First let's define a grantor trust. This is a trust that is taxed to the grantor (settlor, trustor) who is the person that established the trust. Thus, for example, if you set up a trust that is taxed as a grantor trust, and it earned $5,000 of income, you would report that $5,000 of income on your personal income tax return and pay any tax due. The trust would not pay income tax on the $5,000. The trust in this transaction is commonly referred to as an "intentionally" defective grantor trust, because you intentionally plan and structure the trust to be characterized for income tax purposes as a grantor trust. A sale to an intentionally defective grantor trust is an estate, asset protection and family planning transaction in which you sell an asset (perhaps an interest in a family business or FLP or family LLC) to a trust. Because the trust is structured to be a grantor trust for income tax purposes there is no income tax triggered on the sale. It's as if it is a sale to yourself for income tax purposes. For estate tax purposes, however, the trust is deemed to be a completed gift and planned so as not to be included in your taxable estate. The use of this technique can be compared to the use of a grantor retained annuity trust (GRAT). See separate definition for a GRAT. A sale to a defective grantor trust transaction may use a lower interest rate then a GRAT and permit allocation of GST exemption. A GRAT, on other hand, may offer more certainty when transferring an asset with uncertain value. In some situations both techniques may be used.
Subscribe to our email list to receive information on consumer webcasts and blogs, for practical legal information in simple English, delivered to your inbox. For more professional driven information, please visit Shenkman Law to subscribe.