2017 Year-end tax letter | What to do once estate planning is complete

Authored by Randi Schuster

Individuals breathe a sigh of relief once the wills and trusts are executed and all the accounts have been funded. They often feel that now they can put the documents in a drawer and stop paying attention to the details of the estate plan. They could not be more wrong. The creation of the estate plan is only the first step; compliance with that plan may help it to survive a challenge on audit. Below are some of the perils and pitfalls of two of the more common estate planning techniques.

Grantor retained annuity trusts

A grantor retained annuity trust (GRAT) allows the transfer of property to beneficiaries at little or no gift tax cost. The grantor transfers the property and retains the right to receive an annuity from that property for a set period of time which is expected to end before death — usually it is a short period such as two to five years. If the property appreciates above a statutory interest rate, the appreciation will pass to the ultimate beneficiaries. The original value of the property will be returned to the grantor in the form of the annuity.

Operation of the GRAT

  1. File a gift tax return. A transfer to a GRAT is a gift, and, even though there may not be any actual gift tax, it should be reported to reflect the transfer and start the statute of limitations for the examination of the gift.
    1. Consider electing out of any automatic allocation of generation-skipping transfer (GST) tax for all present and future transfers to the GRAT.
  2. Pay the annuity. The annuity must be paid annually. It can either be paid via cash earned in the trust, or, if there is no liquidity, it can be paid by returning fractional interests in the property originally given to the trust.
    1. Failure to pay the annuity properly can jeopardize the treatment of the transfer as one to a GRAT and cause the grantor to pay much higher gift taxes.
    2. If the annuity payments are made via fractional interests in the property, annual valuations are strongly suggested to establish the proper value.
  3. Reflect the transferred property as belonging to the GRAT.
    1. Transfer the ownership of closely held stock or partnership interests from the grantor’s name to that of the GRAT.
    2. Make sure tax returns of the transferred entities reflect the transfers. The GRAT may be a grantor trust for income tax purposes, but it is still a separate entity and the tax returns should reflect that. If the entity issues K-1s, there may be one for the GRAT and one for the grantor.
  4. Consider filing a fiduciary income tax return for the GRAT. During the annuity period, the GRAT is a grantor trust to the grantor and, therefore, the grantor is responsible for all the income. In order to have additional support that the transfer took place, the GRAT can obtain its own employer identification number and file a fiduciary income tax return reporting the income to the grantor.

Qualified personal residence trusts

A qualified personal residence trust (QPRT) is a technique that allows homeowners to transfer their residence to a trust for the benefit of their children at a reduced cost.

Operation of the QPRT

  1.  File a gift tax return. As with the GRAT, even though the gift tax is reduced, it is still a gift and, to make sure it is properly accounted for, the taxpayer should file a gift tax return reporting this transfer.
    1. Consider electing out of any automatic allocation of GST tax for all present and future transfers to the QPRT.
  2. Change the title of the property. The clearest way to demonstrate that the property was given away is to change the title to the QPRT.
  3. Termination of the QPRT. Assuming the grantor survives the QPRT term, at the end, the grantor is no longer entitled to live rent free in that residence.
    1. Fair market value rent needs to be established and paid by the grantor to the new owners of the residence which can be determined from the trust agreement.
      1. If the trust continues to be treated as a grantor trust for income tax purposes, there are no income tax consequences on the payment of rent.
      2. If the residence is either not held in a grantor trust or is held by the beneficiaries individually, the property should now be treated as a rental. There should be depreciation and expenses and a reporting of the rental income.

The above discussion highlights some of the more common mistakes that are made in the operation of GRATs and QPRTs and is not meant to be a comprehensive guide. Taxpayers should always consult with their advisors before, during and after the estate plan is set in place.

For more on individual tax planning, please see our article “With tax reform on the horizon is it time to make a Roth conversion?

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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.