Large estates may be subject to the federal estate tax, which in 2023 applies a 40% tax on all wealth exceeding $12.92 million for individuals, or $28.94 million for married couples. High-net worth individuals often seek ways of reducing their estate tax liability on their already-amassed wealth, which is frequently done by applying “discounts” to their assets through a complicated web of valuation laws. There are other ways, however, to shift future appreciation of a valuable asset out of an estate, thus avoiding further taxation on a substantial increase in the value of an existing asset, such as a business or piece of real estate.
The strategy, in general, involves transferring the asset out of one’s estate, either by gift or sale, for a certain amount of money, thereby “freezing” the asset’s value. Once the asset is out of the estate, it is free to appreciate as much as possible, without the transferring taxpayer owing any further tax liability on the extra value. Through this strategy, a taxpayer owning a business worth $50 million could potentially save millions of dollars in estate taxes if that business grows to be worth $150 million in the following years. This strategy is not aimed at reducing estate tax on wealth already accumulated; rather, it is for minimizing tax on future wealth that would otherwise accumulate, leading to higher estate tax. Two vehicles, the GRAT and the IDGT, are most commonly used in these scenarios.
A GRAT, which stands for a Grantor Retained Annuity Trust, is an irrevocable trust that pays the grantor, or creator of the trust, an annuity payment over a term of years. The grantor will transfer an asset, which is expected to appreciate in the future, to the trust for a predetermined period of time. The trust will make fixed payments, or annuities, over the course of the term, usually annually. Assuming the asset appreciates beyond current IRS-set interest rates, derived from the Applicable Federal Rate, then the appreciation passes tax-free to the trust’s beneficiaries. But if the grantor does not survive the GRAT term, all assets will be reincluded in his or her estate, defeating the purpose entirely.
When the grantor initially transfers property to the trust, the grantor can calculate the value of the annuity interest over the course of the trust’s term. In other words, upon formation of the GRAT, the IRS determines the value that the grantor is expected to receive over the years that the GRAT is in effect. This annuity interest, or the value of the grantor’s payments over the term of the GRAT, depends on the length of the term, the value of the property transferred to the trust, and the IRS-set interest rate in effect at the time of formation. Any amount between the grantor’s retained annuity interest and the total value of the transferred property is a completed gift to the beneficiaries. Any amount exceeding these two will be tax-free appreciation that the beneficiaries enjoy. So, if the IRS-set rate at the time of formation is 5%, and the asset doubles during the term of the GRAT, the grantor could pass considerable wealth onto the next generation free from estate tax.
GRATs are thus desirable for assets that are predicted to appreciate beyond the IRS-set interest rate. If the asset does not appreciate beyond the rate, then no wealth is transferred to beneficiaries. Grantors often prefer to contribute assets like marketable securities, real estate, or family business, such as S-corp. stock or a family limited partnership to GRATs. A main drawback is that, again, the grantor must survive the term of the GRAT to shift wealth. This is why many grantors choose shorter GRAT terms and/or a sequence of GRATs that roll into the next upon completion.
Sale to an Intentionally Defective Grantor Trust
The use of Intentionally Defective Grantor Trusts (“IDGT”) involves an individual selling an asset to a trust in exchange for an installment note. When the asset is sold, it is no longer included in the transferor’s estate, so the transferor will not be responsible for paying tax on any future appreciation. The transferor will, however, have estate inclusion for the amount of the installment note.
In this scenario, the taxpayer creates a “grantor” trust. A grantor trust is determined by statute; if certain powers exist in the trust, such as the power to swap assets, then it is a grantor trust. The effect is that, while the trust assets are removed from the grantor’s estate for estate tax purposes, the grantor still must pay income tax on all trust income. This allows the grantor to distribute money from the trust to beneficiaries, while still paying the income tax instead of the beneficiaries. Many utilize this strategy to further shift wealth to children by paying their taxes, maximizing the transfer of wealth to the next generation without incurring estate tax. By paying income tax on trust income, the grantor also continues to reduce his or her estate, further minimizing estate tax.
There must be a reason for this transaction besides purely reducing taxes. The trust should be funded with assets prior to this transaction to ensure that the sale is a legitimate transaction. This initial gratuitous contribution of “seed” assets to the trust is a taxable gift; while gift tax would be owed on this transfer, grantors can utilize their lifetime gift tax exclusion amount and avoid paying tax on the initial funding.
The asset is then sold from the grantor to the grantor’s own trust, which is outside the taxpayer’s estate and not subject to estate tax. The trust must make payments on the installment note back to the grantor, plus interest at the Applicable Federal Rate, to constitute a legitimate, at-market sale. These payments, and the total value of the note, are included in the transferor’s estate for estate tax purposes. But the asset, now free to appreciate, is excluded from the transferor’s estate. Thus, if a grantor sells a family business to a grantor trust in exchange for a $30 million promissory note, and the business then appreciates to $100 million, the transferor will have an estate of only $30 million.
There are several drawbacks to this method, however. Unlike with GRATs, the installment sale method is not specifically authorized by statute, meaning that the IRS is potentially more likely to audit this transaction and oppose it. Additionally, unlike with GRATs, a transferor must make a sizeable gift to initially fund the grantor trust prior to the installment sale; if no lifetime gift exemption remains, then the transferor would be subject to gift tax liability upon this transfer. On the other hand, a benefit is that the transferor need not survive the term of the note to successfully remove the asset from an estate, unlike with GRATs.