Defective grantor trust may offer valuable transfer tax benefits.

A "defective" grantor trust arrangement can provide extraordinary transfer tax savings to families that want to transfer income-producing assets to junior family members. The primary benefit of a defective grantor trust is that the senior family members are taxed on income that is shifted to junior family members. As a result, the income tax on the income is paid by the senior family members, while the benefit of the income flows to the junior family members without the imposition of a gift tax.

Overview

A defective grantor trust is a trust arrangement that is treated as a grantor trust for income tax purposes, while all or a portion of the trust corpus is excluded from the grantor's estate. Before 1986, defective grantor trust arrangements were often used to pass through the deduction for interest incurred to carry certain life insurance policies on the grantor. However, the Tax Reform Act of 1986 eliminated this benefit with the phased-in elimination of the deduction for personal interest.

Although a defective grantor trust generally does not generate any income tax benefits or additional costs (i.e., overall family wealth generally is unaffected by income shifting because of the current compressed income tax rates), significant transfer tax savings may be realized because there is a shifting of assets between generations at no transfer tax cost.

Example 1: Father, F, transfers $600,000 to a trust for the sole benefit of his children. The trust is structured as a defective grantor trust. As a result, F is taxed on the trust's income each year, but the trust corpus will be excluded from his estate when he dies. Each year, the trust is expected to generate $60,000 of taxable income on which F will pay $18,600 of tax. Although the payment of the tax provides a direct benefit to the beneficiaries of the trust, this benefit is not subject to transfer tax since F is legally obligated to pay the tax. This arrangement could save the family $11,160 a year in transfer tax (assuming a 60% maximum marginal transfer tax rate). The family's transfer tax savings can be increased significantly if the beneficiaries of the trust are grandchildren. If the tax is paid on income that inures to the benefit of F's grandchildren, this arrangement could save the family $27,528 in gift and generation-skipping transfer (GST) taxes, calculated as follows.

$18,600 x 60% (gift tax)          $11,160
$18,600 x 55% (GST tax)            10,230

$10,230 x 60% (gift tax

  on the GST tax)                    6138
                                  $27,528

Structuring the arrangement

A defective grantor trust arrangement must be structured carefully so that the trust "fails" the grantor trust provisions in Secs. 671 through 679, but does not result in inclusion of the underlying property in the grantor's estate under Sec. 2036, 2037, 2038 or 2041. Generally, the most common method of structuring the arrangement is to grant certain powers to a nonadverse trustee, including (but not limited to) the power to (1) acquire any property held by the trust by substituting property of equivalent value, (2) distribute income, without a definite standard, among a class of trust beneficiaries, (3) add persons, other than after-born or after-adopted children, to the class of beneficiaries if the nonadverse trustee also has the power to distribute trust income and principal, (4) pay trust income to (or for the benefit of) the grantor's spouse and (5) distribute trust income to the grantor.

An adverse party is defined as any person (1) with a beneficial interest in the trust, (2) whose beneficial interest is "substantial" and (3) whose interest would be adversely affected by the exercise or nonexercise of the power or interest held by the grantor or other person in question (Sec. 672(a)). A nonadverse party is any person who is not an adverse party (Sec. 672(b)). A trustee is not an adverse party merely because of his interest as trustee (Regs. Sec. 1.672(a)-1(a)).

Under no circumstances should the grantor appoint himself as trustee of the defective grantor trust. In addition, a beneficiary should not be appointed trustee since he may be characterized as an adverse, rather than a nonadverse, party. On the other hand, the grantor may appoint his spouse or a relative. However, if the grantor's spouse is appointed as the trustee, she should not be given a power that could cause inclusion in the trustee's gross estate (e.g., a power to pay income to self that is not limited by an ascertainable standard; see Sec. 2041).

Although any of these powers may be given to a nonadverse trustee if properly drafted, the "safest" alternative is to grant the nonadverse trustee the power to acquire any property held by the trust by substituting property of equivalent value. (This arrangement was approved by the IRS in Letter Ruling 903 701 1.)

