Even though the dot-com era is well behind us, there are still plenty of people reaping windfalls from stock IPOs. The Facebook crowd is the most obvious, but after the Alibaba offering last year and the Etsy one coming up later this year, there’s been a renewed attention among estate planners toward dealing with these issues: how to protect and distribute assets that are expected to greatly increase in value.
It’s not just IPOs that carry some of these attributes. There are also shares in family-owned businesses or works of art, assets that might not carry great valuations at the moment but will possibly be worth much more in the future.
There are two primary trust vehicles that planners have been using to protect these assets: grantor retained annuity trusts (GRATs) and dynasty trusts. Here’s how to present them to your clients.
This is the vehicle by which Facebook COO and “Leaned In” author Sheryl Sandberg was reportedly able to pass down $19 million in Facebook stock to her children without incurring gift taxes. GRATs are typically funded with a gift of assets that are expected to appreciate in value, which then freezes the value of the assets for estate and gift tax purposes. This can be closely held stock or equity in a private company, as well as publicly traded stock or even units in a Family Limited Partnership.
A GRAT must last for a specified term of years — not the lifetime of the grantor. The grantor is treated as owner of the trust during its term, and is taxed on the income from the trust as it is earned. Assuming the grantor lives longer than the specified term, when the trust expires, he or she no longer owns the assets in it, so they remain out of his or her estate for taxation purposes.
But for gift tax purposes, the value of the property is determined at the time it is transferred to the trust. Any further appreciation in value passes to the remainder beneficiaries without further gift taxes applied to either the grantor or the recipients.
Make no mistake: The appreciation in the property, such as the pop in all those Facebook shares, is taxable as capital gains to the grantor. But the transfer in ownership can go largely untaxed.
Irrevocable dynasty trust
Dynasty trusts are similar to GRATs in that the grantor can put assets into the trust, and those assets are subject to gift tax at their present value, at the time the trust is established. Any increase in the value of those assets over the years is not subject to further gift or estate tax.
Income taxes are still due on income generated by trust assets, which makes them a great place to park stocks that will appreciate in value but won’t throw off much income. It’s also common to transfer life insurance policies to a dynasty trust.
Dynasty trusts work especially well for appreciated stock. The trust pays the capital gains tax when publicly traded shares are sold, so neither the grantor nor the beneficiaries have to worry about those costs.
The trust is designed to make distributions to children, grandchildren and other future descendants. Because the beneficiaries never gain control over the assets in the trust, that property stays out of a taxable estate.
Which one is more appropriate?
GRATs are designed to have a limited shelf life. The grantor must take an annuity out of them each year for the length of the term.
It is even possible to reach the point of having a zeroed-out GRAT, in which the remainder in the trust is theoretically worth nothing, meaning there is no taxable gift at all. That saves the lifetime gift tax exemption for other asset transfers.
Dynasty trusts, on the other hand, are designed to last for generations. The basic choice comes down to whether the client wants to fund a trust for appreciating assets in the near or longer term. Also, be warned that dynasty trusts may not be available in every state.