By: Randall A. Denha, Esq.
A beneficiary grantor trust (“BGT”) is an irrevocable trust that treats the beneficiary as being the owner of the trust for income tax purposes but not for estate tax purposes. Although this trust is established by someone else for the benefit of the beneficiary, the beneficiary is the owner and entitled to any income deductions and credits to be attributed to such beneficiary. The BGT was the subject of a recent Private Letter Ruling (PLR 201039010.) Although we cannot rely on a PLR as precedent, we can use it as a guide for navigating the windy road of estate planning.
The BGT is defective for income tax purposes in that the trust income is taxed to the beneficiary, but not defective for estate tax purposes. Put another way, the income tax and any deductions are attributed to the beneficiary during life but no part of the trust assets will be taxed upon death of the beneficiary. If used properly, the BGT can be a very useful tool.
Here is one example of its use: an individual owns a business that is expanding. His mother creates a BGT, making a $5,000 gift to the trust. The trust forms a limited liability company (LLC). The LLC then makes a deal with the business – the LLC builds the building, and the business will rent the building from the LLC. The LLC takes the lease to a lender and obtains financing for the purchase of land and construction of the building.
Over a period of time, the LLC uses the rental income to pay down the mortgage, thereby acquiring equity in the building. When the mortgage is retired, the trust will continue receiving rental income and gaining equity. The annual income tax the beneficiary pays (as a result of the BGT) reduces the beneficiary’s estate. Over time, the beneficiary may get to the point where other assets are depleted, so that the beneficiary’s estate is reduced to the amount that can pass tax free (currently $5M in 2011 and 2012 and $1M in 2013.) Further, the trust beneficiary can live off the trust comfortably, without having a conflict between having plenty of retirement income and avoiding estate tax, because his primary source of income – the trust – is outside of the estate tax system.
The above is just one application of this technique. A BGT works especially well in instances where the beneficiary has a new business opportunity, but would like to keep the business out of his or her estate. This is the typical pattern. For technical tax reasons beyond the scope of this article, the beneficiary needs to be granted a withdrawal right, which makes the beneficiary the initial owner for income tax purposes. This power is what causes the right of income and deductions to pass to the beneficiary. The typical arrangement uses a seed gift of no more than $5,000 to establish the trust. This gift is generally given by the parents of the beneficiary. The BGT offers the beneficiary the ability to control the new business via the trust, receive income from the trust and never have to worry about the asset being included in their estate! The real kicker here is that the beneficiary can later sell assets to the BGT without any gain or loss recognition. Imagine that.
How can the prognosticating beneficiary get the senior generation to assist him/her in this planning? The beneficiary convinces his/her parents or grandparents to give him/her an “advance” on his/her inheritance by making a gift to the BGT. This will allow the beneficiary to operate the business (as the trustee of the BGT). The beneficiary will also have access to the cash flow of the business, without having to worry about it being included in his/her estate (except to the extent the beneficiary’s unilateral withdrawal right has not yet lapsed under the 5 percent / $5,000 power). The beneficiary can also sell assets to the BGT without any gain or loss recognition. Remember the beneficiary is the owner of the trust so how can he recognize gain or loss on a sale to such beneficiary? Finally, the beneficiary’s payment of the BGT’s income taxes reduces his/her estate and is a “tax-free” gift to the beneficiaries of the BGT after the death of the beneficiary.
In summary, a BGT allows the beneficiary to achieve virtually all of his/her tax and non-tax planning objectives. When advising clients on estate planning matters, the planner should advise them to consider establishing BGT’s for their children and grandchildren, and/or advise them to ask their parents and grandparents to establish a BGT for them.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.