property to the trust) will remain responsible for paying the income tax on all income earned by the trust. By allowing the grantor (and not the trust) to make these tax payments, the grantor is in effect making additional tax-free gifts to the trust, which will further reduce his or her estate.

Description
In order for a trust to be classified as a grantor trust, the trust must contain special provisions, which are required by the Internal Revenue Code. Although the Code contains numerous provisions which will result in grantor trust status, many of these provisions will also result in the inclusion of the trust property in the grantor’s estate. Since the estate planning goal is to remove property from the grantor’s estate, it is important to select appropriate grantor trust provisions, which will not have any adverse estate tax effect. Perhaps the most common provision that is used for this purpose is the power in the grantor to reacquire the trust assets by substituting other property of an equivalent value. Such a power of substitution will cause the trust to be treated as a grantor trust, but will not cause the trust assets to be included in the grantor’s estate. It is not necessary for the grantor to exercise this power and actually substitute property; it is only required that the power exists.

Considerations
Although a grantor trust will result in additional estate planning benefits, it is important to understand the financial implications of such a trust. Even though the grantor no longer owns the trust assets, he or she will continue to be responsible for all of the income tax liability associated with the trust. This may be a significant obligation and the grantor should be comfortable with this result before proceeding with such a transaction. Even if a grantor trust is desired, it may be wise to include a provision allowing the grantor or the trustee to terminate grantor trust status by eliminating the power in question. This will add flexibility to the trust and permit a change to be made if the grantor decides he or she no longer wishes to be obligated to pay the income tax.

How U.S. Trust Can Help
Like any trust, a grantor trust requires the designation of a trustee or trustees who are responsible for the administration and investment of the trust assets. Since the primary estate planning goal is to remove property from the grantor’s estate, it is generally not recommended that the grantor serve as trustee. If the services of a professional fiduciary are desired, U.S. Trust may act as either sole trustee, or as co-trustee together with other individuals or family members.

Caution:
The Economic Growth and Tax Relief Reconciliation Act of 2001 was signed into law on June 7, 2001. The law makes substantial changes to the estate, gift and generation-skipping transfer (GST) tax systems, including increases in the applicable credits and exemption, incremental reductions in the tax rates and ultimate repeal in 2010 of the estate and GST taxes. The gift tax will remain in modified form. It should be noted, however, that the repeal of the estate and GST taxes is scheduled to last for one year only and the transfer tax system, as we knew it prior to the enactment of the law, will, without further legislation, be reinstated on January 1, 2011. In light of these changes, prior to making any transfer that may result in a taxable gift, you should consult with your estate planning advisors.

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