October 1999


Estate Planning: What is a Grantor Trust?
Y2K: Last-Minute To-Do List
Transfer of Some Annuity Funds into Another Annuity Is Nontaxable

Estate Planning: What Is a Grantor Trust?

A grantor trust is generally used when planning a person’s will and distribution of an estate. A grantor trust is a specific type of trust that allows the person who creates the trust (grantor) to control the assets in the trust and recognize income generated by the trust. (This type of trust is also referred to as a revocable, living, or inter vivos trust.) To understand the advantages of a grantor trust, you must first understand how it is created and how it differs from other trusts.

Creating a grantor trust

A grantor trust is so called because it is created during the grantor’s lifetime. It is a revocable trust, which means that the trust can be terminated or changed during the grantor’s lifetime, as long as he or she is mentally capable. When the grantor dies, the trust becomes irrevocable and the trust is then administered according to the instructions in the trust documents.

Naming a trustee

The trust documents designate who is a trustee. The grantor may serve as the trustee, or if the grantor does not have the time or experience to manage a trust, he or she may name an experienced person as trustee or co-trustee. A trustee must manage assets, carry out the objectives of the trust as set out in the trust documents, and take care of all reporting requirements and paperwork.

Trust documents

Trust documents determine who has control and ownership of the trust and who manages and disposes of the trust assets. The trust documents should also contain contingency plans in case of death or incapacity of the grantor. In such cases, the trust should designate who is to act on the grantor’s behalf (the successor trustee). The trust documents should also direct the successor trustee on how to manage and distribute the assets. Naming a successor trustee is extremely important, as it allows the assets of the trust to be immediately accessed. If no successor trustee is named, the family of the grantor must apply to a court to be named as a conservator the grantor’s assets. During this court process, the family would have no access to the assets. If any assets are short-term or require immediate or continuous attention, such as stocks or options, lack of the access could hinder the sale or purchase of the assets and affect their value.

Advantages of a grantor trust

Assets held in a grantor trust are not subject to the probate process because at the death of the grantor, the trust is considered a separate legal entity. Probate is a process supervised by a probate court. The process validates the will and the appointment of an executor of the will, oversees the administration of the estate, and can take two years or more to complete. Because the trust is not probated, the beneficiaries of the trust have immediate access to the trust assets, and therefore the distribution of the assets is generally quicker.

In addition, for a less complicated estate, the administrative costs of administering the trust assets will be less than the costs of administering assets subject to probate, since a grantor trust usually will not be required to file an annual accounting of assets with the probate court.

Income, gift and estate taxes

If the grantor of the trust is also a trustee, a separate income tax return may not be needed for the trust. If a grantor makes gifts from the trust during his or her lifetime, generally the gifts are considered as being made by the grantor and may be subject to the gift tax. After the grantor’s death, any property in a grantor trust is included in the grantor’s estate and subject to the estate tax.

Note: Due to the Taxpayer Relief Act of 1997, if the grantor dies after August 5, 1997, a grantor trust can be combined with the decedent’s estate for federal tax purposes. This means that only one tax return would need to be filed, and the trust could take advantage of tax benefits-such as passive losses-from the combined tax return.

Factors to consider

When considering a grantor trust, you should also consider other factors, such as state laws and the type of asset(s) you want to transfer to the trust. For example, if you are considering transferring real estate, the transfer to a trust legally changes the title of ownership to the trust. When doing so, you must take into account whether there is a mortgage on the property. If so, check with the bank or institution that holds the mortgage to see if the title can be transferred without affecting the mortgage; the loan could become payable in full upon transfer.

If the real estate is owned in another state, a grantor trust could help reduce probate costs in the other state. Many times if the owner of property is domiciled in another state, the property may be subject to probate and transfer taxes in those states. However, the trust laws of the state should be carefully reviewed as each state has its own trust requirements. For example, some states require that the trustee be a resident of the state.

If you would like further information on grantor trusts, please contact our office.

Direct Transfer of Some Annuity Funds into Another Annuity Is Nontaxable

In 1994, a taxpayer purchased an annuity contract for $195,643 from insurance company A. Payments under the contract would begin February 4, 2029. Later that year, the taxpayer asked company A to withdraw $119,000 from the annuity contract and to issue a check in favor of, and to directly transfer the funds to, insurance company B. The funds were to be used to purchase a new annuity contract from company B. Company A complied with the taxpayer’s request, and retained $10,000 from the $119,000 as a "surrender charge". Upon receipt of the check from company A for $109,000, company B opened an annuity contract for the taxpayer with a principal amount invested of $109,000. The terms and provisions of the Company B annuity were substantially similar to those of the company A annuity. The taxpayer’s application to company B expressly requested that the transfer of funds and purchase of another annuity were to be treated as Section 1035 exchange. The IRS claimed it was not a Section 1035 exchange because the entire company A annuity was not replaced by the company B annuity. The taxpayer argued that it was a nontaxable exchange because: 1) company A did not distribute any of the funds to her personally, but to company B instead, and (2) she gave up a portion of her company A annuity solely in exchange for the company B annuity. 

    The Tax Court found that the direct transfer of a portion of the funds invested in the company A annuity contract into the company B annuity contract qualifies as a nontaxable exchange under Section 1035. The court found that neither Section 1035 nor the regulations require the exchange of an entire annuity contract for non-recognition treatment. The legislative history of the section states that it was enacted to provide non-recognition treatment for taxpayers "who merely exchanged one (annuity contract)…for another better suited to their needs and who have not actually realized gain". The court concluded that because 1) the taxpayer was in essentially the same position after the exchange as she was before, 2) the funds were still in annuity contracts, and 3) the taxpayer had not received use or benefit from the funds, the transaction qualifies as a nontaxable exchange.

Y2K: Last-Minute To-Do List

Still wondering whether you should listen to all the dire warnings about Y2K or just bury your head in the sand? Chances are, Y2K will affect you and your family in some manner, so it is best to take some precautions. Here are some steps to consider:

  1. By mid-December withdraw enough cash to cover your expenses for about a month. This way you will have money to buy necessities in case your credit and ATM cards don’t work. If you or a family member receives Social Security or pension checks, make sure enough cash is on hand in case these checks are delayed.

  2. Avoid flying during the first few days after the New Year. Airlines and the Federal Aviation Administration depend on high-tech equipment that is particularly vulnerable to Y2K errors. If you must travel, take cash and travelers’ checks. Don’t rely on credit cards and cash advances, particularly if you are traveling to a foreign country. Other countries are less prepared than the United States for Y2K. Find out about travel insurance that offers reimbursement, if trips are canceled. Be sure the insurance does not exempt Y2K computer problems.

  3. Try not to schedule elective surgery for early in 2000. Critical hospital equipment is dependent on computer chips that may not be functioning properly.

  4. Make sure important bills such as insurance policies, property tax bills, water bills, etc. have been paid and that payment records are well documented. After the New Year, examine all bills carefully before paying to make sure that there are no errors in the charges.

  5. If you trade stocks over the Internet, have a backup system and/or printout of your transactions and holdings in case you cannot access the information via the Internet.

  6. Don’t panic, but make sure you have necessary items such as candles, batteries for radios and flashlights, bottled water and non-perishable food. Make sure you car has a full tank of gas.

  7. Fill all prescriptions before 2000, and make sure you have a 60-day supply of needed prescription medication of hand by December 1. American drug manufacturers depend on foreign suppliers for many ingredients, and Y2K may be a bigger problem outside the United States.

  8. Know the local phone numbers for the police, fire, and ambulance services in your town, since 911 may not work.

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