Grantor Trusts: What are the consequences of the Treasury’s Fiscal Year 2023 Revenue Proposals? [1]
What is the Current law?
If a grantor creates a revocable trust, or in some cases an irrevocable trust, and retains certain powers regarding the trust or the trust’s assets—including, but not limited to, the power to control or direct the trust’s income or assets—then the trust is a grantor trust, and the grantor is considered the deemed owner of the trust’s underlying assets. Therefore, for income tax purposes, related items of trust income, deduction and credit are imputed to the deemed owner as if they received the income or incurred the expenses directly.[2] Further, any amount paid by the deemed owner of the grantor trust to satisfy the income tax liability is not treated as a gift by the deemed owner to the trust or its beneficiaries for Federal gift tax purposes.[3] Since the deemed owner and the grantor trust are essentially the same taxpayer, any transactions between the deemed owner and the grantor trust are disregarded for income tax purposes.[4]
Through effective tax planning, the use of grantor trusts, including Intentionally Defective Grantor Trusts (IDGTs) – trusts in which all income accrues to the trust, but is taxable to the grantor – and Grantor Retained Annuity Trusts (GRATs)—irrevocable trusts in which the grantor retains an annuity interest for a fixed term of years based on the grantor’s life expectancy—allow taxpayers to reduce their combined Federal income, gift, and estate tax obligations. By using a GRAT or selling assets to the taxpayer’s IDGT, the taxpayer is able to remove significant value from the taxpayer’s gross estate for Federal estate tax purposes, without Federal income or gift tax consequences, and allow such assets to further appreciate in value without any additional estate or gift tax consequence.
IDGTs and GRATs are often funded with assets that are expected to appreciate in value. When GRATs are created, the gift tax rules determine the value of the grantor’s gift of the remainder interest in the GRAT. At the end of the annuity interest term, the assets remaining in the GRAT are transferred to, or held in further trust for, the beneficiaries. If the value of the GRAT’s assets appreciate at a rate greater than the rate used to determine the grantor’s retained annuity interest, then the appreciation will be transferred to the remainder beneficiary or beneficiaries with little or no gift tax. However, if the grantor dies during the GRAT term, then a portion of the value of the GRAT assets will generally be included in the grantor’s gross estate for Federal estate tax purposes to cover the amount necessary to yield the annuity payment the grantor was entitled to under the remaining term of the trust.[5] Therefore, to lessen this risk the GRAT term is set for a period less than the number of years the grantor is expected to survive.[6] This results in the remainder beneficiary or beneficiaries coming into possession of the GRAT assets at the expiration of the term and the GRAT assets will not be includible in the grantor’s estate as the grantor no longer has an interest in those assets.[7]
Another estate planning tool used for grantor trusts is the sale of appreciated assets to the grantor trust by the deemed owner in an arms’ length transaction.[8] Since transactions between the deemed owner and grantor trust are disregarded for income tax purposes, the effect of the sale is the deemed owner does not have to recognize capital gain on the sale.[9] If the deemed owner is the grantor, then such a sale to the grantor trust removes future appreciation from the grantor’s gross estate without having to pay gift or estate tax.[10] In most sales, the deemed owner will receive a promissory note for the sales price by the trust which will be paid from the future income of the asset sold to the trust.[11]
What are the changes proposed by the Treasury?[12]
Grantor trusts and GRATS are powerful tools for estate planning. However, the proposed changes for Fiscal Year 2023 would have a big impact on their continued usefulness. For GRATs, the proposal would require the remainder interest, at the time it is created to have a minimum value equal to the greater of 25 percent of the value of assets transferred to the GRAT or $500,000. However, this minimum 25 percent or $500,000 value would not be more than the value of the assets transferred. The proposal would also prohibit any decrease in the annuity during the term of the GRAT as well as prohibit the grantor from acquiring an exchanged asset from the trust without recognizing gain or loss for income tax purposes. Finally, the GRAT would be required to have a minimum term of ten years and a maximum term of the life expectancy of the annuitant (generally, the grantor) plus ten years. Together these proposed changes may discourage grantors and estate planners from using GRATs purely for tax avoidance.
For grantor trusts that are not fully revocable by the deemed owner, the proposed changes would greatly impact the transfer of assets between the trust and the deemed owner or any third party by causing these tranfers to trigger income tax recognition. The transfer of an asset for consideration would result in the seller recognizing gain on any appreciation in the transferred asset. In the hands of the buyer, the basis of the transferred asset would be the fair market value of the asset at the time of the transfer. These transfers would include sales of an asset as well as satisfying an obligation by transferring appreciated property.
Further the proposed changes provide that the grantor’s payment of income tax on the income of the grantor trust would be treated as a gift. This gift would occur on December 31 of the year in which the income tax is paid. However, if the deemed owner is reimbursed by the trust during the same year the gift occurs, then the amount of the gift is only the unreimbursed amount of income tax paid.
[1] General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals (treasury.gov).
[2] Portfolio 819-2nd: Grantor Trusts (Sections 671–679), III. Section 671: Trust Income, Deductions, and Credits Attributable to Grantors and Others as Substantial Owners, C. General Consequences of Grantor Trust Status (bloomberglaw.com).
[3] See Portfolio 819-2nd: Grantor Trusts (Sections 671–679), III. Section 671: Trust Income, Deductions, and Credits Attributable to Grantors and Others as Substantial Owners, H. Gift Tax Implications of Grantor Trusts (bloomberglaw.com).
[4] See Portfolio 819-2nd: C. General Consequences of Grantor Trust Status, supra note 2.
[5] See Tax Practice Series: Estate Planning, Explanation, ¶6350.05.B. GRATs and GRUTs (bloomberglaw.com).
[6] Id.
[7] See Tax Practice Series: Estate Planning, Explanation, ¶6350.05.B. GRATs and GRUTs (bloomberglaw.com).
[8] See Tax Practice Series: Estate Planning, Explanation, ¶6350.04.F. Sales to Defective Grantor Trusts (bloomberglaw.com).
[9] Id.
[10] See General Explanations of the Administration’s Fiscal Year 2023 Proposed Regulations, supra note 1.
[11] See Tax Practice Series: Sales to Defective Grantor Trusts, supra note 8.
[12] See General Explanations of the Administration’s Fiscal Year 2023 Proposed Regulations, supra note 1.