Some Gifts Keep on Giving: Maximizing Tax Savings with Grantor Trust Asset Substitutions

On my desk, just below my monitor, I have three small LEGO® toys: a rainbow sitting on a platform of green “grass,” a blue Pegasus unicorn, and a red propeller airplane. To anyone else, they’re just silly child’s toys that don’t belong amongst the seriousness of the financial and legal work strewn across the rest of my desk. To me, they are invaluable. You see, last Christmas I lay down on the carpeted floor next to the Christmas tree with my 7-year-old nephew, Ian, who quite literally “schooled” me in the building of these LEGO® toys that had just been received as a Christmas present. In the time it took me to plod through the directions and snap together just three pieces of the rainbow, Ian assembled the entire airplane and unicorn without even consulting the directions.

Indulge me by allowing me to use this sweet, albeit humbling, story as an allegory for the gift of assets to your heirs. Imagine that you’ve already established and funded a trust for your heirs. (You’ve given them the LEGO® pieces.) You enhanced the benefit of this trust for your heirs by making sure it is drafted as a “grantor trust,” which means that you will pay any tax liability for the trust, even though you no longer have any access to the trust assets. (You helped them assemble the LEGO® toys.) Now, what if you could enhance the value of that gift to them even more? (The memory of the time spent together building the LEGO® toys is the most precious gift of all.)

The kind of trust I’m referencing is an irrevocable trust specially drafted to leave specific powers with the grantor, thus making the grantor the owner for income tax purposes. This type of trust is often called an intentionally defective grantor trust (IDGT). Assets are transferred to the trust by the grantor. The trust language specifies, among other terms, that the grantor no longer has access to the assets, therefore the IRS considers this to be a completed gift—the assets have been removed from the grantor’s estate. However, the powers left to the grantor make the trust taxable to the grantor at the grantor’s ordinary income tax rates, which are often lower than the income tax rates of the trust. The effect of the grantor paying the trust taxes is akin to making an additional gift to the trust beneficiaries but is not considered an additional gift in the eyes of the IRS.

I mentioned that the trust is drafted to leave specific powers with the grantor. One such power is the power to substitute assets (“swap powers”). The swap power gives the grantor the ability to take any of his or her own assets (outside the trust) and exchange them (swap them) for assets in the trust of equivalent value.

Why use it?

• Getting the Growth Out but Maintaining Flexibility: One of the main goals of an IDGT is to maximize the growth of assets outside the grantor’s estate. This is often accomplished by placing high-growth assets in the IDGT at funding. An example of a high-growth asset might be an interest in a privately held business. If this strategy is successful and the growth indeed occurs over time as hoped, these high-growth assets may end up having very large unrealized capital gains. Should the trustee need to liquidate trust assets in order to make distributions or to diversify the portfolio of the trust, this could generate significant taxable capital gains. A substitution can mitigate this issue. The grantor would simply substitute cash or other high-basis securities from outside the trust with the low-basis assets of equivalent value held within the trust. Once the substitution is complete, the trustee has the flexibility to use the cash or high-basis assets within the trust to make distributions or to diversify the portfolio. The substitution is not a taxable event.
• Taking Advantage of the Step-Up at Death: When the grantor brings highly-appreciated assets from the trust back into his estate, ideally he will not need those assets and will hold them until his death, at which point the assets will receive a step-up in basis. Assets remaining in the IDGT are not included in the grantor’s estate and will not receive a basis step-up at death. Heirs of the estate will end up paying far less in capital gains tax (or possibly even zero tax!) when the inherited assets are liquidated, and the trust will pay less capital gains tax on the substituted low-basis assets.
• To Preserve a Loss on Depreciated Assets: If there are depreciated assets or securities with unrealized losses inside the grantor’s estate, these may also be candidates for a swap for highly appreciated assets in the trust. The swap would preserve the loss inside the trust which the trustee could use to offset gains taken over time as trust assets are liquidated.

When to use it?

Although the grantor is responsible for exercising the swap, an investment advisor may be in the best position to help monitor the timing for such a swap if the swap includes marketable securities. For closely held business interests, the business owner or appraiser may be in the best position to monitor the values and suggest the optimal timing. In general, the timing for a swap might be ideal when:

• The Low-Basis vs. High-Basis Condition Exists: The trust has accumulated large unrealized capital gains and the grantor has eligible assets for substitution such as cash, high-basis assets or proceeds from a recent liquidity event. Importantly, the grantor should not need the cash or assets deposited into the trust and is in a position to hold the appreciated assets from the trust in his estate long-term, ideally for the rest of his life. Alternatively, if the grantor does not have sufficient eligible assets for the substitution, he can consider drawing on a line of credit to access the cash for the substitution. Ideally, this line would be at a low interest rate and paid off shortly after the substitution.
• A GRAT Has Been Successful and is Nearing the End of its Term: A GRAT, or grantor retained annuity trust, is a specific kind of IDGT whereby any amount remaining at the end of the term of the trust (the residual) is considered a “win” and is paid out to the remainder beneficiaries. This “win” can be locked in before the end of the annuity period by substituting volatile assets (equities) from within the GRAT for less volatile assets (fixed income and cash) from the grantor’s estate. The grantor and the investment advisor should closely monitor the timing for completing this substitution prior to the end of the annuity term.
• Later in the Life of the Grantor: While no one has a crystal ball, a swap that is completed with the goal of taking advantage of the step-up in basis will be completed late in life. This would limit the opportunity for additional growth of the assets within the grantor’s estate while still taking advantage of the step-up in basis.

Pitfalls and Reminders

• The swap power is a non-fiduciary grantor power. The trustee does not have any power to execute this swap. However, the trustee’s approval of the swap must be documented. The trustee’s approval indicates his or her agreement that the swap is allowed per the terms of the trust, and that the assets used for the swap are suitable.
• It is important to have a plan in place to monitor values and discuss the possibility of substitutions regularly with advisors in order to achieve optimal timing and to avoid missing the opportunity altogether.
• When substituting assets, it is important to clearly document the assets being swapped. If assets are not easily valued (illiquid securities, closely held business interests, etc.), obtain an appraisal to document that the values exchanged are equivalent.
  • Consider documenting the swap on a gift tax return to provide proof to the IRS of the equivalent values.
  • If the IRS finds that the values were not equal, they could claim the grantor retained too much interest in the entire value of the trust, resulting in the entire trust being includable in the grantor’s estate.
• If you know a swap is in the near future, get your ducks in a row! Have appraisals completed if needed and prepare paperwork in advance.
• If the grantor is incapacitated or otherwise incapable of exercising the swap, a power of attorney for the grantor can also exercise; be sure the POA document gives this authority and be sure the POA is aware of the possible transaction.
• Be sure to consult your legal advisor if considering the use of stock in a controlled corporation in the swap. It is likely best to exclude these assets from a swap transaction.

Rest assured if you have an irrevocable grantor trust managed at Bragg, we are monitoring your account, keeping your life circumstances in mind, and regularly asking ourselves if an asset swap will make sense for your situation.

We hope this information is useful. Please consult your attorney for legal advice regarding the ideas discussed here. Bragg Financial is not licensed to practice law.