Articles & Alerts

Intentionally Defective Trusts Offer Estate Tax Benefits

January 30, 2023

In most circumstances, you wouldn’t consider implementing something that is deliberately defective, but when it comes to estate planning you just might. If your individual estate is worth more than $12.92 million or $25.84 million as a couple, which are the current estate tax exemption thresholds, then you might want to use an “intentionally defective grantor trust” as part of your estate plan. The trust removes assets from your estate and prevents them from being subject to the estate tax at your death.

There are two ways to fund such a trust. You could make a gift to the trust. Note, that gift taxes for the amount you transfer to the trust won’t be invoked unless you exceed the lifetime gift tax exemption of $12.92 million for individuals and $25.84 million for couples.

You could also sell assets to the trust. You would do this in exchange for a promissory note, whereby the trust would pay you a certain amount, with a small amount of interest, for a set period of years. When selling assets to the trust, you won’t be taxed on any capital gains you realized since acquiring the assets.

You’ll pay annual income taxes on trust revenue

If the assets in the trust generate any revenue, such as rental income from a real estate property or dividend or income payments from investments, you will have to pay the annual income taxes due on that revenue. This nuance is where the trusts get their name. They are “effective” for estate tax purposes because they remove assets from your taxable estate, but they are “defective” for income tax purposes because you still have to pay income taxes on the revenue the assets in the trust generates. You would not take the income for personal use however as it stays within the trust. Further, the income taxes you pay are not considered gifts to the trust, so the amounts paid for the income taxes are not also subject to gift taxes.

These trusts are irrevocable as you cannot ever regain ownership of the value of the assets placed in the trust. But they are unlike other irrevocable trusts because you can maintain some control over the trust. After establishing the trust, you can at some later point swap the assets in the trust for other assets of equal value. You may also be able to change the beneficiaries of the trust. The fact that you are still paying income taxes on the trust revenue is what enables you to maintain this degree of control over the trust.

These trusts also enable you to “freeze” the value of assets that might highly appreciate. If held outside a trust, any further increases in the value of that asset would be counted as part of your estate and potentially subject to estate taxes. Once inside the trust and outside your estate, however, any further appreciation in the value of the assets placed in the trust would be free of estate taxes.

Your tax advisors and estate planning attorney can help you determine if an intentionally defective grantor trust would be an effective part of your plan and, if it is, what assets would be most suitable to place in such a trust. For more information or to discuss this strategy in detail, contact your Anchin Relationship Partner, or Tara Burek, a Partner in Anchin’s Private Client Group.