Example 2: Mother, M, and Father, F, have already given substantial lifetime gifts to their children; therefore, they are in the 55% estate/gift tax bracket. They have a $2,000,000 asset that generates income of 10% per year that they now want to give to their grandchildren. In addition, they want their grandchildren to net $200,000 per year. M and F and their grandchildren are all in the 31% income tax bracket. M and F can accomplish their objective in one of two ways: (1) They can give the children the $2,000,000 asset; the children will pay the annual income tax of $62,000 on the earnings of $200,000, and M and F will give them annual gifts of $62,000; or (2) they can give the $2,000,000 asset to a defective grantor trust with the grandchildren as beneficiaries; the grandchildren will still get the annual earnings of $200,000, but M and F will pay the annual income tax. In both cases, the grandchildren will net $200,000 per year. However, the second alternative generates substantial annual transfer tax savings.

Gift tax on annual gift (55%)        $34,100
GST tax on annual gift (55%)          34,100
Gift tax on GST tax (Sec. 2515)       18,755

Additional annual cost of

alternative 1 $86,955

In addition, under alternative 1, the gift tax paid on the annual gifts given within three years of M's and F's deaths would be included in their estates.

Combining the benefits

of a GRAT and a defective

grantor trust arrangement

with ownership of S stock

Additional transfer tax benefits can be generated if the defective grantor trust arrangement is used in conjunction with a grantor retained annuity trust (GRAT) that owns S stock. The amount of the benefit is based on (1) the amount of the annuity retained by the senior family member, (2) the term of the retained annuity, (3) the Sec. 7520 rate in effect on the transfer date, (4) the amount of posttransfer appreciation in the value of the S stock and (5) the S corporation's taxable income during the annuity term.

This technique has four benefits: (1) The value of the senior family member's interest is frozen for transfer tax purposes, regardless of whether the senior family member's annuity interest expires before his death. (If the annuity interest expires before death, the value of the add-back to the transferor's estate for post-1976 taxable gifts is frozen at the date of gift value; and if the annuity interest expires at death, the value of the inclusion in the gross estate under Sec. 2036(a) is frozen at the capitalized value of the retained annuity (Rev. Rul. 82-105)); (2) all future appreciation in the value of the S stock generally is removed from the senior family member's estate; (3) the interest in the S corporation is transferred to younger generation family members at a discounted value; (4) all the S corporation's income is taxed to the senior family member regardless of the actual amount of cash distributed.

A GRAT can be a qualified S shareholder provided it is structured as a defective grantor trust. Sec. 1361 (c)(2)(A)(i) provides that a grantor trust is a permitted S shareholder provided the entire trust is a grantor trust. Since the terms of a GRAT do not necessarily require distribution of all of the trust's income, a GRAT generally must be structured as a defective grantor trust to qualify as an S shareholder without satisfying the qualified subchapter S trust (QSST) requirements of Sec. 1361(d). Although it is possible to structure a GRAT that qualifies as a QSST, this type of arrangement would require the distribution of all trust income in excess of the fixed annuity each year (which is permitted under Sec. 2702 by Prop. Regs. Sec. 25.2702-3(b) (1)(iii)). As a result, there is a risk that the S election could be involuntarily terminated if all the trust's income is not, in fact, distributed. Moreover, it is doubtful the provisions of Rev. Rul. 82-105 (i.e., freeze value of interest at capitalized value of retained annuity) would apply if the trust permits or requires the distributions of amounts in excess of the fixed annuity. See Example 3 at left.

Example 3: When a GRAT Owns S Stock

Father, F, transfers S stock valued at $1,000,000 to a GRAT that is structured as a defective grantor trust when the Sec. 7520 rate is 8.6%. He retains a 10-year $25,000 term certain annuity interest, with no reversionary interest. After he annuity term, the S stock is distributed to F's daughter, D. If F dies in year 11, overall family wealth will be increased by $2,770,000.

[TABULAR DATA OMMITTED]

If F dies after year 5, the benefit of using this arrangement is $1,110,850,

determined as follows.

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