Cummings & Lockwood Estate Planning FAQs

A grantor trust, also known as an “intentionally defective” grantor trust, is a trust which requires the grantor to report the income generated by the trust assets on the grantor’s individual income tax return.

Many gifting vehicles are intentionally designed as grantor trusts so that the grantor can continue to bear the income tax burden associated with assets that have been removed from the grantor’s estate through a completed gift.  In short, the gift by the grantor is complete for gift tax purposes but not for income tax purposes.  This allows the trust property to grow inside of the grantor trust without the drag of an income tax burden.  Thus, grantor trust status is a powerful tool that a family can use to allow previously gifted trust assets to grow undiminished by taxes.  Under current law, the payment of taxes by the grantor is not considered a gift.

There are many administrative “defects” that can be used to intentionally trigger grantor trust status, but among the most popular are the ability for the grantor to “swap” assets with the trust, the ability of the trust to make premium payments for a life insurance policy on the life of a grantor, and the appointment of a Trust Protector who has the right to add beneficiaries to the trust. 

An installment sale in the estate planning context is usually structured as a sale for a Note which provides for payments of interest only for a term of years with a balloon principal payment at the end of the term.  This technique is useful to transfer investments or business interests to the next generation while simultaneously providing income to the seller.  This is also useful if the buyer, usually a descendant of the seller, does not have the financial resources to purchase the interest with cash, or if the buyer/descendant cannot or will not obtain outside financing.

The grantor sells assets to the Trustee of an irrevocable trust.  The Trustee will pay for the interest by issuing a promissory note for the purchase price. The Trustee often does not make any down payment for the sale.  Prior to the sale, the trust should either have its own assets or be “seeded” to provide enough trust assets to equal at least 10% of the property being purchased.  If the assets in the trust are not sufficient for the transaction to be considered an arm’s-length sale, the Internal Revenue Service (“IRS”) could argue that the sale is really a contribution to the trust with a retained income interest, which could cause the entire value of the trust assets to be includible in the seller’s estate for estate tax purposes.  In exchange for the interests, the Trustee would give the seller/grantor a promissory note for the value of the interests it receives.

Often in this type of planning, the sale is structured to be made to a trust that is designed as a “grantor trust” (that is, a trust the assets of which are treated as being wholly-owned by the grantor for income tax purposes).  If the trust is a grantor trust, the sale of the interests would be treated as if you were selling the interest to yourself.  As a result, you could take a reporting position that no capital gain is recognized when the trust buys the interests.  For the same reason, the trust’s interest payments under the promissory note should not be treated as income to you. 

If the trust is treated as a separate “person” for income tax purposes (referred to as a “nongrantor trust”), the sale would be a taxable event for income tax purposes and income reported under the installment method.  Further, the trust would be liable for any income or capital gains earned by it, which, generally, are taxed at the highest rates that apply to individuals because the tax brackets that apply to trusts are very compressed.

The installment sale offers several benefits:

The grantor pays income taxes on behalf of the grantor trust.

If the trust is designed to be a grantor trust, the grantor pays the tax liability on the annual income generated by the interests held by the trust, as well as the trust’s capital gains in the event that the interest were to be sold inside of the trust.  This results in an estate tax benefit because the grantor pays the income taxes on earnings that accrue to the benefit of descendants, but the payment of those income taxes is not treated as a taxable gift under current law.  Having said that, however, the grantor must be willing and able to absorb the demands on his or her personal assets to pay these taxes. 

No gift tax on the sale.

As discussed above, the transfer of the interests to the trust would be structured in the form of an arm’s-length sale, i.e., an exchange of an interest for an installment note bearing at least an IRS “safe harbor” rate of interest (for example, the mid-term rate for notes 3-9 years in November 2023 is 4.69%).  As a result, this transfer should be respected as a sale for fair market value, in which case there should be no gift tax consequences, provided that the fair market value of the asset sold is in fact the same as the face amount of the promissory note.

