Tax-Efficient Wealth Transfer

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Tax-Efficient Wealth Transfer

When the sunset clause embedded into the inheritance tax’s progressive repeal started to loom on the horizon, many rich taxpayers did all they could to lower their taxable estates before the provision went into effect in 2011. While estates worth less than a few million dollars may often escape estate taxes with straightforward preparation, bigger estates need more imaginative estate planning approaches.

Many different forms of trusts may be utilized to achieve various estate planning aims and objectives, however moving substantial quantities of money or other assets into these trusts at the same time will often result in gift liability. Although a sprinkle, Crummey Power, or five-and-five power may alleviate this quandary, it is not always the best option for a variety of reasons. One option is to create a form of trust called as a deliberately faulty grantor trust (IDGT).

A Simple Strategy

The IDT is an irrevocable trust intended to ensure that any assets or monies placed in the trust are not taxable to the grantor for gift, estate, generation-skipping transfer tax, or trust reasons. The grantor of the trust, on the other hand, must pay income tax on any money earned by the trust’s assets. This aspect is effectively what makes the trust “defective,” since all of the trust’s income, deductions, and/or credits must be recorded on the grantor’s 1040 as if they were his or her own. However, since the grantor is required to pay taxes on all trust income on a yearly basis, the assets in the trust are permitted to grow tax-free, avoiding gift taxation to the grantor’s beneficiaries.

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For all practical reasons, the Internal Revenue Service cannot see the trust (IRS).There will be no reportable gain, loss, or gift tax charged on the transaction as long as the assets are sold at fair market value. There will also be no income tax on any proceeds from the sale paid to the grantor. However, many grantors want to transform their IDGTs into complicated trusts, allowing the trust to pay its own taxes. They won’t have to pay them out of pocket every year this way.

What Type of Assets Should I Put in the Trust?

While many other assets might be utilized to establish a defective trust, limited partnership interests provide reductions from their face values that significantly boost the tax savings gained by their transfer. Because limited partners have little or no influence over the partnership or how it is administered, master limited partnership assets are not evaluated at fair market value for gift tax purposes. As a result, a valuation discount is applied. Private partnerships with no liquid market also get discounts. These reductions might range from 35 to 45% of the partnership’s worth.

How to Transfer Assets into the Trust?

Combining a small donation into the trust with an installment sale of the property is one of the finest strategies to transfer assets into an IDGT. The typical method is to give 10% of the asset and have the trust make installment sales payments on the other 90%.

Example – Reducing Taxable Estate

Frank Newman is a rich widower who is 75 years old and has a net estate of more than $20 million. Half of it is invested in an illiquid limited partnership, with the balance in stocks, bonds, cash, and real estate. Unless adequate steps are taken, Frank will undoubtedly face a substantial estate tax payment. He want to leave the majority of his fortune to his four children. As a result, Frank intends to purchase a $5 million universal life insurance policy on himself in order to offset the expense of inheritance taxes. The yearly premiums for this coverage will be about $250,000 per year, however the gift tax exclusion will cover less than 20% ($48,000) of this cost ($12,000 annual gift tax exclusion for each kid). This implies that each year, $202,000 of the premium cost will be liable to gift tax.

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Of course, Frank could utilize some of his unified credit exemption each year, but he has already set up a credit shelter trust structure that would be jeopardized by such a scheme. However, by forming an IDGT trust, Frank may transfer 10% of his partnership assets into the trust at a far lower valuation than their true value. The partnership’s entire worth is $9.5 million, thus $950,000 is first given into the trust. However, after applying the 40% valuation deduction, this gift will be valued at $570,000. The partnership’s remaining 90% will thereafter pay yearly dividends to the trust. The same reduction will be applied to these distributions, thereby cutting Frank’s taxable estate by $3.8 million. The trust will accept the distribution and use it to pay Frank’s interest as well as the cost of the insurance premiums. If there is insufficient income, new trust assets might be sold to make up the difference.

Frank is now in a winning situation, whether he survives or dies. If this happens, the trust will own both the insurance and the partnership, insulating both from taxes. If Frank survives, he will have earned at least $202,000 more to cover his insurance payments.

The Bottom Line

IDGTs have several applications, but a full examination of their advantages is beyond the scope of this essay. Certain tactics may also be used to avoid the generation-skipping transfer tax. Those interested in learning more about these trusts should study about all of the aspects to consider in estate planning and talk with a certified estate planning attorney.

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