Estate planning strategies vary as new rules change the playing field. Now that fewer taxpayers are likely to be subject to federal gift and estate tax, many families are focusing more on income tax strategies in their estate plans.
Grantor vs. nongrantor
A nongrantor trust is simply a trust that’s a separate taxable entity. The trust owners the assets it holds and is responsible for taxes on any income those assets generate. A grantor trust, in contrast, is one in which the grantor retains certain powers and, therefore, is treated as the owner for income tax purposes.
Both grantor and nongrantor trusts can be structured so that contributions are considered “completed gifts” for transfer tax purposes (thereby removing contributed assets form the grantor’s taxable estate). But, traditionally, grantor trusts have been the estate planning tool of choice. Why? The trust’s income is taxed to the grantor, reducing the size of the grantor’s taxable estate and allowing the trust assets to grow tax-free, leaving more wealth for beneficiaries. Essentially, the grantor’s tax payments serve as an additional tax-free gift.
But with less emphasis today on gift and estate tax savings, nongrantor trusts offer some significant benefits.
Reducing income taxes
The TCJA put new limits on itemized deductions, but nongrantor trusts may offer a way to avoid those limitations. The tax law nearly doubled the standard deduction to $12,000 for individuals and $24,000 for married couples (both annually indexed for inflation) and limited deductions for state and local taxes (SALT) to $10,000 (not indexed). These changes have reduced or eliminated the benefits of itemized deductions for many taxpayers, especially those in high-SALT states.
By placing assets in nongrantor trusts, you may be able to increase your deductions because each trust enjoys its own $10,000 SALT deduction limit.
For example, Andy and Kate, a married couple filing jointly, pay well over $10,000 per year in state income taxes. They also own two homes, each of which generates $20,000 per year in property taxes. Under the TCJA, the couple’s SALT deduction is limited to $10,000, which covers a portion of their state income taxes, but they receive no tax benefit for the $40,000 they pay in property taxes.
To avoid this limitation, they transfer the two homes to a limited liability company (LLC), together with assets that earn approximately $40,000 per year in income. Next, they give 25% LLC interests to four nongrantor trusts. Each trust earns around $10,000 per year, which is offset by its $10,000 property tax deduction. Essentially, this strategy allows the couple to deduct their entire $40,000 property tax bill.
Consider the fine points
If you’re contemplating using this strategy, be aware that the tax code contains a provision that treats multiple trusts with substantially the same grantors and beneficiaries as a single trust if their purpose is tax avoidance. Many experts believe that this provision is ineffective because the IRS has never issued implementing regulations.
As with any tax reduction method, fine points are key. It’s important to understand the best ways to ensure you gain, rather than lose, the tax benefits you seek. For instance, you may want to have separate beneficiaries for your nongrantor trusts. To ensure you understand all the ins and outs of this strategy, get professional tax advice.
Sarah Krick, CPA
With over a decade of experience, Sarah works closely with clients to understand their goals. Combined with her expertise in trust and non-profit tax preparation, Sarah not only helps small businesses and individual clients stay compliant; she also assists organizations to highlight internal controls and processes through SOC engagements. Sarah’s expertise extends into financial statement audits and attestation engagements.