Sale to a Grantor Trust (SAGT) Advanced Markets Client Guide An innovative estate planning tool John Hancock Life Insurance Company (U.S.A.) (John Hancock) John Hancock Life Insurance Company of New York (John Hancock)
Estate planners have been using the Irrevocable Life Insurance Trust (ILIT) 1 for many years, to increase wealth and liquidity outside of the taxable estate. However, transfers to ILITs may be subject to gift tax, and trusts typically pay income tax at higher rates than individuals. One of the most effective techniques that estate planners are using is a variation of the ILIT, known as the Sale to a Grantor Trust (SAGT). SAGTs can take advantage of the grantor trust rules to fund an irrevocable trust with life insurance as well as other assets. Funding a SAGT during life can reduce the taxable estate, and in addition the grantor can make ongoing tax-free gifts to the trust through the payment of income tax from individual assets. For people with income producing and appreciating assets, such as a family business or income-producing real estate interests, a SAGT can be an excellent estate-planning tool. What Is a SAGT? A SAGT is an irrevocable grantor trust in which trust income is attributed to the grantor instead of the trust. A SAGT, like an ILIT, keeps assets outside of the taxable estate. However, while the ILIT must pay its own income taxes, the income taxes incurred by a SAGT are paid by the grantor of the trust, minimizing the trust s expenses. As a result, a SAGT combines the income tax benefits of a grantor trust with the estate tax benefits of an irrevocable trust.
Why Use a SAGT? The unique tax structure of a SAGT makes it a great estate-planning tool to transfer assets to the grantor s heirs. Since the grantor will be paying the income tax on the trust income, the trust income will not be depleted by taxes and can be used to fund the life insurance coverage that the grantor needs. By paying the income tax for the trust, the grantor is effectively making additional gifts to the trust without having to use his/her gift tax exemptions. In addition, selling an asset to the trust can be a great way to take advantage of the income tax benefits of a SAGT. 2 How Does a SAGT Work? The grantor will typically make gifts of cash or income-producing assets to the trust, such as stock or interest in a family limited partnership (FLP). After the initial gift, the grantor may also sell additional assets to the trust, in exchange for an interest-bearing promissory note (typically an installment note with a balloon payment). The trustee can use the income earned by the trust assets to pay the life insurance premiums on a policy for the grantor. The grantor(s) of the trust will pay the trust income taxes at their individual income tax rate. With the passage of the 2010 tax Act, combining the use of higher amount exempt from gift taxes available during lifetime (also referred to as the lifetime gift tax exemption) with a SAGT can be a powerful way to transfer substantial assets to the next generation during lifetime without incurring gift taxes. In 2011 and 2012, the lifetime gift tax exemption is $5M per person. In 2013, the amount drops to $1M per person. 3 STEPS TO FUNDING A SAGT Step 1: Create the SAGT: The grantor creates a SAGT to keep trust assets outside the taxable estate. The trust is drafted so that the grantor is considered the trust owner for income tax purposes, but not for gift and estate tax purposes. Step 2: Gift Assets to the Trust: The grantor will make a gift of cash and/or assets to the SAGT. This is usually done using annual exclusion gifts ($13,000 per person in 2011) and any gift exemption amounts (currently $5,000,000 per person, dropping to $1,000,000 beginning in 2013 per person) to avoid gift taxes. This is also known as seed money and generally represents at least 10% of the value of assets that will be sold to the SAGT. If the grantor wants to have a multi-generational trust that is exempt from generation-skipping transfer tax (GSTT), he/she can allocate GSTT exemption to the initial gift (GSTT exemption does not need to be allocated to assets that are purchased by the trust). Step 3: Sale to the Trust: After the gift, the grantor may enter into a sale agreement with the trust. In this arrangement, the grantor will sell to the trust income-producing assets such as limited partnership interests or S-Corporation stock. An appraiser may apply valuation discounts to the assets, particularly if the assets are closely held or if they are inside a partnership or a limited liability company (discounts can be applied for assets used in the sale and the gift). The promissory note for the sale is usually structured as a term of years and interest on the note should be at or above the applicable federal rate (AFR), which is published monthly by the IRS. 2
