Trusts have historically been an effective strategy for keeping family and business wealth intact, while passing them on to new generations at a favorable tax rate while avoiding probate. As the favorable gift and estate tax law is expected change at the year's end, trusts are becoming more popular among business owners and high net-worth families as a way of lowering their tax burden.
One of the more common - albeit complicated - trusts some are turning to are intentionally defective grantor trusts. Unlike other safeguards, IDGTs allow businesses and families to pass wealth onto children and grandchildren without reducing their liquidity, according to Forbes.
The financial product, if set up properly, allows businesses and individuals to move assets out of taxable estates and transfer gains to beneficiaries tax-free. The trust may be considered "defective" due to a purposeful flaw. Assets are removed from an individual's estate, lowering the heir's tax burden, while allowing owners to continue paying income taxes on those assets. The latter essentially allows owners to gift those assets to beneficiaries at a locked-in value.One caveat that discourages many business owners from leaning on this type of trust is that it can be particularly complex and, if not structured properly, draw scrutiny from the Internal Revenue Service. Further, if the value of assets declines, heirs may not gain the full benefits from this financial product. For this reason, individuals relying on a trust are encouraged set it up with a professional, have any assets appraised accordingly, and ensure they fully understand the inner workings and potential risks of these arrangements.