| By :
Shane Flait
Transferring some of your wealth while you're alive will trigger a gift tax when you die. You also have to pay an estate tax on the value of your estate when you die, too. These are hefty taxes that lower what you can ultimately leave to your beneficiaries. You can use a 'defective' trust to help reduce them. Here's how... Currently (2011 and 2012) you pay both an estate tax and a gift tax respectively on the value of your estate when you die as well as the value of all the gifts you made during your life. Both these taxes exempt the first $5 million respectively of your estate's value and the total gift amount you've made. Any amount in excess of this exemption is taxed at a flat 35%. There's a generation-skipping tax that is imposed just like the above taxes but in addition to them. It occurs when you gift to someone two generations below you - usually to your grandchildren, but it doesn't have to be a relative. However, there's a gift tax break that exempts the first $13,000 you gift to anyone annually from gift taxes. This 'annual exemption' is never counted toward your total gift tax amount during your lifetime. But you do have to make that annual gift to get the exemption each year. So, it's not something you can accumulate in arrears. Trusts can help you to avoid or minimize estate and gift taxes. Transferring assets to an irrevocable trust will take them out of your estate and allow them to continue to grow over the years so even more is eventually transferred to the beneficiaries without affecting your estate. That's a way to save yourself from paying some estate tax, but it means giving up ownership of those assets. You can minimize the gift tax on funding the trust by contributing to it yearly at the level of the annual gift tax exclusion level ($13,000 in 2011) per beneficiary of the trust. To do so, the trust must have a 'Crummey provision'. It allows beneficiaries a certain amount of time each year to take out their share of that year's funding - i.e. your contribution (which you don't want them to do!). That way it ensures that your funding satisfies the 'present gift' requirement for enabling you to take the annual gift tax exclusion. But to transfer more than the gift tax exclusion, you'll trigger an eventual gift tax on that excess amount. That amount of gift tax is due when you die. But you can avoid that gift tax on the excess amount if you use a special type of trust known as an 'intentionally defective' grantor trust (IDT). You are the grantor. The IDT is an irrevocable trust designed so that any assets or funds put into the trust aren't taxable to the grantor as a gift, estate or generation-skipping transfer tax. You create the IDT purposefully flawed so that you must continue to pay income taxes on the earnings of the trust yourself - and not the trust. All income, deductions and credits that come from the trust must be reported on the your (the grantor's) 1040 as if they were the owner of the a revocable trust. In this case the assets funding the trust aren't recognized as being transferred from you - the grantor. This is why gift taxes don't apply! Nevertheless for estate tax purposes the value of the grantor's estate is reduced by the amount of the asset transfer since the IDT is an irrevocable trust. Because the grantor pays the taxes on all trust income out of his own pocket annually, the assets in the trust are allowed to grow tax free for the benefit of the trust's beneficiaries.
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