Intentionally defective grantor trusts (IDGT) have become a popular estate planning tool, used to shift wealth by removing an appreciating asset from an individual's estate without creating a taxable gift. The grantor trust rules differ for income tax and gift and estate tax, creating planning opportunities, particularly when used with other wealth-shifting techniques.
An irrevocable grantor trust must be created, and proper drafting of the documents is essential to ensure that the trust is a grantor trust. If properly structured, the trust will be disregarded for income tax purposes and the trust's income or deductions will be taxable to the grantor (the individual creating the trust who also sells the asset to the trust).
Typically, once the trust is created, the grantor would sell the asset to the trust in exchange for a note—generally an installment note. The asset must be sold at its fair market value and an adequate interest rate must be charged on the installment note. In addition, the grantor must gift cash or other assets with value at least 10 to 20 percent of the value of the asset being sold.
The assets sold to the IDGT should have the potential for substantial appreciation. If those assets are, for example, an interest in a closely-held corporation or a limited partnership interest, then the assets can be valued at a discount and still deemed to be sold at fair market value. Discounts can be taken for lack of marketability and lack of control. Thus, the value of the asset sold for a note can be significantly reduced via discounting. However, it should be noted that the IRS has in the past challenged unusually large discounts.
The sale of the appreciating asset to the IDGT is not taxed to the grantor for income tax purposes. For income tax purposes, the grantor and the trust are treated as one. As a result, both the note payments as well as the interest payments made to the grantor are not subject to federal income tax.
At the end of the trust’s term, the trust assets will not be included in the grantor’s estate. The assets will pass to the trust’s beneficiaries free of tax. If the grantor dies before the note is paid, only the unpaid balance of the note is included in the grantor’s estate. Any appreciation in the value of the trust assets goes untaxed.
It is important to keep in mind that IDGTs are not for everyone. IDGTs are not supported by any specific Internal Revenue Code sections. The planning techniques are based on interpretations of IRS rulings and case law. Therefore, they are not IRS-risk free. If you’re thinking of creating an IDGT, you should consult a tax or estate planning professional who can be sure to guide you in the right direction.
Richard J. Nelson can be reached at Email or 215.441.4600.