Removal of appreciation from the taxable estate.

By exchanging a potential growth asset for a non-growth asset (the promissory note), the grantor would be “freezing” the value of property remaining in the taxable estate for estate tax purposes.  If the interests sold to the trust outperform the interest rate on the promissory note, the transaction enables the grantor to pass that excess amount of value to the trust free of gift and estate taxes.  Further, limiting the annual payments to interest, at least initially, it is easier to shift value to younger generations by deferring the payment of the principal to the maximum extent possible.

Generation-Skipping Transfer (“GST”) planning.

Property held in a trust may be subject to a GST tax upon the death of the grantor’s children and future generations of descendants.  In 2023, the GST exemption is $12,920,000 (less any used for prior lifetime gifts), which means that the grantor can provide for up to $12,920,000 (less any used for prior lifetime gifts) to be held in trusts for the grantor’s descendants, without any GST tax being imposed upon the death of each descendant.  If structured as an installment sale, the grantor may immediately allocate her GST exemption to the trust upon its creation (i.e., the initial “seed money”).  By allocating GST exemption to any transfer made to the trust upon its creation, any assets purchased by the trust (including the transferred interests) would be GST-exempt.  This provides a better ability to leverage the use of GST exemption to maximize GST tax avoidance for successive generations.

An installment sale has the following primary disadvantages:

The sold assets will not receive stepped-up basis in the event of your death.

If you were to hold your interest in the asset until your death, such interest will be included in your taxable estate and will receive a step-up in cost basis at that time to its then fair market value.  In that case, a sale of the interest shortly after your death would not generate capital gain.  However, by selling your interest in the asset to a grantor trust (and thereby removing the interest from your estate), the property will not obtain the step-up in cost basis upon sale or at your death.  Thus, a subsequent sale of the interest by the Trustee would generate a capital gains tax even if the sale occurs immediately after your death.  Despite this concern, if the maximum federal estate tax rate is much higher than the capital gains tax rate, the advantages outlined above (i.e., the avoidance of gift tax on the transfer and on the future income tax liability paid by you, the avoidance of estate tax on future appreciation, and the leverage of your GST Exemption) may outweigh this disadvantage.

Promissory note included in your taxable estate.

If you die before the promissory note is satisfied in full, it would be an asset held by you and included in your taxable estate.

Reversal of traditional IRS income tax position.

Even if you sold your interest in the asset to a grantor trust, the IRS may claim that the sale results in capital gain to you at the time of the transaction.  If the IRS successfully took this position, you would recognize a capital gain on the sale of the interest at the time of transfer to the trust.

Estate may recognize capital gain.

If you die holding the promissory note, your estate may recognize capital gain on any unpaid principal. 

IRS may treat the entire transaction as a gift.

The IRS may assert that the transaction was really a gift and not a sale.  To avoid this risk, it is important that there is no pre-arrangement to forgive any interest or principal due under the promissory note, and the value of what is sold should be supported by the appropriate valuation, including, possibly, an appraisal.  The transaction should be structured like a commercial or “arm’s length” transaction. 

IRS may treat a portion of the transactions as a gift.

Even if the IRS is unsuccessful in attacking the entire transaction as a gift as described above, the IRS could attack the transactions on another front by asserting that the fair market value of the transferred interests is greater than the fair market value of the promissory note given back to you.  The IRS could argue that (1) the promissory note was not worth its face value because the trust was not a creditworthy borrower or (2) the appraised value of the interest in the asset was simply too low.  It is important to support the sales price with an appropriate valuation or appraisal.

Sold interests may under-perform the IRS interest rate.

In this case, you will have actually increased the size of your estate and decreased the value sold to the trust because the interest and principal payments on the promissory note will exceed the value of the interests sold to the trust.  Of course, this is always a risk that needs to be taken into account, and is difficult to predict or plan for.

Absence of express statutory sanction.

The installment sale to a grantor trust is a technique that does not have an express statutory sanction.