You could transfer income producing assets into a Grantor Retained Annuity Trust (GRAT). The trust would pay you a specified annuity and any appreciation in the property transferred to the GRAT would be excluded from your estate for estate tax purposes.
The sale of assets to an Intentionally Defective Grantor Trust (IDGT) is one of the most powerful tax planning tools available.
With this technique, you would sell an asset (e.g., a building) to an IDGT for the benefit of your children, and receive back a promissory note from the trust. The trust would make payments to you under the note.
The transaction would be set up so that you could take a Discount on the value of the asset, thereby maximizing the benefit of the gift.
The IDGT is given this name because it is set up so that you continue to be treated as the owner of the transferred asset for income tax purposes, even though it is owned by the IDGT. This means that you have sold the asset to yourself for income tax purposes.
Selling an asset to an IDGT has the following results:
- You will not recognize a tax gain on the sale.
- The payments the IDGT makes to you under the promissory note are not taxable to you.
- The IDGT will collect the rent and pay the expenses of the asset (such as property taxes, etc).
- The IDGT will keep all net income after making payments to you under the promissory note.
- You pay all the income taxes related to the asset and the income taxes it produces (and you are entitled to the deductions related to the asset), even though the IDGT keeps all the monies from the asset after paying expenses and the promissory note.
For example, assume the asset annually produces $200,000 of rental income, the expenses on the asset are $25,000 and the payments on the promissory note from the IDGT to you are $20,000 per year. The IDGT receives the $200,000 in rent, pays the $25,000 in expenses and pays you $20,000 on the note. The IDGT keeps the $155,000 of net income, for the benefit of your children. Because you are treated as continuing to own the asset, you will include the $175,000 of net rental income ($200,000 less $25,000 in expenses) in your income and you will pay the income tax on that amount. If you are in a 40% income tax bracket, you will pay $62,000 in income taxes. You can use the $20,000 the trust paid you on the promissory note, and you will need to pay an additional $42,000 out of your pocket.
While the above may seem unfair to you, remember that your family has benefitted as follows:
- You have transferred the asset to your family (through the IDGT) at a value less than its actual value, through discounting.
- The trust keeps the $155,000 net income per year, which is excluded from your estate.
- Your payment of the income taxes is, in effect, an additional gift to your children without being subject to gift taxes.
- The amount of the income taxes you pay (less the monies you receive from the promissory note) reduces your estate and your estate taxes.
This transaction can be combined with a Self-Canceling Installment Note.
A Disclaimer is a method of refusing to accept assets which would otherwise have been distributed to you as a result of another person’s (the “decedent”) death. In effect, if you make a disclaimer, you would be saying “I do not want that particular asset”; instead, that asset would be distributed to whomever would have received that asset had you died before the decedent.
A disclaimer which is properly made (i.e., follows the requirements of the Internal Revenue Code) results in the disclaimed asset being distributed directly from the decedent to the beneficiary and you are ignored in the transfer of the asset.
If a disclaimer is not properly made, the asset is treated as having been received by you from the decedent, and you then making a gift to the beneficiary, which can have gift tax consequences.
For example, assume a parent died and left you $500,000. If you already have an estate which would be subject to estate taxes when you die, inheriting the $500,000 could cause your children to pay an additional $225,000 in estate tax when you die, leaving them only $275,000. If you properly disclaim the $500,000, that money would be treated as passing from your parent directly to your children with no gift tax consequences to you and no inclusion in your estate for estate tax purposes.
If you would like more information regarding Trusts, please contact our office at 818-226-9125.