For years wealthy investors have used grantor trusts to
minimize their potential federal estate taxes. But today those same investors
now have to worry about the growing income-tax liability the trusts are
generating. As a result, some financial advisers say planning for income taxes
has caused some rethinking regarding how to best use the trusts, specifically
the intentionally defective grantor trust and grantor-retained annuity trust.
Intentionally defective grantor trusts, or IDGTs, are
popular in estate planning because they allow the grantor to move assets out of
his or her taxable estate, thereby lowering potential estate taxes, while
remaining responsible for the income taxes. This way, the income tax burden
isn’t transferred to heirs.
However, the latest bull market has created potentially
substantial taxable gains for many clients, and with the top federal rate on
long-term capital gains at nearly 24%--compared with 15% in 2012--some advisers
caution that it may be more difficult for certain clients to pay that
income-tax bill.
One solution is a common provision that allows grantors to
essentially turn off the grantor status of the trust, which means the trust
must pay its own income taxes going forward. However, this election can only be
made once--the grantor can’t switch back and forth from paying to not paying
the income taxes--so there should be thoughtful consideration of the decision
to stop paying the income taxes on behalf of the trust.
Meanwhile, higher income taxes have prompted some advisers
to take a closer look at the assets their clients hold in grantor-retained
annuity trusts, or GRATs, which let people give a portion of an asset’s future
profits to heirs free of gift or estate tax.
Most of this planning revolves around what is known as the
“step-up” in cost basis, which helps eliminate the long-term capital-gains tax
on assets that are held until death by raising the owner’s cost basis for such
assets to the full market value.
However, in a GRAT, what is transferred to beneficiaries
typically doesn’t receive that step-up at death. Therefore, to cut down on
capital-gains taxes, it is better to have higher basis assets in the GRAT
because those assets won’t get a step-up in basis.
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