Swapping With A Grantor Trust
By: Randall A. Denha, J.D., LL.M.
In simple terms, a “Grantor Trust” is a trust in which the grantor, the creator of the trust, retains one or more powers over the trust and because of this the trust’s income is taxable to the grantor. Put another way, a grantor trust is a type of trust under which the tax law considers the trust assets as still owned by the transferor for income tax purposes. As such, (i) all of the income and deductions are taxed to the transferor on the transferor’s income tax return and (ii) transactions between the transferor and the trust are disregarded for income tax purposes and therefore does not cause recognition of any income or capital gains taxation. Even better is that for estate tax purposes, the asset is not subject to estate tax despite being subject to income tax (depending on the powers retained by the grantor). Some might say, “it’s defective for income tax but effective for estate tax.”
Grantor trusts play a key role in estate planning and, as previously mentioned, they can be structured to exclude their assets from the transferor’s taxable estate, even though the transferor is still considered the owner for income tax purposes; as such, the trust grows “tax-free” outside of the transferor’s estate because the transferor can cover the income tax out of his or her other assets. The effect is to reduce the transferor’s estate while growing the trust.
Under the Tax Code, one can receive a step-up in basis for assets held in one’s estate at death. This means that assets are reappraised at the fair market value at the date of death of the grantor. Heirs inherit the asset under this new cost basis, usually minimizing capital gains taxes if they sell the appreciated asset at a later date. What’s important to note is that this step up provision does not apply to irrevocable trusts, since these are not considered part of the grantor’s estate. Without the provisions of the tax code, assets in the trust would be subject to higher capital gains taxes when sold. If the grantor possesses a highly appreciated asset in the trust and wants to receive a step up in basis when passing this asset to heirs at death, it may be best to use swap powers in order to take advantage of the provisions applicable to estates.
How does this swap power work? Under current law, a swap power permits the grantor of the trust to swap assets from his/her personal name into the trust, in exchange for assets of equivalent value. This can be used to pull highly appreciated assets out of an irrevocable trust so they are included in the grantor’s estate on death, and can achieve a step-up or increase in income tax basis. This means the basis on which capital gains is calculated is reset to fair value, thus eliminating capital gains on a later sale. If the Trump administration enacts a capital gains on death tax, this same swap power may be used in reverse to swap appreciated assets from a client’s estate, where they would be subject to a capital gains tax on death, into an irrevocable trust, where they might avoid that gain. This flexibility is another reason to plan now and not wait.
As we know, death and taxes are a certainty. However, what isn’t certain is the tax landscape at the death and for this reason, estate planning needs to be flexible and creative in its approach. If done correctly, a client will be well served and be able to navigate the waters, regardless of conditions. Under the current federal tax landscape the utilization of the swap power may provide a meaningful benefit. If a trust does not currently contain such powers, consider decanting or modifying the trust to provide such flexibility.
