Defective Grantor Trusts
A defective grantor trust is a trust that has been carefully drafted so that the transfer of property to the trust is not a gift for gift and estate tax purposes and is not a sale for income tax purposes. By transferring enough of the ownership to make the property no longer the property of the grantor for gift and estate tax purposes, the assets transferred to a properly structured defective grantor trust is no longer included in the taxable estate of the grantor. However, the grantor continues to be taxed on the income generated by the asset, and the grantor continues to deduct losses generated by the property.
A defective grantor trust comes into existence when an individual (grantor) who has enough assets to be concerned about estate and gift taxes sets up a trust to achieve certain benefits.
In general, a defective grantor trust is a trust in which the grantor is denied the actual use and enjoyment of assets contributed to the trust. Therefore, contributions to such a trust must be irrevocable transfers, and the grantor cannot be a trust beneficiary. Since the grantor has irrevocable parted with use and enjoyment of the contributed assets, the property is treated as removed from the grantor’s taxable estate.
However, the defective grantor trust document reserves to the grantor at least one of several powers that for income tax purposes results in the trust and all of its property still being treated as the grantor’s property for income tax purposes. The powers and situations in which the grantor is treated as the ongoing owner for income tax purposes are in Code Section 671 through Code Section 677. For instance, the trust document will give the grantor the ability to replace the property in the trust with property of similar value (Code Section 675(4)).
By having the property transferred to the trust treated as the property of the individual for income tax purposes, a sale of property by the grantor to the trust is treated as a transfer from the grantor to himself. Under Rev Rul 85-13, the transaction is not a sale for income tax purposes.
A transfer of property to the trust is generally done via an installment sale. Many tax professionals believe that the trust must have some property before the sale for the IRS and the courts to respect the sale as legitimate. Consequently, before the sale occurs, the grantor generally gives the trust money equal to 10% of the installment sale amount.
Structuring the transfer of property as a sale at fair market value is very important so that no gift arises on the transfer. However, for income tax purposes, no income or loss is recognized on the transfer.
Since the transfer to the trust is treated as a sale for fair market value for estate and gift tax purposes, the grantor removes the future appreciation of the transferred assets from his estate.
Furthermore, the grantor continues to be taxed on the income generated by the property. Therefore, the trust receives 100% of the income generated by the assets in the trust while every year the grantor depletes his estate by the income tax the grantor is personally paying for the trust income. In essence, the grantor is able to make continuing nontaxable gifts to the trust beneficiaries for the income tax he personally paying every year.
The defective grantor trust gets the grantor’s basis in the assets. Had the property remained in the grantor’s estate, its basis would be adjusted up or down to the property’s fair market value at the grantor’s death. However, if properly done, you can achieve both the benefits of removing the appreciation from estate tax and obtaining a stepped-up basis at the time of death. Many defective grantor trusts give the grantor the right to swap assets in the trust for assets of equal value. If an asset in the trust is swapped out for another asset of the grantor, the asset swapped out of the trust and back to the grantor is included in the estate of the grantor. Furthermore, the asset swapped into the trust is not included in the taxable estate of the owner. By swapping assets, the grantor includes the appreciated asset in his estate, which receives a stepped-up basis for it when he dies. The property swapped into the trust continues with a carryover basis. So if appreciated stock is in the trust you could swap it out with cash, therefore at death the stock would get a step up in basis while the basis in cash remains the same.
The perfect asset for a defective grantor trust is an asset that produces cash flow and either can be transferred currently at a discount or will appreciate significantly.
Businesses in the form of S corporations, LLCs, or partnerships are the optimal type of asset. Such entities produce cash flow-through profits, and the cash can be distributed to the defective grantor trust tax free. Illiquid assets such as a house do not lend themselves to a defective grantor trust because of the cash-flow requirement.