This article originally appeared in the July 2010 issue of Smart Business Philadelphia magazine.
The intentionally defective grantor trust has become a popular estate planning tool. If structured properly, a grantor trust can be treated differently for income tax and gift and estate tax, creating planning opportunities, particularly when used with other wealth shifting techniques.
Smart Business spoke with Richard Nelson, director of the Tax Strategies Group at Kreischer Miller, about how a defective grantor trust works.
How does an intentionally defective grantor trust work?
An intentionally defective grantor trust (IDGT) is an estate planning tool used to shift wealth by removing an appreciating asset from an individual’s estate without creating a taxable gift. It also removes future appreciation from estate tax.
The trust must be a grantor trust and also irrevocable. 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 (individual creating the trust).
The IDGT will be treated as a grantor trust if it fails one or more of the grantor trust rules found in the Internal Revenue Code.
Generally, if the grantor retains sufficient control over the trust and the trust assets, it will be treated as a grantor trust even if irrevocable.
Two of the common drafting techniques used to ensure that the grantor trust fails the rules is to give the grantor the power to reacquire the trust property by substituting property of an equivalent value or by giving an individual the power to add to the trust additional beneficiaries.
These powers should result in the grantor being treated as the owner of the trust for federal income tax purposes but not for inclusion of the asset for estate tax purposes.
Generally, 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.
When using an installment sale it is essential that the asset sold to the trust is not the only source of payment regarding the note.
Once the trust is created, and prior to the sale, the grantor must gift cash or other assets with a value of a minimum between 10 percent and 20 percent of the value of the asset being sold in exchange for the installment note.
How does this create tax and estate planning opportunities?
The sale of the appreciating asset to the IDGT is not taxed to the grantor for income tax purposes. This is because, 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 will not be 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, as well as any appreciation, 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.
During the term of the trust, any income earned by the trust on the assets held by trust is taxed to the grantor. For an additional benefit, the grantor should pay the income tax on the income earned in the IDGT from other sources held by the grantor.
This results in an additional reduction in the grantor’s assets for estate tax purposes and also increases the assets passed to the beneficiaries.
What are some other benefits that the IDGT provides?
The assets sold to the IDGT should have the potential of substantial appreciation. If those assets are, for example, an interest in a closely held corporation or a limited partnership interest, those assets may be valued at a discounted value and be deemed sold at fair market value.
Discounts may be taken for lack of marketability and for lack of control. Thus, the value of the asset sold for a note may be significantly reduced via discounting.
However, it should be noted that the IRS has in the past challenged unusually large discounts.
Is the defective grantor trust for everyone?
IDGT’s are not for everyone. IDGT’s are not specifically supported by any specific Internal Revenue Code sections. The planning techniques are based on interpretations of IRS rulings and case law. They are not IRS risk free.
Individuals who are not risk adverse must carefully consider the potential downsides in their planning.
In addition to considering the federal tax consequences, individuals should check their respective state statutes regarding grantor trusts. Some states do not recognize grantor trusts and, therefore, the sale to the trust of the potential appreciated asset would be taxed by the state either at the time of the sale or as the payments are received on the installment note.
Also, the rules are different in community property states, so individuals should obtain competent assistance in planning, structuring and implementing an IDGT. ●
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