A common estate planning technique for high net worth individuals is a Sale to a Defective Trust.
In general, a “defective grantor trust,” (now more simply known as a “grantor trust”) is a trust that is disregarded for income tax purposes. Thus, all of the trusts income, deductions, etc. are treated as though they are received by (or paid by) the grantor. Furthermore, although the trust is disregarded for income tax purposes, it is respected for estate and gift tax purposes, thereby enabling a grantor to transfer assets outside of his or her estate without any income tax consequences.
The sale/transaction works as follows:
Step 1: Grantor establishes an irrevocable trust with his or her spouse and/or other family members as beneficiaries.
Step 2: Grantor gifts and sells assets to the trust established under step 1 in exchange for a promissory note with the required minimum interest payments set out by the IRS.
The result at the end of the transaction is twofold. First, for estate tax purposes, all future appreciation of the assets gifted and sold to the trust will grow outside of the grantor’s estate. Second, for income tax purposes, the grantor does not need to recognize any income tax on the sale, since the sale to a grantor trust for income tax purposes, is deemed to be a sale to the grantor himself. Furthermore, all income from the trust will be taxed at the grantor’s individual tax rate rather than the rate for trusts. This is important since the highest income tax rate for individuals (37%) kicks in at income over $500,000, whereas the highest income tax rate for trusts (also 37%) kicks in at only $12,500.
The end result is that all assets transferred to the trust will be successfully removed from the grantor’s estate. Additionally, since the grantor’s spouse is a Trustee and beneficiary of the Trust, such spouse may access the trust’s assets should the need arise.