By: Henry VanBuskirk, CFP®, Wealth Manager
(This is part 3 of a four-part estate planning series)
In part 2 of this series, we discussed strategic ways that you can get assets out of your estate. In this post, we would like to go over how you can capitalize on minimizing your estate tax, while your heirs enjoy the appreciated value of your asset, and how you are able to have some benefits of your own during your lifetime. This is sometimes referred to as an “estate freeze”. Two estate freezing techniques that may be appropriate for your unique estate planning goals are utilizing an Intentionally Defective Grantor Trust (IDGT) and a Grantor Retained Annuity Trust (GRAT). If you have concerns regarding how these strategies could affect certain estate and gift planning transactions in which you intend to engage or have previously engaged, please contact your tax advisor and estate planning attorney to further discuss your estate and gift planning inquiries. Our firm is happy to work with you and your estate planning attorney on your unique situation and we can work together to help you achieve your estate planning goals.
Intentionally Defective Grantor Trust (IDGT)
This irrevocable trust allows the grantor to continue paying income taxes on certain trust assets. Even though this sounds like a negative feature, this is what makes it “intentionally defective” and it has several benefits. This is because since the grantor must pay all taxes on all trust income annually, the assets in the trust can grow tax-free, and more importantly, avoid gift taxation for the beneficiaries of the trust. Generally, it is best to sell assets to the IDGT because gifting assets to the IDGT could trigger gift taxes. Further, when assets are sold to an IDGT, there are no taxes owed because there is no capital gain recognized. Therefore, it is recommended that you take a highly appreciated asset (like a stock with a low-cost basis or shares of a family business) and sell it to the IDGT over a stated time (usually 10 years) in the form of an installment sale. The goal of the IDGT is to have your heirs inherit the funds in the IDGT and gift those assets at the original value that the IDGT was funded at and lower your taxable estate.
Basics of an IDGT
IDGT example: Mommy and Daddy Warbucks have an estate worth $100 million and are concerned about the size of their estate when it comes to what their heirs will inherit and what the estate tax bill will look like upon the Warbucks’ death. Part of their estate includes ABC stock that they bought for $100,000 that is now worth $10 million. Assume that the Warbucks’ sell the ABC stock to their newly formed IDGT over 10 years. After the end of the 10 years, the IDGT is fully funded with ABC stock. Now assume that for the next 10 years, the Warbucks’ IDGT appreciates to $20 million, their estate is now $110 million and then they pass away. During those 10 years that all shares of the ABC stock were in the IDGT, the Warbucks’ paid income tax on the dividends received, but did not pay any capital gains on any of the appreciation throughout the life of owning ABC stock. Further, they were able to gift their heirs $20 million of stock and receive a step up in cost basis. Additionally, they reduced the size of their estate when it comes to calculating tax liability to $90 million (instead of $110 million if they had not done an IDGT). As there are a lot of moving parts and due to an IDGT’s complexity, it is highly recommended that we work with you and an experienced attorney if an IDGT is recommended for your estate plan.
Grantor Retained Annuity Trust (GRAT)
A GRAT is an irrevocable trust that allows the grantor to fund the trust but retain the right to receive the original value of the assets contributed, while earning a rate of return specified by the IRS (referred to as the 7520 rate). After a predetermined period, the beneficiary will be gifted the assets tax-free in the trust and the grantor will have to pay a gift tax on the original value of the GRAT. The grantor will still be on the hook for income taxes for income received during the term of the GRAT. If the grantor passes away before the term of the GRAT is up, then the value of the remainder interest is also included in the grantor’s estate.
Basics of a GRAT
Fun Fact – Mark Zuckerberg transferred $3,023,128 to his GRAT as Facebook went public in 2012. He did this to help future generations in his estate receive the value of the stock when the GRAT term was up. When the GRAT term was up, the stock was valued at $37,315,513 and Mark was able to transfer that to his beneficiaries tax-free, while also being able to receive the original $3,023,128 after the term of the GRAT is up. Mark did have to pay income taxes on income received during the term of the GRAT and had a gift tax liability based on the original $3,023,128 at the end of the GRAT term, but as we learned from previous installments of this series, he would just utilize some of his married lifetime federal estate tax exemption of $24,120,000 to take care of the gift tax liability. Think what you will about Meta Platforms, Inc. (formerly known as Facebook), but Mark was able to legally lower his future tax bill with some careful planning that everyone has access to, not just the major CEOs of the world.
For the 4th and final part of this estate planning series, we will cover the last planning pillar that we use when discussing estate planning – Gifting Assets from the Estate.
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