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How grantor trusts (and alternatives) aid estate planning

Grantor trusts have long been a valuable estate planning tool because they allow affluent individuals to separate assets for estate and income tax purposes. But a recent legislative proposal would have radically changed how these trusts could be used, effectively eliminating their tax shelter benefits. Since the initial proposal, this particular section has since been removed, but ideas that surface once tend to come around again. So, to be better prepared for any future changes, let’s look at the benefits of grantor trusts as well as some alternatives you can use to boost your estate planning goals.

Benefits of grantor trusts for estate planning

Under current law, investors can use a grantor trust to place assets outside of their taxable estate while still maintaining income tax ownership of that trust. This means grantor trusts can provide significant estate planning benefits because everything included in that trust is not considered their property from an estate tax perspective, but is considered their property from an income tax perspective. The grantor can effectively make non-reportable gifts in the form of paying income tax on behalf of assets in the trust.

In addition, a spouse can set up a grantor trust for the benefit of their spouse during life. So effectively, the married couple can continue to benefit from the property that resides outside of the taxable estate as long as both spouses are living and married.

The recently removed legislation would have changed all that by making grantor trusts part of a decedent’s taxable estate if the deceased is considered the income tax owner of the trust. The bill would have also changed the rules regarding sales between an individual and a trust. But that didn’t happen. So, for now, grantor trusts remain a viable way for affluent individuals and families to protect assets and achieve tax efficiency.

Alternative, tax-efficient estate planning strategies

Proposed changes to grantor trust rules were ultimately left out of the final legislation. But because they have already been targeted by lawmakers looking to close what they deem tax loopholes, there’s a chance changes could come in the future. As such, investors should continue to consult with their financial advisors and monitor any changes in tax law to respond accordingly. If the tax benefits of grantor trusts are eliminated in the future, here are a few alternative strategies that can better position your portfolio for success and help you accomplish your estate planning goals.

Establish a grantor trust now before the law changes

The proposed rule changes would only have impacted future trusts, meaning trusts that have already been established and funded would essentially be grandfathered in. These kinds of provisions are fairly common and give investors a chance to act now and establish grantor trusts before new legislation can be enacted. If you do not already have a trust, now may be a good time to set one up.

Move assets into an already established trust

If you have a grantor trust, you may want to fund that trust with assets now before new rules can be enacted. Investors can use the very high current gift exemption ($12.06 million person in 2022) to move assets and pre-fund both grantor trusts and irrevocable life insurance trusts (ILITs).

It’s also important to note that if the trust is structured properly, grantors have the ability to substitute assets of the same value in and out of a trust without exposing those transactions to taxation. So, if new laws are proposed, the key is to simply get value into a grantor trust before the change takes effect.

For example, rather than waiting for a full appraisal on complex business interests so those assets can be added to a trust, investors can instead move easy-to-value assets (like cash or securities) into a trust and then substitute those assets when the business appraisal is completed. This will buy you some time to get a satisfactory appraisal while still funding your trust before any rule changes take effect.

Loan money to a trust

Individuals can also loan money to a trust to add value. This may be useful if a family has already used up their entire lifetime exemption. Under the proposed legislation, it was unclear if sales of assets would cause partial inclusion, so loans may be a safer, more attractive option.

Terminate the grantor trust status and shift to more tax-efficient assets

Taking this action would change a grantor trust into a non-grantor trust, which would then pay its own taxes using the funds contained within that trust. However, it’s important to note that tax rates for trusts are much more condensed than personal income tax rates. That means that a trust moves into the top marginal tax bracket of 37% after generating just $12,950 in income, whereas a married couple only hits the top rate after making $523,600, according to 2021 marginal tax rates. Because of this, investors should closely manage the types of assets the trust owns and its income tax exposure. Shifting to more tax-efficient assets with limited tax exposure — like cash value life insurance or private placement life insurance (PPLI) — can help protect the value of your portfolio by utilizing the trust as a shelter for transfer taxes, and life insurance as a shelter for income taxes.

Consider other financial vehicles and legal structures

If grantor trusts aren’t going to be a feasible way to transfer assets out of your estate, consider looking at other options that can provide some of the same tax benefits. For example, limited liability companies (LLCs) and family limited partnerships (FLPs) offer a way to transfer assets to family members while still providing liability protection and direction on how those assets are dispersed without using the grantor trust structure. An experienced financial advisor can help you explore available options and find ways to achieve financial goals that extend beyond your lifetime.

Estate planning that protects and preserves generational wealth

Grantor trusts can aid estate planning by allowing individuals to remove assets from their taxable estate. But many affluent families also use grantor trusts as an effective income tax planning tool. So, it will be important for families to continue monitoring developments in the legislature and consult with financial professionals about alternative solutions. With a well-designed estate planning strategy and active wealth management, you can utilize these available financial vehicles to maximize the value of your estate for future generations.

Want to learn more about tax-efficient estate planning designed to preserve generational wealth? Contact Granite Harbor Advisors to schedule a conversation with our team about your financial goals and how we can help you achieve them.

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