Using a gifting trust is one of the most advantageous ways to protect assets for your family and preserve estate and gift tax exemptions — which may significantly decrease at the end of 2025 as part of the Tax Cuts and Jobs Act expiration, absent enactment of pending legislation that would increase the exemption amount in 2026. When considering gifting, or when your gift tax exemption has been exhausted, there are other strategies available to pass additional wealth to your heirs. These include the use of inter-family promissory notes, Grantor Retained Annuity Trusts (GRATs) and the use of swap powers that may exist under existing gift trusts.
One of the simpler methods to transfer wealth to future generations is through an “estate freeze” technique. The idea here is to convert appreciating assets inside an individual’s estate into a fixed-yield, non-appreciating asset. Below highlights a couple ways to approach this.
Loaning money is one of the easiest ways to transfer wealth out of your estate. It could be as simple as lending cash to a child or grandchild at a low interest rate so they can buy a home or other appreciating assets. The IRS specifies a minimum interest rate on inter-family loans, which is updated each month for several note terms. (Currently ranging from 4.00% - 4.77%).
Lending money to a child or grandchild was especially advantageous in recent years when interest rates were much lower. For example, the June 2020 IRS minimum interest rate for a loan of 30 years would have been at roughly a 1% interest rate. Making a 30-year loan to a grandchild at that interest rate was a great way to transfer some wealth over time without making a reportable “gift.”
Increasing the complexity, another option is to sell an appreciating asset, such as an interest in a family business, to a family member through an “installment sale.” With this strategy, the business owner would sell some portion of their company shares to an heir in exchange for an amortizing installment note to be repaid over a fixed term, 10 years for example. Each year after the sale, the buyer would make payments of principal and interest on the note using the cash flow from the business operations to fund the payments. The seller collects the note payments and pays income tax each year under the special “installment sale” tax rules, where capital gain from the sale of the shares is paid over time as the note principal is collected, rather than paying the tax all up front in the year of sale.
This approach can serve several purposes. An installment sale can:
Learn how to take an installment sale a step further for favorable capital gain tax treatment on the sale of shares in “Trust & Taxes 101: Intentionally Defective Grantor Trusts”
A “GRAT” is another estate freeze technique that has been very popular in the last 20 years for those with taxable estates. Essentially, you transfer assets to a trust for a fixed period of time, and the trust is required to repay an annuity back to you each year shortly after the anniversary date of setting up the trust.
Depending on the size of the annuity payment, a portion of the transfer is considered a gift, and a portion is effectively treated as return of principal. The term of the trust can vary, although two-year terms are the most common. The IRS rules for GRATs also specify a fixed annual rate of return back to the grantor based on a special interest rate the IRS updates monthly, known as the Section 7520 rate. Any return earned in excess of the IRS rate remains in the trust after the required annuity is repaid and can pass to the beneficiaries under the terms of the trust.
What we most often see put in place are two-year term GRATs where the value of the annuity the grantor receives back from the trust is equal to 100% of the assets placed in the trust at the start. These are known as “zero gift GRATs,” because there is little to no reportable taxable gift made as part of the set up and funding — often resulting in a $1 taxable gift reported on the gift tax return.
GRATs are best illustrated through an example, assuming:
Under these assumptions, the grantor will receive back $537,808 at the end of Year 1. They will receive another $537,808 at the end of Year 2 under the IRS present value calculation.
Now let’s assume the assets appreciated 10% in Year 1 and were flat in Year 2:
That $24,384 could then be distributed to heirs after the end of Year 2 with no gift tax consequences. While this amount may seem like a small win, if you had 20% growth consecutively over two years and put more than $1 million in assets into the trust, it could result in sizeable transfers to the beneficiaries.
On the flip side, you can also have situations where a negative return occurs on trust assets. If that happens, the grantor simply receives 100% of the trust assets back and the GRAT is a failed strategy. You are out of pocket the cost of setting up the legal documents and administering the GRAT for two years, but it’s a limited downside.
Overall, GRATs are:
Many individuals with a taxable estate have set up “intentionally defective grantor trusts” (IDGTs) as part of their estate plan. They’ve gifted and/or sold assets to these trusts to use the lifetime gift exemption and, therefore, removed future appreciation from their taxable estate. One advantage of an IDGT is that the income of the trust is taxed to the grantor, which allows trust assets to grow income tax free.
One of the common provisions that make a trust “defective” is the inclusion of a “swap power.” A swap power generally allows the grantor of the trust to transfer personally owned assets to the trust in exchange for trust assets of equivalent value as of the date of the swap. This swap could encompass assets for assets, or cash for assets. For income tax purposes, the swap transaction is ignored since the trust assets and personal assets are all deemed to be held by the grantor for income tax purposes. As such, this provides an opportunity for the grantor to move assets into and out of the trust for a better income tax result.
When exercising swap powers, one of the characteristics the trustee must evaluate and ensure is that the assets being swapped are of equivalent value. The transaction may not leave beneficiaries of the trust in a better or worse economic position. Trading ABC publicly traded securities for XYZ publicly traded securities of equal value held in a trust containing these provisions would be an appropriate swap transaction, since publicly traded securities have a readily ascertainable fair market value.
The timing of a swap of trust assets can be important for estate planning purposes. For instance, a grantor or their spouse might be diagnosed with a terminal illness. This taxpayer may find it beneficial to exercise a swap power to reacquire an asset for which they hope to receive a step-up in basis. This might be as simple as having a grantor swap high-basis assets or cash into the trust in exchange for low-basis assets that would receive a large step up.
In addition to tax basis planning, contributing rapidly appreciating assets to a trust is an appropriate estate planning technique to remove future appreciation from a taxable estate. If the assets in the IDGT are not appreciating as or have “run their course” and are now expected to level off or even decline in value going forward, it may be wise to swap higher growth assets into the trust for the lower growth assets.
GRATs are set up as defective trusts, and swaps can also be effective in certain situations. One case would be where the assets funded into the GRAT have gone down in value significantly, and the GRAT is doomed to failure. Swapping cash or other assets into the GRAT would allow you to take the current GRAT assets back, drop them into a new GRAT at the current low value, and hope they come back dramatically during the term of the new GRAT.
A second approach in this scenario would be when GRAT assets have gone up tremendously in value, and you aren’t sure that win is going to hold. You could swap cash or other stable assets like bonds for the GRAT assets at the high valuation level, locking in a win for the GRAT through the end of its term. Again, you could put the growth assets back into a new GRAT, but sometimes locking in a win early on in the GRAT is a beneficial strategy.
Clearly, a swap power provision can add flexibility to the grantor’s estate tax planning when this power is available.
Whether you are considering promissory notes, GRATs or the exercise of swap powers, each in their own way can assist you in passing additional assets to your heirs. Working with your tax advisers and legal counsel will help you evaluate the best opportunities available.
Contact Scott Swain, Matt Rager or a member of your service team to discuss this topic further.
In this blog Cohen & Co is not rendering legal, accounting, investment, tax or other professional advice. Rather, the information contained in this blog is for general informational purposes only. Any decisions or actions based on the general information contained in this blog should be made or taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.