IRS Grants a
Wish
© Forbes
Magazine
Estate planners and their wealthiest clients are
rejoicing over a surprise move by the Internal Revenue Service.
On July 6 it released a “revenue ruling”
that clears up a long standing gift and estate tax relating to an
estate-planning tool – irrevocable grantor trusts –
widely used by wealthy families. Even better, the ruling clears
up the confusions in a taxpayer-friendly way.
The ruling makes clear that the person who sets
up the trust – the grantor – can pay the annual income
taxes owed by the trust without the payment being treated as an
addition taxable gift to the beneficiaries of the trust (say, the
grantor’s children or grandchildren). In addition, the ruling
explains how trust documents should be worded to avoid the horrendous
result of having all of the assets in a trust included in the grantor’s
estate when he/she dies.
“It’s a big ruling for people who have
a lot of money and want to get it to future generators,” says
Jere Doyle, senior director of Mellon Financial’s (nyse:MEL
– news – people) Private Wealth Management Group.
How big? The way the math works, after 20 years
of the grantor paying the income taxes for the trust, there could
be twice as much in the trust as there would be if the trust paid
its own taxes, says Bernard Kent, a tax partner with PricewaterhouseCoopers
in Detroit.
Grantor trusts are the bread and butter of estate
planning for families with $5 million-plus in assets. It’s
common for a husband and wife to each set up a $1 million grantor
trust to take advantage of the amount any individual can give away
over his or her lifetime gift-tax-free. (That’s in addition
to the annual gifts up to $11,000 you can make gift-tax free to
as many recipients as you like.)
In a basic grantor trust, the grantor puts $1 million
in cash or assets into a trust – often choosing assets such
as initial public offering stock expected to appreciate a lot –
and the money in the trust goes to the trustee after the grantor
die. A traditional trust itself pays taxes on its trust income while
the assets grow. Or if the money is distributed, the beneficiaries
pay the taxes. However, in the grantor trust version, the grantor
pays the taxes. However, in the grantor trust version, the grantor
pays the taxes on the income. This has two benefits: First, the
money builds up faster; plus, the grantor is getting additional
money out of his or her taxable estate.
Estate Planners have been using grantor trusts for
the past two decades, but the always had to warn clients that the
IRS might consider the income tax payments by the grantor to be
further taxable gifts to the beneficiaries of the trust. Worse,
if the trust were required to reimburse the grantor for taxes paid,
that could arguably cause the assets of the trust to be included
in the grantor’s estate, essentially killing the whole strategy.
The new IRS ruling, technically a “revenue
ruling” that applies to all taxpayers, puts both these fears
to rest. The IRS blesses the indirect gift – the payment of
income taxes – from the grantor to the trust. And it says
that if the trustee has the ability, but not the obligation, to
repay the grantor for the income taxes that the grantor pays on
behalf of the trust, then the trust assets will generally not be
included in the grantor’s estate. “you can sleep at
night now that you know this is the government’s position,”
says Doyle.
The ruling also applies to special kinds of grantor
trusts, such as a generation-skipping trust, which is designed o
avoid taxes at the grantor’s children’s deaths, as well
as a grantor-retained annuity trust, where the grantor can transfer
any amount of property betting that it will grow faster that the
payments he is required to received back from the trust over a period
of years.
The ruling is a boon for clients served by the high-net-worth
groups of companies like Mellon Financial, J.P. Morgan Chase (nyse:
JPM – news – people) and Merrill Lynch (nyse: MER –
news – people) whose wealth planners help set up these kinds
of trusts.
One caveat: The IRS noted that is the trust has
the ability to reimburse the grantor for taxes paid – plus
there are other factors such as giving the grantor the power to
remove the trustees and name the grantor as successor trustee –
you could have an estate tax inclusion problem. “If you have
the wrong language in your trust, the game is over,” warns
Robert S. Keebler, an accountant with Virchow Krause & Co. in
Green Bay, Wis.
So if you set up a new trust, make sure you word
it right. What if you have an old trust that requires reimbursement
of taxes? Don’t worry. The estate tax inclusion provision
applies only to trust created on or after October 4, 2004.
