Have you been thinking about transferring your assets to your children, grandchildren, or your descendants? You may want to consider a grantor retained annuity trust (GRAT) or an intentionally defective grantor trust (IDGT) to freeze the value of the assets you transfer.

An overview of GRATs

A GRAT is an irrevocable trust that allows you to transfer your assets to the trust, while retaining the right to receive a fixed annuity payment for a term of years. Once this trust is established, you’re barred from contributing any additional property to it. At the end of the term, the remaining trust assets can be distributed to your beneficiaries with little to no gift tax.

A GRAT is especially useful if you have significant estate tax liability at death. GRATs may be used to freeze the value of your estate by diverting all or part of its appreciation to your beneficiaries. Asset appreciation can be transferred to your heirs tax-free, which is why GRATs are popular for assets that are expected to appreciate quickly (like shares in an auspicious startup or IPO). The fund keeps the money from appreciation from counting against your lifetime exemption from estate and gift taxes, and the trust appreciates when the assets in it grow faster than the minimum annuity interest rate.

IDGTs may be more efficient in some cases

Although GRATs are useful for reducing estate taxes for intergenerational transfers, IDGTs may be more efficient in certain circumstances.

A sale to an IDGT is more complicated than it would be to a GRAT, but it can potentially offer greater transfer planning opportunities. Like GRATs, an IDGT is also an irrevocable trust that’s defective for income tax purposes, but effective for estate tax purposes. IDGTs allow you to make a gift of either cash or assets to the trust, which is then held for your beneficiaries.

With an IDGT, you preserve certain powers that cause the trust to be treated as a grantor trust for income tax purposes without causing the trust assets to be included in your estate. For example, you might retain the power to swap trust assets with other assets that have an equivalent value, or you may be able to borrow from the trust without adequate interest or security. You would be treated as the owner of the trust for income tax purposes.

You can also sell assets to the grantor trust without recognizing a gain on the sale. Once you’ve made a gift to the IDGT, you can sell the appreciated assets to the trust in exchange for a promissory note. The interest income on the note won’t be recognized since the IDGT is a grantor trust. If the trust assets’ income and growth exceed the interest rate on the note, the excess is passed to your beneficiaries without a gift tax. For estate purposes, the trust assets aren’t considered a part of your estate, but any outstanding balance on the note is.

From a transfer tax perspective, it’s advantageous to make a note taxable on your trust’s income because your payment of the trust’s taxes will allow you to make additional tax-free gifts to the trust with each payment of the trust’s tax liabilities.

When you make an initial gift to the IDGT, you may use a portion of your lifetime gift exemption or you may have to pay a gift tax. Like with a GRAT, there’s no step-up basis for the underlying assets.

If you die before the end of a GRAT’s term or before the IDGT note is paid off, there are estate tax consequences. All of a GRAT’s assets may be included in your estate if you die during the term of the contract. In contrast, if you die before the IDGT note is paid, only the outstanding note balance is included.

Due to the structure of GRATs, the generation-skipping transfer tax exemption can’t be allocated until the end of the GRAT term. The exemption should be allocated so distributions to your heirs won’t incur a tax. The exemption can’t be allocated until the end, so it’s not possible to know how much will be needed. In addition, the value of the trust might exceed the available exemption. However, it is possible to allocate the tax exemption to the initial gift to an IDGT.

Contact us today to find out more about the tax implications of each multigenerational wealth transfer option in your given situation.