For years, countless business owners reduced estate taxes for their heirs through well-knownestate-freeze strategies. By making lifetime gifts in trust to his children, a business ownereffectively removed from his estate any future appreciation in his business interest, while continuingto enjoy control and income from the business. Other valuable assets, such as a home, also figured inthe overall tax planning needed to preserve the family's most important asset the family business.
Recent Federal Tax Code changes attached conditions to most estate-freezing techniques, making thesestrategies much less attractive. But a few freezing techniques survived and still produce substantialtax savings. One often overlooked technique is the "residential GRIT" (Grantor Retained InterestTrust), which enables an owner to gift his home and freeze its value for tax purposes while retainingthe right to live in it for a specified number of years.
To establish a residential GRIT, a taxpayer (grantor) transfers title to an irrevocable trust and paysgift tax based on the home's value at the time; the length of time the grantor plans to continueliving in the home; the grantor's age at the time of the trust's formation; the property value'sprojected appreciation (figured from sales of comparable real estate in recent years), and a rateissued monthly by the Treasury, which is used with IRS tables in valuing the interest retained orgifted by the grantor (it was 8.2 percent for July, 1992).
If the grantor survives the term of the trust, his savings on estate taxes can be tremendous.Consider, for example, a woman named Vera who owns a $2 million residence that has appreciatedannually at about 5 percent. Vera wants to transfer the home to her children, but also wants tocontinue to live there until her death. She is 72 years old and, according to standard actuarialtables, has a life expectancy of 85 years, or another 13 years.
If Vera creates a residential GRIT with a term of 10 years, she makes a gift worth $528,425 (when allof the above-mentioned factors are considered). Assuming a gift tax rate of 38 percent, she will pay$200,802 in taxes, and in the 10th and final year of the trust, title to the home will pass to herchildren.
If Vera lives another 13 years, at her death the home will have an appreciated value of $3,771,298.Her heirs will owe no estate tax on the home (because the property no longer belonged to her), andVera will have successfully transferred the house to her children for $200,802 in gift tax. If she hadnot used a GRIT, the estate tax on the home would have come to $1,100,000. But since she did use aGRIT, even if Vera had already claimed her $600,000 unified credit (the combined exemption allowedfrom gift and estate taxes), she would have saved her heirs a total of $899,198.
In the chart below, note that the taxable value of a gift increases with the age of the grantorbut decreases with the length of the trust. The longer the trust term, the greater the tax savings.For example, using the $100,000 increments shown in the chart, a 65-year-old grantor who conveys a $1million residence to his children in a 10-year trust will have a taxable gift of $334,950. But if heincreases the term to 15 years, he will pay tax on a gift of only $171,700. He cuts his tax in half byincreasing his risk to include another 5 years. If a 75-year-old grantor with the same home stretcheshis GRIT term from 10 to 15 years, he reduces his gift tax by two-thirds.
In addition to freezing an asset's value for substantial tax savings, a residential GRIT allows agrantor to "leverage" his unified credit. For instance, if Vera in the example above has notpreviously used more than $71,575 of her $600,000 unified credit, she would owe no gift tax at theGRIT's execution; there would also be no estate tax on the home at her death. (Incidentally, becauseof proposed legislation, it may make even more sense now to use one's unified credit sooner ratherthan later: Some Congressmen have supported financing a national health insurance plan by reducing theunified credit amount from $600,000 to $200,000.)
Let's then assume that Vera also has a $2 million cosmetics business that she wants to pass on to herson and daughter. If the business appreciates at just 5 percent, the business's projected taxablevalue at her death would be $3,771,298, which results in a marginal federal estate tax rate of 55percent. These taxes could easily jeopardize the business's future.
But because Vera saved nearly $900,000 using a GRIT, her heirs will have more funds with which tocover estate taxes on the business, and a liquidation is therefore less likely. Also, the businesswill be taxed at a lower rate because Vera's home was not in her estate and so did not push up themarginal estate tax rate.
What are the risks of using a residential GRIT? If the grantor does not survive the trust period, thenthe home's entire value is included in his estate. However, the grantor can counterbalance the risk ofdying before the term's end while maximizing the benefits of the GRIT by purchasing life insurance.The policy on the grantor's life for the trust period protects his estate by providing funds for anyunexpected estate taxes from the residence.
Finally, a grantor not only designates how long he plans to continue in the home, he also chooses thetrust's length. The GRIT can terminate when his retained term (say, 10 years) ends, and the house thengoes outright to the beneficiaries. Or the house can continue in trust for the beneficiaries evenafter the grantor's retained interest has ended. Under either arrangement, the grantor's legal rightto remain in the home ends when his retained term interest is over.
But what if the grantor outlives his retained term? To re-establish his legal right to possession, hecan buy back the home from the beneficiaries (who avoid capital gains if the home remained in trustfor them). Or, if the home continues in trust, he can rent from the trust, thereby transferringadditional wealth to his children without paying more in gift tax.
Residential GRITs offer an opportunity that should not be overlooked by family business owners whowant to prevent taxes from forcing their heirs to sell the business. The risks of using a residentialGRIT to best advantage are minor and can be eliminated by insuring the trust's term.
Reduced transfer costs from using a residential GRIT
|(Taxable amounts for each $100,000 in value of residence)|
|GRIT duration in years|