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.
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:
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.