
FEATURED ARTICLE
Tax Planning for Realized Gains and Ordinary Income
Tax planning strategies for realized gains and ordinary income
Tax planning strategies for realized gains and ordinary income
Non-grantor trusts and Grantor Retained Annuity Trusts (GRATs) are two popular types of irrevocable trusts. How do you know which one is right for you? This article explains what these trusts are and when they make sense.
A non-grantor trust is a type of irrevocable trust that is treated as a separate taxpayer for income-tax purposes. By setting one up in a no-tax state, taxpayers can avoid state income tax. Properly structured non-grantor trusts also help families avoid estate tax, since assets gifted to them (and any appreciation after the date of the gift) will be outside the grantor’s estate for estate-tax purposes.
Typically, a person (the “grantor”) creates a non-grantor for the benefit of one or more loved ones — such as children, grandchildren, or siblings. The grantor funds the trust using a portion of his or her lifetime gift and estate tax exemption. Once an asset is in the trust, that asset is outside the grantor’s estate and will never be subject to gift tax, estate tax, or generation-skipping transfer tax as long as it remains in the trust. Any resulting appreciation will also be outside the grantor’s estate. (You can learn more about non-grantor trusts here.)
Imagine that Jim is a New York City resident with a $25 million net worth and a portfolio that generates 9% annual returns (divided equally between capital appreciation and cashflow). If Jim sets up a non-grantor trust and then contributes a $6 million asset to it, he will use up $6 million of his lifetime gift tax exemption, but the asset will be able to grow outside of his taxable estate. After 25 years, the non-grantor trust’s assets will be worth about $33.5 million! And if Jim dies in Year 25, he will have saved his heirs about $15.2 million of tax between state capital gains taxes and estate taxes relative to the counterfactual where he hadn’t funded the non-grantor trust.
A GRAT is a type of irrevocable trust that moves assets out of a person’s taxable estate without using that person’s lifetime gift and estate tax exemption. It’s a powerful gift and estate tax strategy. The basic idea is that a person (the “grantor”) transfers an asset to the GRAT and sets an annuity term (usually two years). A portion of the principal is returned to the grantor each year until the end of the term. The exact size of each annuity payment is based on a standardized formula, but basically the grantor is entitled to receive the full amount of the original principal amount plus interest that is based on the government’s interest rate, known as the “7520 rate.” By the end of the term, the original principal (plus some interest) has been returned to the grantor. Any remaining amount in the trust passes to the grantor’s named beneficiaries free of estate tax or gift tax. The GRAT’s magic comes from the ability to transfer wealth to beneficiaries free of tax by simply funding the trust with assets that outperform the 7520 rate. The 7520 rate is equal to roughly 120% of the yield on a 7-Year Treasury Note, so it typically comes out to somewhere in the 3%-5% range. (You can learn more about GRATs here and you can estimate the potential returns here.)
Imagine that Christine is a New York City resident with a $25 million net worth and a portfolio that generates 9% annual returns (divided equally between capital appreciation and cashflow). If she contributes $6 million to a two-year GRAT when the 7520 rate is 4%, the GRAT will pay her approximately $6.3 million over the course of the first two years. But because the GRAT’s assets are appreciating at 9% while the 7520 rate is only 4%, there will be a remainder left over at the end of Year 2. That remainder — about $500,000 — will pass to Christine’s remainder beneficiary, perhaps a grantor trust for the benefit of her daughter. If Christine decides to set up “Rolling GRATs” — that is, GRATs where the annuity payments are used to fund new GRATs — and she keeps setting up new GRATs each year for 25 years and naming the grantor trust for her daughter as the remainder beneficiary, by Year 25 she will have transferred about $33.1 million to trusts for her daughter, saving her daughter the equivalent of about $14.5 million of tax.
GRATs funded during two-year periods where Christine’s investments performed poorly would fail, but Christine and her daughter would be no worse off than if Christine hadn’t funded the GRAT (aside from the cost of setting up the GRAT).
Note that in this example the GRATs transfer slightly less wealth than the non-grantor trust described above. But that’s not always the case. If the assumed returns had been higher or more volatile, the GRAT could have easily outperformed.
Non-grantor trusts and GRATs both save estate tax, but they’re used in different circumstances.
Non-grantor trusts can save state income tax, which is a big deal for people in high-tax states like New York or California. You’ll often see people in high-tax states with $10 million to $25 million of assets setting up non-grantor trusts. These people tend to be more focused on state income tax than on estate tax. Non-grantor trusts are also desirable for people with QSBS stock, since they can claim their own $10 million QSBS exclusions.
GRATs are ideal for people with volatile assets that are easy to value, like individual stocks or crypto, who are looking to transfer assets to their children. GRATs are particularly useful for people who have limited unused lifetime gift tax exemption, since GRATs don’t require lifetime gift tax exemption in order to work.
It is important to note that there are lots of other gift and estate tax strategies that may make more sense than a GRAT or a non-grantor trusts , depending on circumstances. Those strategies are also worth exploring. Moreover, non-grantor trusts and GRATs are not mutually exclusive; some people set up both.
Non-grantor trusts and GRATs are both powerful tax strategies. Non-grantor trusts make sense for people looking to transfer less volatile assets. GRATs make sense for people with volatile assets who are looking to transfer assets to a trust without using any lifetime gift tax exemption.
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