Intentionally Defective Grantor Trusts Under Attack by 2013 Revenue Proposals

By:  David R. Schoenhaar, Esq.*

A common Estate Planning technique is the utilization of intentionally defective grantor trusts.  A grantor trust is a trust in which the grantor is treated as the owner for income tax purposes and when the grantor dies, the trust is often drafted in a manner to avoid inclusions in the grantor's estate for estate tax purposes.  The grantor's payment of the income taxes is in effect an annual tax free gift to the trust, which allows the trust assets that would otherwise be utilized to pay the tax burden, to stay in the trust and grow.  Also, since transactions between the trust and the grantor are ignored, there is no income tax event when the grantor sells a low basis asset to the grantor trust.

Sounds too good to be true?  Apparently the Obama Administration thinks so because their Fiscal Year 2013 Revenue Proposals contain a provision to include grantor trust assets in the grantor's estate.  The reasoning for this radical proposal is to coordinate the income and transfer tax rules and prevent this type of planning which can lead to the transfer of significant wealth by the grantor without transfer tax consequences.

According to the proposal, if a grantor is treated as an owner of a trust for income tax purposes (1) the trust assets would be included in the gross estate of the grantor for estate tax purposes, (2) distributions from the trust to a beneficiary during the grantor's life would be subject to gift tax, and (3) if at any time during the grantor's life the grantor ceases to be treated as an owner of the trust for income tax purposes, the remaining trust assets would be subject to gift tax.  The proposal would be effective with regard to trusts created on or after the date of enactment and with regard to any portion of a pre-enactment trust attributable to a contribution made on or after the date of enactment.

If you are an estate planning attorney you are probably thinking about all the grantor trusts that you have drafted in the past and are in the process of drafting.  Like many of the other Obama Administration proposals this one is likely to be met with significant resistance.  However, this is certainly a proposal that needs to be followed as it would significantly change estate planning as we know it.

*David R. Schoenhaar, Esq., is an associate at Ruskin Moscou Faltischek, P.C. and is a member of the firm's Trust and Estates Planning and Litigation Department.

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