RUNNING THE NUMBERS
ON A SALE TO A DEFECTIVE GRANTOR TRUST
by Lee S. McCullough, III
A sale to a defective grantor trust is often the best tool available for reducing or eliminating estate taxes in a large estate. The federal estate tax is in a state of flux and uncertainty, but the assumptions included below reflect my best guess as to what the law will be. For purposes of this article, I have assumed an exemption of $3,500,000, an estate tax rate of 45%, and an interest rate of 3%. I have omitted any gifting for simplification purposes.
Consider the following example:
Background Information
John owns a business worth $15,000,000 and it produces $1,000,000 per year in income to John. He and his wife also own cash, real estate and personal assets worth $5,000,000 and a term life insurance worth $3,000,000.
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Assets Included in Taxable Estate Business $15,000,000 Cash & Real Estate $ 5,000,000 Life Insurance $ 3,000,000 Total Taxable Estate $23,000,000 Estimated Tax $ 7,200,000
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Assets Outside of Taxable Estate $0 |
Step 1: John uses accepted discounting methods and sells his business and life insurance to one or more defective grantor trusts for his wife and children, in exchange for a promissory note equal to $9,000,000. Because it is a sale from a grantor to a defective grantor trust, the sale is does not trigger income taxes or capital gains.
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Assets Included in Taxable Estate Note Receivable $ 9,000,000 Cash & Real Estate $ 5,000,000 Total Taxable Estate $14,000,000 Estimated Tax $ 3,150,000
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Assets Outside of Taxable Estate Note Payable $ 9,000,000 Business $ 15,000,000 Life Insurance $ 3,000,000 |
At the conclusion of Step 1, John has already reduced his taxable estate by $9,000,000!
Step 2: Each year, the business will pay the dividends of $1,000,000 to the trust. The trust will then pay the $1,000,000 to John as a payment on the note. The payment is part principal and part interest. Because it is a payment from a defective grantor trust to a grantor, the interest is not taxable to John. Because the trust is a defective grantor trust, John is personally liable for the income taxes earned by the business even though it is owned by the trust. John pays income taxes of $400,000 and he spends the rest of his income. The note will be paid off in less than 11 years. If the assets appreciate by 50% during that time, the numbers will look like this:
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Assets Included in Taxable Estate
Cash & Real Estate $ 7,500,000 Total Taxable Estate $ 7,500,000 Estimated Tax $ 255,000
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Assets Outside of Taxable Estate
Business $22,500,000 Life Insurance $ 3,000,000 |
Step 3: Because the trust is a defective grantor trust, John is personally responsible for the income taxes. If he pays the income taxes from his own money, and allows the money in the trust to grow without income taxes, this is the equivalent of a tax-free gift to the trust each year. John’s estate will be reduced by $400,000 per year as long as he chooses to pay the income taxes for the trust. Within two years, his estate will be reduced to an amount that is below his exemption and he will have reduced his estate tax obligation to zero.
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Assets Included in Taxable Estate
Cash & Real Estate $ 6,700,000 Total Taxable Estate $ 6,700,000 Estimated Tax $ 0
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Assets Outside of Taxable Estate
Business $22,500,000 Life Insurance $ 3,000,000 |
The total tax savings can be summarized as follows:
Value of estate with no sale to defective grantor trust: $32,200,000
Estimated estate tax with no sale to defective grantor trust: $11,340,000
Estimated estate tax savings from sale to defective grantor trust: $11,340,000
The total tax savings can be broken down into three categories:
Savings from valuation discounts: $ 2,700,000
Savings from freezing estate against future appreciation: $ 4,725,000
Savings from using income taxes & spending to reduce the estate: $ 3,915,000
Now consider the same analysis with a larger estate:
Background Information
Allison owns a business worth $50,000,000 and it produces $8,000,000 per year in income. Allison is single. Her living expenses are $1,000,000 per year and her income taxes are $3,000,000 per year. She owns cash, real estate and personal assets worth $15,000,000.
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Assets Included in Taxable Estate Business $50,000,000 Cash & Real Estate $15,000,000 Total Taxable Estate $65,000,000 Estimated Tax $27,675,000
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Assets Outside of Taxable Estate $0 |
Step 1: Allison uses accepted discounting methods and sells her business to defective grantor trusts for her children, in exchange for a promissory note equal to $30,000,000. Because it is a sale from a grantor to a defective grantor trust, the sale does not trigger income taxes or capital gains.
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Assets Included in Taxable Estate Note Receivable $ 30,000,000 Cash & Real Estate $ 15,000,000 Total Taxable Estate $ 45,000,000 Estimated Tax $ 18,675,000
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Assets Outside of Taxable Estate Note Payable $ 30,000,000 Business $ 50,000,000
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At the conclusion of Step 1, Allison has already reduced her taxable estate by $20,000,000 and her estimated tax by $9,000,000!
Step 2: Each year, the business will pay dividends of $4,000,000 to the trust. The trust will then pay the $4,000,000 to Allison as a payment on the note. The payment is part principal and part interest. Because it is a payment from a defective grantor trust to a grantor, the interest is not taxable to Allison. Because the trust is a defective grantor trust, Allison is personally liable for the income taxes earned by the business even though it is owned by the trust. Allison pays income taxes of $3,000,000 and she spends the rest of her income. The note will be paid off in less than 10 years. If the assets appreciate by 50% during that time, the numbers will look like this:
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Assets Included in Taxable Estate
Cash & Real Estate $ 22,500,000 Total Taxable Estate $ 22,500,000 Estimated Tax $ 8,550,000
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Assets Outside of Taxable Estate
Business $75,000,000
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Step 3: Because the trust is a defective grantor trust, Allison is personally responsible for the income taxes. If she pays the income taxes from her own money, her estate will be reduced by $3,000,000 per year and the income that is accumulating in the trust will increase by $3,000,000 per year. She will have reduced her taxable estate to the exemption amount and her estate tax obligation will have been reduced to zero.
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Assets Included in Taxable Estate
Cash & Real Estate $ 3,500,000 Total Taxable Estate $ 3,500,000 Estimated Tax $ 0
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Assets Outside of Taxable Estate
Business $96,000,000
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The total tax savings can be summarized as follows:
Value of estate with no sale to defective grantor trust: $99,500,000
Estimated estate tax with no sale to defective grantor trust: $43,200,000
Estimated estate tax savings from sale to defective grantor trust: $43,200,000
The total tax savings can be broken down into three categories:
Savings from valuation discounts: $ 9,000,000
Savings from freezing estate against future appreciation: $ 11,250,000
Savings from using income taxes & spending to reduce estate: $ 22,950,000
Richard Oshins, a well known estate tax attorney from Nevada, has called these three benefits the squeeze, freeze and burn. The valuation discount is called the “squeeze. The sale to the defective grantor trust is called the “freeze”. Using income taxes and spending to reduce the taxable estate and let the non-taxable asset grow tax free is called the “burn.” By effectively implementing a squeeze, freeze and burn strategy, you can substantially reduce or completely eliminate the federal estate tax on almost any estate.