With high unemployment, a sagging real estate market and a slow economy, many households have felt the effects of a severe recession. One silver lining for estate planning: applicable federal rates (AFRs) have fallen to very low levels, and the IRS publishes AFRs monthly for federal income tax purposes.
AFRs are used to value remainder and annuity interests and to ensure debt transactions do not carry below-market interest. Low AFRs make certain grantor-trust strategies more attractive for transferring wealth and purchasing life insurance inside trusts.
Delving into the DIGT.
An intentionally defective irrevocable grantor trust (DIGT) is an irrevocable trust drafted so the grantor is treated as the owner for income tax purposes while the trust assets remain outside the taxable estate. Calling it “defective” is a drafting term, not a flaw: the grantor pays the trust’s income tax, which lets the trust accumulate assets without using the grantor’s annual gift tax exclusion for premium payments or income.
Lending funds the smart way.
One common DIGT strategy is for the grantor to lend money to the trust on an interest-only promissory balloon note that uses the published AFR as the interest rate. The trust pays only interest during the term and repays principal at maturity; meanwhile, the trust invests the borrowed funds.
Here's how it works:
The grantor loans cash to the DIGT and receives a note. The trust invests the funds, the trust pays the interest, and the grantor pays income tax on the trust’s income. The grantor can then use the after-tax cashflow to buy a no-lapse guaranteed life insurance policy inside the trust.
Here's an extra plus: often the investments funded by the loan generate enough income to cover the note interest and the insurance premiums, preserving the loan principal to repay the balloon payment at maturity. Many planners structure the note and life policy so the policy is fully paid within about nine years; by year ten the grantor has the loan principal repaid and the trust owns a paid life insurance policy.
This technique generally requires a substantial liquid loan to the trust. If you cannot make a large loan, some grantors set up a smaller loan as a sinking fund to stretch premiums over a longer schedule, but that approach requires a clear exit strategy to repay principal.
The great GRAT method.
A grantor retained annuity trust (GRAT) is an irrevocable trust that lets a grantor transfer potential appreciation to beneficiaries with minimal or no gift tax, especially effective when AFRs are low. You transfer assets into the GRAT, retain an annuity for a set term, and at termination any excess appreciation passes to the beneficiaries income- and gift-tax efficiently.
If the assets appreciate less than the annuity payments, the trust “fails” and assets revert to the grantor, who can then consider opening another GRAT. Because downside risk is limited, many advisors recommend GRATs for owners expecting significant estate growth.
Not only does a GRAT provide a tax-efficient way to transfer future appreciation, it also reduces the value of your taxable estate. Financial advisors commonly suggest GRATs to investors who expect their estate to exceed exemption thresholds by the end of their lives; for more on related charitable and trust planning strategies, see Protecting Philanthropic Legacies with Charitable Remainder Annuity Trust Insurance.
Anything but defective.
When used properly, intentionally defective grantor trusts can be powerful estate-planning tools: they can facilitate life-insurance purchases inside trusts, shift future appreciation out of the taxable estate, and make use of low AFRs. Consider your liquidity needs, the size and term of any promissory note, and the long-term insurance funding schedule before proceeding.
Discuss these techniques with your advisors, or Protecting Philanthropic Legacies with Charitable Remainder Annuity Trust Insurance, and if you want personalized quotes, consider taking the next step and talk to an agent about how grantor trusts might fit your plan.
Frequently Asked Questions
What is an intentionally defective grantor trust (DIGT)?
A DIGT is an irrevocable trust drafted so the grantor pays the trust’s income tax while the trust assets remain outside the grantor’s taxable estate.
How does lending to a DIGT avoid using gift exemptions?
When the grantor makes a loan to the trust rather than a gift, the transaction uses a promissory note at an AFR-based rate and generally does not consume the grantor’s gift tax exemption.
Why are GRATs more attractive when AFRs are low?
Low AFRs reduce the assumed growth the grantor must provide to make the GRAT effective, increasing the chance that appreciation will pass to beneficiaries tax-efficiently.
Are there risks with these trust strategies?
Yes. Risks include insufficient trust investment returns, the borrower’s failure to repay, and the need for significant upfront liquidity; work with an attorney and tax advisor before implementing them.