Defective trust can be used to generated tax alpha for a private investor. Can someone explain why is the case? PS: In study session#4, there is a whole bunch of material covering the effectiveness of various account options (e.g. GRAT, charitable trust etc etc…). This seems to require an awful lot of memorizing. Does anyone know how much of this is really required for the exam… I would rather save my memorizing capacity for something that is valuable! thanks, BN
i think def. trust generates tax alpha for the beneficiaries becuase the grantor will be the one paying the taxes and not the beneficiiaries… I would saying knowing GRAT, def. trust, etc…is necessary. does this sound right?
yes you’re right! From what I was able to interpret…Defective trust is set up by the donor (lets say a father for his daughter) and the plan assets are invested. The asset captures investment income and capital gains. Under normal circumstances (imagine the same father had opened an e-trade) the account should pay taxes and thus the account value will decrease by the tax amount. However, in the case of a defective trust, the father can pay taxes outside of the trust thus allowing the trust assets to grow tax free… But, 3rd & Long is also right in reco GRAT and Def. trust at least. It is a lot of material, I’m finding this tougher than L2…so much memorization!
Here is my take on these: GRAT (defective trust): grantor receives annuity, beneficiaries get what’s left in the trust at maturity. - short maturity - discounts if the donated assets are part of LLC, partnership, etc. - Tax Alpha - Used to transfer assets below Fair Market Value CLT: Annuity goes to charity, remainder goes to beneficiaries CRT: Annuity goes to Grantor, remainder goes to charity - use distribution to charities to offset gains on investments - No access to funds by grantor - use to save taxes on low basis stock - used for tax deduction on charitable donations - May be defective GST : - Complete per estate taxes, by may be defective per income taxes - When defective can generate tax alpha - grantor pays taxes
There is a good example in the Loss Harvesting section that explains tax alpha… I don’t have it in front of me.
I added a little more for charitable trusts: CLT: Annuity goes to charity, remainder goes to beneficiaries - TAX DEDUCTION ON CHARITABLE DONATIONS (FOR TRUST) CRT: Annuity goes to Grantor OR BENEFICIARIES, remainder goes to charity - use distribution to charities to offset gains on investments (THIS IS ABOUT CLT) - No access to funds by grantor - use to save taxes on low basis stock - used for tax deduction on charitable donations (FOR GRANTOR) - May be defective (HOW DO YOU KNOW IT ?)
By the way did you get it why Defective Grantor Trust is not included in the list of 7/8 wealth planning alternatives but rather was included in intergenerational transfer strategies ?
peter19 Wrote: ------------------------------------------------------- > By the way did you get it why Defective Grantor > Trust is not included in the list of 7/8 wealth > planning alternatives but rather was included in > intergenerational transfer strategies ? This is by far the worst reading for me, but I’ll add my “understanding” Defective Trust are not efficient from the point of view of the trust itself since the trust pays taxes like an individual ( no tax benefits for trust), that’s probably why it’s not in the wealth planning alternatives (if grantor dies during trust is in effect, trust will pay gift taxes and all other taxes an individual would have to pay) They are however tax-efficient from the point of view of the grantor as he can select to pay the taxes for the trust and use those payments to off-set other income. The grantor can also guarantee loans for the trust (tax free gift) and increase the trust value by paying the taxes.
