Sale to an Intentionally Defective Grantor Trust
Where a grantor has income producing assets (for instance, commercial real estate subject to a long-term lease) that the grantor expects to appreciate significantly in value, a sale of that property to an income tax defective grantor trust is an attractive estate planning technique. Such a trust is deemed defective for income tax purposes because the grantor is considered to be the owner of the trust for income tax purposes, such that the grantor and the trust are deemed to be the same person with respect to income tax issues. Consequently, the sale of assets to the trust by the grantor does not result in any taxable capital gain. While the grantor is deemed the owner of the trust for income tax purposes, the trust is designed so that the trust assets are not includable in the grantor's taxable estate for estate tax purposes.
Typically, such a transaction takes the form of an installment sale over an extended term, with the trust's payment obligation to the grantor being evidenced by a promissory note. For tax reasons, the term of the note should not exceed the grantor's actuarial life expectancy. However, the note may contain a provision providing for the termination of the repayment obligation in the event the grantor dies prematurely. This provision presents the opportunity for a windfall to the grantor's beneficiaries in the event of an untimely death. However, the use of this provision requires that a premium be attached to the promissory note, either in the form of an increased principal amount or above-market interest rate.
This estate planning technique is useful where the property being sold will generate enough income to offset the promissory note payments. It is often wise to combine such a sale with a concurrent gift of other assets to the trust, in order to give the trust other means of repaying the note.
The benefit of this technique is that it presents the opportunity to transfer property at no gift or estate tax cost to the beneficiaries, while having the asset pay for its own transfer by applying the income stream to the promissory note payments. Moreover, since all of the income produced by the asset is taxed to the grantor, the grantor's payment of that income tax liability is, essentially, an additional tax-free gift to the beneficiaries of the trust.