An intentionally defective grantor trust is an extremely effective tool that accomplishes multiple objectives. First, it helps to minimize gift or transfer tax liability that a person may have to pay if the asset passed through normal probate process or it were gifted to the intended recipient. Second, it helps to step up the cost basis, which can be extremely valuable if the asset grew in value and then stabilized. It is often an effective tool for a small business owner who seeks to pass his/her business on to children or grandchildren. It is even more fitting if the same small business grew in size but then stabilized in value.
But, the question has to be asked. What’s with the reference “defective” in its name? It certainly is not a name conducive to marketing its rather impressive abilities. The term does not refer to something being broken (or busted). The term defective has a simple explanation, it is defective as to income tax liability. To state it in the inverse may help to explain it better; the trust is effective for estate tax purposes. In other words, the trust does not eliminate all taxes in that the grantor still pays the income taxes generated by the asset that is the corpus of the trust, but it does eliminate estate tax liability. Furthermore, it is a “grantor trust”, as defined at 26 U.S.C. § 675, meaning that it satisfies the legal definition of a grantor trust.
WHAT ABOUT GIFT TAX LIABILITY?
The transaction has to be structured properly to allow for the avoidance of gift tax liability. A good example is small business owner – let’s call her Deb – wants to ensure that her kids inherit her very lucrative company that specializes in providing services to disadvantaged, inner-city children. Deb sells her company to the trust, in return the trust gives Deb a promissory note. 26 U.S.C. § 675 establishes that a trust is a grantor trust for income tax purposes if the owner maintains control over the asset in a non fiduciary capacity. As such, even after the sale, Deb maintains control over the business to insure that the promissory note is paid in full.
However, when the income tax liability is due for Deb’s business over the next several years, it is paid for by the money that is due to Deb from the promissory note. Ideally Deb wants the promissory note to pay the same amount as is due to for the income taxes. Precision is possible but getting a figure that is approximately the same as is due for the income tax of the business is more likely. Deb’s children will also realize an added benefit for this transaction. Since Deb sold the company to the trust for its true market value, it has a stepped up or heightened cost basis. That means that if and when Deb’s kids takes over sole control of the company and the trust transfers the company out of its portfolio, they will have minimal, hopefully zero transfer tax liability.
As with any estate planning decision, it is best to consult with an experienced estate planning attorney.