Step 4: Trust Earns Income: Assets transferred to the SAGT will earn income each year, which will accumulate inside the trust and can be used to pay the insurance premiums and the loan. The grantor will pay the tax due on the growth each year at his or her individual income tax rate. However, any interest income paid to the grantor by the trust will not be taxable since the IRS has ruled that the grantor and the trust are considered to be the same person for income tax purposes. 3 Essentially, the payment of income tax allows the grantor to make additional gifts to the trust without actually using his/her gift tax exemption. Step 5: Transfer to the Heirs: At the grantor s death, the trust assets can pass to the grantor s heirs free of estate, gift and generation-skipping transfer taxes. The life insurance death benefit should also be free of income tax. Favorable Tax Rulings on Grantor Trusts 1. Income Tax Neutral Transactions The IRS has ruled in Revenue Ruling 85-13 that transactions between the grantor and the grantor trust are income tax neutral for both parties. This means that there is no capital gain recognized by the grantor on the sale of assets to the trust and that the loan interest paid to the grantor by the trust does not have to be recognized as income. However, the trust will not be able to deduct the loan interest that it pays to the grantor. 2. Favorable Grantor Trust Ruling The IRS has ruled in Revenue Ruling 2004-64 that payment of income tax by the grantor is not an additional gift to the trust. If there is sufficient cash in the trust, the trust may reimburse the grantor for the income tax paid, but should not be required to reimburse the grantor. Sale of Asset In Exchange for Note (A Gift of a portion of asset can also be made) Return on asset funds premium & interest payments Grantor Trust Income Taxes Interest Payments/Balloon Payment Premiums Grantor Trust Death Benefit John Hancock 3
Summary A Sale to a Grantor Trust is a sophisticated planning technique that may allow you to achieve significant tax benefits while funding an irrevocable trust during lifetime. This type of trust can be particularly useful when you are looking to transfer large amounts of limited partnership interests, S-Corporation stock, or other income-producing assets without incurring gift tax. You may also want to consider a SAGT if you have already used your lifetime gift tax exemption amount. Essentially, a SAGT allows you to transfer assets outside your taxable estate at a discounted value and then use the trust income to fund a needed life insurance policy. 4
1. Trusts should be drafted by an attorney familiar with such matters in order to take into account income and estate tax laws (including the generation-skipping transfer tax). Failure to do so could result in adverse tax treatment of trust proceeds. 2. In 2011, trusts pay income taxes at the highest income tax rate (35%) after $11,350 of income. Individual income tax payers generally do not reach the 35% income tax bracket until their income is over $379,150 (for married taxpayers filing jointly or single taxpayers). 3. Under the current law, which is based on the Unemployment Insurance Reauthorization and Job Creation Act of 2010 (2010 Tax Act)," the maximum estate tax rate is 35% with a $5,000,000 exemption for each individual. For 2012, this $5,000,000 will be indexed for inflation, taking into account inflation that occurred from January 1, 2010 through December 31, 2011. The $5,000,000 exemption amount can be used either during lifetime, as a gift tax exemption amount, or at death as an estate tax exemption. In addition, each individual has a $5,000,000 exemption to the generation-skipping transfer (GST) tax; this $5,000,000 can be used during life or at death. If an individual passes away with an unused amount of exemption remaining, that individual s surviving spouse can use the unused portion of the decedent s $5,000,000 exemption, to shelter a transfer from either gift or estate taxes. The 2010 Tax Act will sunset at the end of 2012, returning us to the estate tax rate and exemption that existed in 2001. 4. See IRC Sections 671-678, known as the grantor trust rules. This material does not constitute tax, legal or accounting advice and neither John Hancock nor any of its agents, employees or registered representatives are in the business of offering such advice. It was not intended or written for use and cannot be used by any taxpayer for the purpose of avoiding any IRS penalty. It was written to support the marketing of the transactions or topics it addresses. Comments on taxation are based on John Hancock s understanding of current tax law, which is subject to change. Anyone interested in these transactions or topics should seek advice based on his or her particular circumstances from independent professional advisors. Insurance products are issued by John Hancock Life Insurance Company (U.S.A.), Boston, MA 02116 (not licensed in New York) and John Hancock Life Insurance Company of New York, Valhalla, NY 10595. 2011 John Hancock. All rights reserved. INSURANCE PRODUCTS: Not FDIC Insured Not Bank Guaranteed May Lose Value Not a Deposit Not Insured by Any Government Agency IM1422CG 03/11 MLINY03221114544