However, in the grantor trust version, the grantor pays the taxes on the income.
Defective grantor trust is a really stupid name for something that, in the right circumstances, can be a very good idea.
It would be, but for one thing: The income tax people at the IRS disregard transactions between a taxpayer and a grantor trust.
For this purpose, it is not necessary to use some exotic trust structure or obscure jurisdiction, but a well-drafted irrevocable grantor trust should usually suffice.
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Somewhere along the line somebody realized that people might be disturbed by hearing that their trust was defective so the term became Intentionally Defective Grantor Trust.
Even more hidden are complex provisions such as a grantor trust proposal targeting certain sales transactions (particularly business sales), and elimination of several Generation Skipping Tax planning benefits.
Mixing apples and oranges, managers argue that if they make an intentionally defective transfer of profits interests to a grantor trust, it would be as though they never gave anything away.
Also, there can be an installment sale (when the value of the asset is low) to a defective grantor trust that is a completed transfer but not taxed for income tax purposes.
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Sales to a Grantor Trust (aka Intentionally Defective Grantor Trust (IDGT)) Another popular technique is to engage in strategic sales (or even gifts) of property to an Intentionally Defective Grantor Trust (IDGT).
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Very popular over the last ten years and different from the defective grantor trust discussed above, grantor retained annuity trusts (GRATs) have been used to transfer appreciating assets to future generations free of gift tax.
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In a "grantor trust, " for example, the tax is paid by the person who sets up the trust, so it doesn't drain assets from the trust itself, says Alan Kufeld, a certified public accountant at Rothstein Kass's family-office group.
When structured as a grantor trust, the tax benefit of donations should pass back to the person who created the trust when those donations are made, but the creditor would have to first unwind the trust before attempting to clawback donations.
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The ruling also applies to special kinds of grantor trusts, such as a generation-skipping trust, which is designed to 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 than the payments he is required to receive back from the trust over a period of years.
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 additional taxable gift to the beneficiaries of the trust (say, the grantor's children or grandchildren).
The IRS blesses the indirect gift--the payment of income taxes--from the grantor to the trust.
Transactions between the grantor and the trust are ignored for income tax purposes.
The technique, known as a grantor retained annuity trust, or GRAT, allows rich families to pass on wealth while dramatically cutting their estate and gift tax bills.
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The first is a GRAT (grantor retained annuity trust ), which Facebook billionaires Mark Zuckerberg and Dustin Moskovitz set up to shelter gains that otherwise would be taxable to their as yet-unborn heirs.
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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.
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.
Here's the key: When the grantor sets up the trust, the IRSfixes the value of his gift based on the assumption that the trust will earn a modest return--about 7.5%, but the IRS-set rate fluctuates with interest rates.
Back in the heyday of using trusts for shifting income, if a trust contained one of those powers, like the power of the grantor to withdraw property from the trust and replace if with property of equal value, someone who thought the trust was being used to shift income, would consider that power to be a defect.
Returns are prepared as if the grantor did everything that the trust did.
With a GRAT, a grantor puts assets into a trust and takes back an annuity payout for typically two to three years.
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.
Using such trusts a grantor (parent) can pay income tax on trust income accumulating for the benefit of children and descendants.
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Let us say that you are the grantor, meaning you have the bucks and you create the trust.
Estate planners have been using grantor trusts for the past two decades, but they 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.
That is, from an income tax perspective, income, deductions and credits at the trust level are captured on the personal income tax return of the grantor.
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