Defective grantor trust may offer valuable transfer tax benefits.

• Author: Taylor, Rick J.

A "defective" grantor trust arrangement can provide extraordinary transfer tax savings to families that want to transfer income-producing assets to junior family members. The primary benefit of a defective grantor trust is that the senior family members are taxed on income that is shifted to junior family members. As a result, the income tax on the income is paid by the senior family members, while the benefit of the income flows to the junior family members without the imposition of a gift tax.

Overview

A defective grantor trust is a trust arrangement that is treated as a grantor trust for income tax purposes, while all or a portion of the trust corpus is excluded from the grantor's estate. Before 1986, defective grantor trust arrangements were often used to pass through the deduction for interest incurred to carry certain life insurance policies on the grantor. However, the Tax Reform Act of 1986 eliminated this benefit with the phased-in elimination of the deduction for personal interest.

Although a defective grantor trust generally does not generate any income tax benefits or additional costs (i.e., overall family wealth generally is unaffected by income shifting because of the current compressed income tax rates), significant transfer tax savings may be realized because there is a shifting of assets between generations at no transfer tax cost.

Example 1: Father, F, transfers $600,000 to a trust for the sole benefit of his children. The trust is structured as a defective grantor trust. As a result, F is taxed on the trust's income each year, but the trust corpus will be excluded from his estate when he dies. Each year, the trust is expected to generate $60,000 of taxable income on which F will pay $18,600 of tax. Although the payment of the tax provides a direct benefit to the beneficiaries of the trust, this benefit is not subject to transfer tax since F is legally obligated to pay the tax. This arrangement could save the family $11,160 a year in transfer tax (assuming a 60% maximum marginal transfer tax rate). The family's transfer tax savings can be increased significantly if the beneficiaries of the trust are grandchildren. If the tax is paid on income that inures to the benefit of F's grandchildren, this arrangement could save the family $27,528 in gift and generation-skipping transfer (GST) taxes, calculated as follows.

$18,600 x 60% (gift tax) $11,160 $18,600 x 55% (GST tax) 10,230 $10,230 x 60% (gift tax

on the GST tax) 6138...