The Life-Changing Magic of Grantor Trusts

Grantor trusts which were created by the Internal Revenue Code (“IRC”) of 1954, when the tax rates for individuals and trusts were the same, were originally intended to prohibit the wealthy from placing investment assets in a trust and taking advantage of the progressive tax rates for both their personal returns and trust returns.  An individual could put investment assets in a trust, maintain control of the assets and pay lower rates on the investment income since the progressive rate structure would begin again with the trust.  The 1954 IRC stated that if certain powers were maintained by the grantor, the income of the trust assets would be included in his/her personal income tax returns. Grantor trusts were looked at as a way to curtail the transfer of wealth to lower brackets.  Fast forward to the year 2020 when individual tax rates are more attractive than trust tax rates and grantor trusts are now advantageous to many people since less tax will be paid on the income if included on the individual income tax return instead of the trust’s fiduciary income tax return.

Mr. Donaldson explained the powers that may or may not cause grantor trust status and the effect these powers have on the inclusion of the assets in the grantor’s estate.  One of the powers addressed was SWAP powers. This is the power to re-acquire trust property by substituting equivalent value assets.  This power does NOT cause the gross estate inclusion of the trust assets. 

Exercising a SWAP power is a good technique to leverage the benefit of receiving a step-up in basis at the grantor’s estate while not increasing the gross estate value.  There are several situations where the SWAP power should be exercised by the grantor. 

1. NEAR DEATH SWAPS TO LEVERAGE THE IRC SEC. 1014 STEP-UP – Assets held in a “defective grantor trust” will not be included in the grantor’s estate, but will also not qualify to be eligible for the IRC Sec. 1014 (a) basis step-up. It is not unusual for these trusts to hold low-basis assets intended to appreciate long-term.  If the grantor’s death is anticipated in the short term, the grantor might consider swapping the low-basis assets out of the trust and placing high-basis assets held individually into the trust.  Should the grantor die, the low-basis assets would receive the step-up in basis and the high-basis assets now in the trust would not be included in the grantor’s estate.
2. NEAR DEATH SWAPS TO PERSERVE LOSS – As planners we spend a lot of time thinking about step-up but remember there can be a step-down also. If the grantor holds a loss asset (the basis exceeds value), perhaps the grantor should swap the loss asset he holds for low-basis assets held in the trust.  In doing so, the loss is now preserved in the trust.
3. SWAPS TO ELUDE THE THREE-YEAR RULE – Suppose the grantor has a life insurance policy that he owns outright but also holds other assets in a defective grantor trust. The current FMV of the policy may be substantially less than the death benefit.  Creating an irrevocable life insurance trust may be a concern because the grantor is most likely not going to survive the requisite three years following the transfer.  The grantor can however, swap the policy into the defective grantor trust and also avoid estate tax inclusion of the death benefit.  The reason the three-year rule does not apply is because for transfers for tax purposes, this transfer is an exchange for full and adequate consideration.  In addition, since the exchange does not trigger the “transfer for value” rule, the death benefit is still excluded from gross income for federal income tax purposes. 

These techniques may be beneficial depending on the gross asset value of the grantor, the type of assets owned both outright and in trust and the life expectancy of the grantor. 

To read more Heckerling content, please see below:

• The Life-Changing Magic of Grantor Trusts
• Why Do I Cringe Every Time I See an S Corporation in My Client’s Estate Plan?
• You Mean I Can’t Bribe the Coach? Modern Ethics Issues You Didn’t See Coming
• What Makes a Special Needs Trust So Special, and When Should One Be Used?
• Cures for a Cosmopolitan Hangover: What We’re Doing for International Clients Following Tax Reform
• Peripatetic Clients: No, It’s Not an Illness but They Need Your Constant Care
• Planning for Retirement Benefits After the SECURE Act
• Creative Planning Techniques with Grantor and Non-Grantor Trusts
• A Sequel Much Worse Than the Original:  Planning for GST Tax on Nonexempt Trusts