Estate PlanninG

Maximizing Wealth Sharing: Tax-Efficient Trust Strategies for High Net Worth Individuals

A benefit of working hard is sharing the fruits of your labor with your loved ones. However, gift or estate tax consequences may impact high net worth clients when they share their wealth. By crafting a comprehensive estate plan, we can address these concerns and protect high net worth clients and their loved ones. The following three types of trusts may assist high net worth clients in sharing their wealth in a tax-advantageous way.

Grantor Retained Annuity Trust

A grantor retained annuity trust (GRAT) is an irrevocable trust you can use to make large financial gifts to your loved ones while also minimizing gift tax liability. These financial gifts remove future appreciation from your estate, reducing the amount that will be subject to estate tax at your death. However, there may be gift tax liability, which would be owed and paid at the trust’s creation. You create a GRAT and then fund it with accounts and property, such as those that are expected to appreciate in value over the GRAT’s term. Then, you receive a fixed annuity payment, based on the trust’s original value, for a specified time period. Once the period has terminated, the remainder of the trust’s accounts and property are transferred to your named beneficiary.

The rate of return that you receive is based on the specific rate determined by the Internal Revenue Service, known as the Internal Revenue Code (I.R.C.) § 7520 rate. The key to saving taxes and having money available to be transferred to the beneficiary is for the trust’s accounts and property to outperform this rate. To limit or eliminate the gift tax that would be due when making a gift to someone, the value you retain (the amount that is ultimately distributed back to you) is subtracted from the value of what was transferred to the trust. This is also known as the subtraction method. Ultimately, the goal is for this number to be zero (known as a zeroed out GRAT) or as close to zero as possible. This means that any appreciation is transferred to your beneficiary at the trust’s termination gift-tax free. 

Let’s look at what a possible outcome could be when using a GRAT. In this situation, let’s say you make a $1 million gift to a GRAT, the current I.R.C. § 7520 rate is 4.2 percent, and the annuity will be paid over five years. If the trust only makes 4.2 percent, then the client will be in roughly the same position as it was when it was created because everything will be returned to the client. If the trust makes 7.5 percent, then there will be approximately $123,562 remaining that will be transferred to the beneficiaries with no gift tax (assuming a zeroed out GRAT). If the trust does even better and makes 10 percent over the course of five years, then the beneficiaries will receive $231,419.

Grantor Retained Unitrust

A grantor retained unitrust (GRUT) is an irrevocable trust that is like a GRAT. Accounts and property are transferred to the trust and you retain a right to receive an annuity for a fixed time period. Then, at the trust’s termination, the trust’s remaining accounts and property are given to your named beneficiary. However, with a GRUT, the annuity payment that you receive each year is calculated based upon a fixed percentage of the trust’s value that year. Therefore, since the trust’s value can vary from year to year, the annuity amount can vary even though the same percentage is used each year to calculate the annuity.

Like a GRAT, the gift tax is due at the time the accounts and property are transferred to the trust, and the gift tax liability is based on using the subtraction method. Because the annuity is based on the trust value that year, it is unlikely that the difference between what you give and retain will be zero, which will require that some gift tax be paid. 

Qualified Personal Residence Trust

A qualified personal residence trust (QPRT) is an irrevocable trust that you can use to remove your residence from your overall estate. Ownership of the residence is transferred to the trust, and you retain the right to use and enjoy the property for a specified time period. Then, once that time terminates, the residence is transferred to your named beneficiary. If you would like to continue living in or using the residence, you will have to pay the beneficiary rent. You may need to consider your relationship with the beneficiary when evaluating whether this tool would serve your needs.

Although this transfer reduces the amount subject to estate tax at your death, gift tax will still be owed when the property is transferred to the QPRT. The value of what is transferred to the trust (the amount subject to gift tax) is the residence’s value less the value of what you keep (because you have the right to continue using it). This estate planning tool’s effectiveness depends on the federal interest rate when the trust is created. The higher the interest rate, the lower the gift value and the lower the potential gift tax liability. 

You can establish a QPRT for no more than two residences. It can be funded using a principal residence or a vacation home or secondary residence, or a fractional interest in these types of residences. It is also important to note that if the residence currently has a mortgage, it may be advisable to pay off the mortgage before transferring ownership to the QPRT to avoid complications in administering the trust.

The important thing to note with all three types of trusts is that you must survive the trust term. When trying to determine the length of the trust, it is important to consider your current age and life expectancy. If you die before the trust terminates, the tax benefits will be undone and the full value of the account or property will be counted towards your estate tax liability.

Because each transaction is subject to taxation, it is important that you evaluate the gift tax, estate tax, and nontax considerations before making a decision. We are available to meet with you, discuss your unique situation, and craft a plan that leaves your hard-earned wealth to those you care about as you wish. To learn more, call Santaella Legal Group, serving all of California, at (925) 831-4840, or reach out to us here.