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Defective trust Featured

9:10am EDT December 20, 2002
Regardless of what may or may not happen with the estate -- a.k.a. death -- tax in the next few years, it's a good idea for those with large estates to begin as early as possible to decrease their estate tax liability.

One way to do that is to set up a type of grantor trust, sometimes referred to as a defective trust.

"With a defective trust, the grantor is taking advantage of an anomaly in the income and estate tax laws," says J. Michael Kolk, managing partner at Cohen & Co.'s Akron office. "It is a technique that is used on income-producing assets like S-corps, LLCs, partnerships and rental properties."

A defective trust deals with the double-edged sword of appreciating property and assets in estate planning. The trust buys the asset and issues a note for the value after a gift of at least 10 percent is seeded to the beneficiaries.

"For estate tax purposes they are creating a trust that is outside their taxable estate," says Kolk.

The first benefit comes after grantors sell an appreciating asset to the trust, because they are selling something to themselves and it is not subject to tax. A note is issued freezing the value of the asset for the grantor, and it creates taxable income that may help lessen the overall value of an estate in the long run.

The trust works best with high-worth individuals who feel confident they will be around long enough to benefit from the sale.

"During the period this grantor trust exists, they are still taxed ... basically, they are paying the tax for the grantee so that at the end of the note it is in their name and there is no tax," says Kolk.

One important thing to keep in mind is the importance of "seeding" a percentage of the property's value. According to the IRS, the grantor cannot maintain "a life interest" in the property, or it can be deemed part of the estate rather than a separate trust.

Kolk recommends seeding at least 10 percent.

"Ten percent seems to be a safe harbor. If you try to get too aggressive ... (and) 'retained an interest,' they will bring it back into the estate." How to reach: Cohen & Co. (800) 229-1099 or www.cohencpa.com