Grantor Retained Annuity Trust (GRAT) can be very tax efficient if structured properly, it all comes down to using a discount rate assumption, which is mandated by IRS and can be used in your favor (especially in times when fed funds rate is low). When GRAT is created: Gift to beneficiaries = Initial value of GRAT - PV of annuity payments to the grantor And this is where the tax efficiency comes in, to get PV of annuity payment to the grantor, you need to use a discount factor, IRS tells you to use Section 7520 rate (120% times fed funds rate), I think its 3.2% now. When you are setting up your GRAT, you can choose a grantor annuity payment in such a way that when discounted at 3.2% over the life of the GRAT it equals to how much money you put in in the GRAT, so gift value is $0 (or make it such that the difference is $1,000). What that means, you don’t pay any gift tax or pay tax on $1,000 (if the difference is $1,000). Now time goes by, the assets in the trust are growing, and lets say your average return is more than 3.2%, that means that after grantor gets all of his annuity payments, there will still be money left in the GRAT. And the whole beauty of it that it all goes to beneficiaries tax free (in a sense no estate tax will need to be paid on that amount; capital gains will have to be paid when assets are sold, but that is not the point here). So when you create a GRAT structured in such a way, you want invest in higher risk assets (private equity, hedge funds, smal-cap, etc.), hoping that at the end you beat 3.2% or whatever the rate IRS mandates at the time. If you are able to beat that benchmark, you effectivelly made your bequest and avoided estate taxes, and that amount can be very substantial. Worst case scenario, if your investment tanks, you won’t be any worse off, since no gift tax was paid at the outset. The only problems in GRATs is if the grantor dies while the GRAT is still is in affect, then this will negate the whole strategy, since all assets in the trust will become part of grantor estate, and be subject to estate tax. Here is an ilustration. You set up a 8-year, $10M GRAT today. To make it zero-cost GRAT, you set your annuity payment at $1,436,608 (PV of $10M for 8 years at 3.2%). In this case value of the gift to beneficiaries is $0 and no gift tax is paid. Now, if your average return is 5%, the value of remaining assets in GRAT after 8 years is $1.1M, if return is 10% then remaining value is $5M, if return is 15% than then remaining value is $10.9M (which is more than you put in GRAT in the first place). And all of that goes to beneficiaries estate tax free.
I think you mixed up here the terms Defective Grantor Trust and Grantor Retained Annuity Trust (which is for sure one of types of defective trusts). On my opinion, we could refer Defective Grantor Trusts to wealth planning strategies. It’s very similar to GRAT (with exception to annuity payment). And CFA in Exampe on p/244 uses DGT as one of possible strategies along with GRAT, GST, etc.
volkovv Wrote: ------------------------------------------------------- > Grantor Retained Annuity Trust (GRAT) can be very > tax efficient if structured properly, it all comes > down to using a discount rate assumption, which is > mandated by IRS and can be used in your favor > (especially in times when fed funds rate is low). > > When GRAT is created: > > Gift to beneficiaries = Initial value of GRAT - PV > of annuity payments to the grantor > > And this is where the tax efficiency comes in, to > get PV of annuity payment to the grantor, you need > to use a discount factor, IRS tells you to use > Section 7520 rate (120% times fed funds rate), I > think its 3.2% now. When you are setting up your > GRAT, you can choose a grantor annuity payment in > such a way that when discounted at 3.2% over the > life of the GRAT it equals to how much money you > put in in the GRAT, so gift value is $0 (or make > it such that the difference is $1,000). What that > means, you don’t pay any gift tax or pay tax on > $1,000 (if the difference is $1,000). > > Now time goes by, the assets in the trust are > growing, and lets say your average return is more > than 3.2%, that means that after grantor gets all > of his annuity payments, there will still be money > left in the GRAT. And the whole beauty of it that > it all goes to beneficiaries tax free (in a sense > no estate tax will need to be paid on that amount; > capital gains will have to be paid when assets are > sold, but that is not the point here). > > So when you create a GRAT structured in such a > way, you want invest in higher risk assets > (private equity, hedge funds, smal-cap, etc.), > hoping that at the end you beat 3.2% or whatever > the rate IRS mandates at the time. If you are able > to beat that benchmark, you effectivelly made your > bequest and avoided estate taxes, and that amount > can be very substantial. Worst case scenario, if > your investment tanks, you won’t be any worse off, > since no gift tax was paid at the outset. > > The only problems in GRATs is if the grantor dies > while the GRAT is still is in affect, then this > will negate the whole strategy, since all assets > in the trust will become part of grantor estate, > and be subject to estate tax. > > Here is an ilustration. > > You set up a 8-year, $10M GRAT today. To make it > zero-cost GRAT, you set your annuity payment at > $1,436,608 (PV of $10M for 8 years at 3.2%). In > this case value of the gift to beneficiaries is $0 > and no gift tax is paid. Now, if your average > return is 5%, the value of remaining assets in > GRAT after 8 years is $1.1M, if return is 10% then > remaining value is $5M, if return is 15% than then > remaining value is $10.9M (which is more than you > put in GRAT in the first place). And all of that > goes to beneficiaries estate tax free. Thanks man for the great post. Do you work in this area or did I miss a whole lot of pages in the CFAI readings ?
