Article

Examining the heightened scrutiny of grantor trusts

Is immediate action needed to take advantage of grantor trust tax benefits?

September 20, 2024
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Policy Tax policy

Executive summary

  • Grantor trusts are an effective and popular wealth transfer tax tool but have been under increased scrutiny from those who perceive them as tax avoidance schemes.
  • Election outcomes could end up closing the window of opportunity to utilize grantor trusts.

Examining the heightened scrutiny of grantor trusts

Irrevocable grantor trusts offer a unique combination of tax benefits that make them a valuable tool for estate planning. This is because they are treated differently for gift and estate tax purposes than they are for income tax purposes. This special treatment can result in significant tax savings. Common types of irrevocable grantor trusts include Intentionally Defective Grantor Trusts (IDGT), Spousal Lifetime Access Trusts (SLATs), Irrevocable Life Insurance Trusts (ILITs) and Grantor Retained Annuity Trusts (GRATs).

Common types of irrevocable grantor trusts include:

  • Irrevocable life insurance trusts (ILITs)

How do irrevocable grantor trusts generally work?

Grantor trusts are not separate entities from their deemed owner for income tax purposes. The grantor and the trust are treated as one taxpayer and the grantor is liable for the trust’s income tax. Grantor trust status can apply to the entire trust or only a portion of it, and the grantor trust status can be changed under certain circumstances. 

Grantor

Grantor makes gift (or sale) to a grantor trust

Irrevoable Grantor Trust

← → 

Income tax liability is obligation of Grantor and is not considered an additional gift to the trust. Exchanges between grantor and the trust are disregarded for income tax purposes.

Beneficiaries

*

Lifetime distributions to beneficiaries are income tax-free.

What are some of the grantor trust tax benefits that are under scrutiny?

  • Transferring assets to an irrevocable grantor trust can remove assets from the grantor’s gross estate and allow the appreciation to avoid transfer tax.
  • The payment of income tax on behalf of the irrevocable grantor trust, by the grantor, is not an additional gift to the trust. This allows the trust to grow income tax free during the grantor’s life.
  • Exchanges between a grantor trust and the grantor are generally not taxable transactions because the grantor is the deemed owner of the trust for income tax purposes.
  • Certain grantor trust provisions allow flexibility, such as the ability to swap assets of equivalent value between the grantor and the trust without incurring income tax.
  • Certain types of grantor trusts, such as a GRAT, allow individuals to transfer the appreciation on assets outside of their estate while making only a very small gift.
  • trated below, these additional legislative efforts have included:

How have lawmakers tried to limit or eliminate the benefits associated with grantor trusts

Due to the tax advantages offered by grantor trusts, some lawmakers have become increasingly concerned with their potential misuse as perceived tax avoidance tools. Repeated legislative attempts to curtail these benefits demonstrate some lawmakers’ persistence in addressing this issue, raising the question of whether these estate planning strategies may eventually become less effective or eliminated.

Notably, the Obama and Biden administrations have proposed eliminating these estate planning strategies. 

Vice president Kamala Harris, the Democratic nominee for president, has indicated a similar intent. 

Specifically, several measures proposed in Congress over the last six years have sought to limit these benefits by increasing income and/or transfer tax liabilities of high net worth individuals who utilize these techniques.

As illustrated below, these legislative efforts have included:

January 2019

For the 99.8 Percent Act

  • GRAT terms must be at least 10 years but can’t go longer than the grantor’s life expectancy plus 10 years.
  • Minimum taxable GRAT gift value would be the greater of 25% of the fair market value of the trust property or $500,000 (but not more than the value of assets contributed). 

September 2021

Build Back Better Act (Note, these provisions were dropped in the November 2021 version of the Act).

  • Exchanges between a grantor and a grantor trust would be taxable events.
  • Assets held in a grantor trust would be included in the grantor’s gross estate at fair market value.
  • Any distribution from a grantor trust other than to the grantor or spouse would be a taxable gift.

March 2024

Getting Rid of Abusive Trust Schemes (GRATS) Act

  • Payment of income tax by grantor would be a taxable gift.
  • Exchanges between a grantor and a grantor trust would be taxable events.
  • GRAT terms must be at least 15 years but can’t go longer than the grantor’s life expectancy plus 10 years.

August 2024

American Housing and Economic Mobility Act (iterations of similarly titled bills in 2019, 2021)

  • Appreciation on grantor trust assets would be includible in the grantor’s gross estate.
  • A distribution of appreciated property from a grantor trust to a beneficiary would be considered a taxable gift.
  • GRAT terms must be at least 10 years.

What does the future use of grantor trusts look like?

The future viability of grantor trusts will likely depend on the outcomes of the 2024 presidential and congressional elections. While the presidential candidates have indicated the direction in which they hope to steer these policy issues, the balance of power in Congress will go a long way toward determining whether either party can advance its agenda. However, in any scenario, the margins of majorities matter. 

Democratic sweep

Likely that some aspects of the grantor trust rules will change. The extent of changes may be based upon the extent of the control over the branches of government. Changes may include:

  • Transactions between grantor and their grantor trust may be recognized for income tax purposes.
  • Appreciation on grantor trust assets may be included in the grantor’s estate.
  • Reduced flexibility and benefits of GRATs due to new term and payment restrictions.
  • Payment of income tax on behalf of the grantor trust may be considered a gift to the trust.

Republican sweep

Continued use of grantor trusts with no new restrictions or recognition events.

Divided government

There may be some new restrictions on grantor trusts, but likely less severe than under a Democratic sweep with some adjustments to planning strategies.

In the case of a sweep by either party, Congress could move quickly to change tax rules. A Democratic sweep could mean that 2024 is the last chance to institute this sort of estate planning strategy. And even in that case, beating that deadline may not guarantee success. One recent proposal on the subject does not protect existing planning; however, this may be an outlier, as historic bills have contained such a provision.  

If you are considering utilizing a grantor trust, it may make sense to be ready to act quickly. However, there is a chance that future laws could still affect your 2024 planning. Consult with your tax advisor to determine how these potential changes impact your estate plan. 

RSM contributors

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