The Tax Cuts and Jobs Act passed in 2017 necessitated a reevaluation of many individuals’ estate plans. It significantly increased the ability of high-net-worth individuals and families to pass wealth free of estate, gift, and generation-skipping transfer (GST) taxes, while increasing the importance of income tax planning due to changes to income tax rates and brackets, as well as standard and itemized deductions.
Many of these beneficial changes are set to expire at the end of 2025, so it may be imperative to evaluate your overall family wealth plan—particularly if it incorporates existing trust planning—with today’s tax laws in mind. In many cases, borrowing or leverage can be an important component to your existing estate planning strategies by improving or creating tax management opportunities. This article seeks to quantify the enhanced benefits of leverage in the following situations: (1) locking-in the appreciation of assets in a grantor retained annuity trust (GRAT) to help mitigate potential downside investment risk; (2) “restarting” a “failed” GRAT seeking to capture future upside potential; and (3) substituting high basis assets into an intentionally defective grantor trust (IDGT) for low basis assets to preserve the potential step-up in basis at the grantor’s death. It is important to keep in mind that each situation is unique, and there is no one-size-fits-all approach to using leverage to accomplish your planning objectives.
What is a Grantor Trust?
A grantor trust is a type of trust in which the trust owner (grantor) relinquishes ownership of the assets placed in the trust but is treated as the owner of the trust assets for income tax purposes (including tax liability, deductions, and credits against tax). Creating this type of trust is a common estate planning strategy for high-net-worth individuals and families, particularly when funded with assets that have low income tax bases relative to their fair market value. Use of this strategy may result in income and estate tax savings when the grantor trust is irrevocable.
Irrevocable grantor trusts
Irrevocable grantor trusts, or IDGTs, may be created for both tax and non-tax reasons. A few of the major benefits of creating such a trust are: (1) when you, as the grantor, make a gift or sell assets to the trust, you are allowed to pay the income taxes on the trust assets, thus allowing the assets held inside the trust to grow income tax free; (2) such income taxes paid are not considered a gift to the beneficiaries of the trust (hence preserving your lifetime gifting exemption) and do not cause inclusion of the trust assets in your estate; and (3) you can swap or substitute your assets with trust assets without any income tax consequences provided the assets swapped are of equivalent value.
Grantor retained annuity trust
A Grantor retained annuity trust, or GRAT, is a popular method of transferring the growth of assets held in trust to future generations at a greatly reduced gift tax cost. The grantor transfers assets that are expected to appreciate significantly over a period of time such as 3, 5, or 10 years in return for a series of fixed annuity payments. The hurdle rate, or 7520 rate as it is commonly called, is used to determine the amount of the annuity payment that is required to be disbursed by the GRAT to the grantor. The value of the annuity payments retained by the grantor is subtracted from the value of the assets transferred to the GRAT in determining the value of the remainder interest passing to the beneficiaries outright or in further trust. When GRAT assets appreciate faster than the hurdle rate, the GRAT can successfully pass this difference to the beneficiaries gift and estate tax free. A common way to provide for the GRAT to grow is to have lower annuity payments in the earlier years. With this approach, the GRAT would then provide for annual increases in the annuity payment of up to 20% in each of the remaining years to satisfy the distribution requirements.
Locking-in a GRAT with leverage
A strategy to help protect appreciation from downside risk. A successful GRAT is one that has grown in value so that it has assets remaining at the end of the term after all annuity payments are made to the grantor. Often, a GRAT’s value may surge early through strong performance only to experience a significant downturn later in its term, reducing the strategy’s overall effectiveness. The lock-in GRAT seeks to protect the early appreciation from the potential for downside risk later in the term. The grantor substitutes or swaps assets of equivalent value that have low volatility for the riskier and highly appreciated GRAT assets. When the grantor does not have the liquidity or low volatility assets to accomplish the substitution, borrowing may provide a solution.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service. It is not designed or intended to provide financial, tax, legal, investment, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought. Note that financial and estate planning strategies require individual consideration, and there is no assurance that any strategy will be successful.
Please see important disclosures at the end of the article.