No, I don’t work in this area, just something I learned on my own. CFAI mentioned briefly about Section 7520 rate and how the value of the gift to beneficiaries is calculated, but didn’t go into any details.
Hey Volkovv: Do you know if CLT and/or CRT could be defective?
Yeah, they can be, it all has to do with how the language of the trust agreement is written. However, tax treatment of both CLT and CRT is very convoluted. This link gives a fairly good overview of different trusts http://www.familywealthplanning.com/sTaxSaving.html
With respect to a GRAT, I know there is some detail above on this, but I am having a hard time understanding how you transfer assets below the fair market value? Also, what purpose does this serve? Also, if they are being donated as part of an LLC or partnership what is meant by the valuation discount?
purpose is to minimize gift tax. You as a grantor make gift for trust in the form of partnership or LLC interests. Since the interests are not liquid assets you could apply some valuation discounts on them
here how it works You set up a partnership, and the partnership makes an investment in some illiquid asset (say some private equity investment), you then transfer full or partial interest of the partnership to your GRAT. Before the transfer, you have to access the value of your investment, you can argue that since your investment is illiquid and if you would to sell it right away there is illiquidity cost to pay. The value of that illiquidity cost is essentially a mark below fair market value (at least for the time being). So, if you illiquid investment was $10M, but because of illiquidity it can currently can be valued at $8, the $2M difference is illiquidity discount (a.k.a valuation discount). The purpose of this is to transfer an asset to the GRAT at the lowest value possible, to minimize the value of the tax (gft tax) on that asset. Now if you combine the valuation discount strategy with what I wrote above, and make the GRAT zero-cost at the outset, so no or very minimal gift tax is paid. Then when the trust matures, the value of the GRAT that beat section 7520 rate, plus the whole value of the valuation discount and its share of the gain (if the investment turned out to be profitable) goes to your beneficiaries tax free from gift/inheritance tax standpoint (capital gains tax will still has to be paid, either by trust itself, the grantor, or the beneficiaries once the assets are transfered to them).
Quick question, when there is a gift tax on a GRAT, does the grantor or the trust pay the gift tax? And also, should I view gift taxes and estate taxes as mutually excluysive? In other words, if something is gifted via a trust, then it is no longer part my estate so thus exempt form estate taxes when I kick the bucket. Also, a bit of clarification for CLTs & CRTs. In a CRT, are there are gift of estate taxes? Seems like no because the beneficiary is a charity. However, in a CLT, the benficiary can be your kid so is there is a gift or estate tax? Thanks As you can tell from my question I have unfortunately never received a gift or estate
When GRAT is set-up, the grantor will pay the gift tax if the value of the gift to beneficiaries is above 0. Gift and estate taxes in this context are mutually exclusive. GRATs are usually set up as defective trusts (i.e., they are are defective from income tax standpoint, but not from estate tax standpoint). Once the assests are transferred over and gift tax is paid, the assets are no longer part of your estate and are not subject to estate tax. One exception is when the grantor dies before GRAT matures. In this situation assets in the GRAT will be turned over to the grantor estate and that negates the whole tax efficiency of the trust. You are right about CRT, no gift or estate tax here, since remainder assets go to charity. In CLT, it depends who the beneficiary is. Grantor himself can be a beneficiary, in this case no gift tax is paid. But if the beneficiary is some one else (like children) then gift tax will be paid in the same fashion as with GRAT.
Thanks volkovv…clears things up