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There’s nothing wrong with a defective trust

In recent years, the intentionally defective grantor trust (IDGT) has emerged as one of the most effective techniques available for minimizing taxes in large estates. By combining the estate tax benefits of an irrevocable trust with the income tax advantages of a grantor trust, IDGTs offer some intriguing estate planning opportunities.

Asset preservation involves several components, including asset protection* techniques (such as creditor protection trusts), minimizing estate taxes and other expenses, and investment strategies designed to provide long-term growth. Let’s
focus on the investment component.

Defective reasoning

Irrevocable trusts can allow you to freeze the value of assets for transfer tax purposes. When you contribute property to an irrevocable trust, you’re subject to gift tax on its current fair market value, but all future appreciation in value passes to your beneficiaries tax free.

An IDGT (also referred to as an intentionally defective irrevocable trust, or IDIT) behaves like other irrevocable trusts for estate tax purposes, but by retaining certain powers over the trust (such as the right to reacquire trust assets by substituting other property of equal value), you can make it “defective” for income tax purposes. In other words, the assets are removed from your estate, but the IDGT is treated as a grantor trust for income tax purposes.

Because you’re treated as the owner of a grantor trust, you report the trust’s net income on your individual tax return. Why is that a good thing? Because paying the trust’s income taxes allows you to substantially increase the amount of wealth your beneficiaries receive without triggering additional gift or estate taxes.

Ordinarily, an irrevocable trust is responsible for its own taxes, which consume a portion of its assets. By structuring the trust as a grantor trust for income tax purposes, however, you achieve the equivalent of an additional tax-free gift to your beneficiaries: Your income tax payments reduce the size of your estate while increasing the trust’s value by the amount of income taxes it would otherwise have paid.

The IRS has given its full blessing to this technique, ruling that a grantor’s payment of taxes for a properly structured grantor trust doesn’t constitute an indirect gift to the trust’s beneficiaries.

Selling power

An IDGT can be an ideal vehicle for selling assets that have appreciated in value and are expected to continue appreciating. In a typical transaction, you make a taxable gift of seed money – say, 10% of the purchase price – to the trust. Next, you sell property to the trust in exchange for a promissory note.

A grantor trust is treated as the grantor’s alter ego for income tax purposes. Essentially, a sale to an IDGT is a sale to yourself, so you won’t recognize any capital gain or loss on the sale, nor will you owe any taxes on the note payments. You will, of course, pay taxes on the trust’s net income.

The property sold to the IDGT – along with all future appreciation – is removed from your taxable estate. In addition, so long as the purchase price is equal to the property’s fair market value and the note bears adequate interest at the applicable federal rate (AFR), there’s no gift tax on the transaction. To the extent that the trust’s earnings and appreciation top the AFR, the excess is transferred to your beneficiaries tax free.

|IDGTs are particularly effective for sales of interests in closely held businesses, such as S corporations or limited liability companies. Even though an IDGT is treated as the grantor’s alter ego for income tax purposes, it’s treated as a separate entity for valuation purposes. Thus, minority interests sold to the trust are entitled to valuation discounts for lack of control and lack of marketability. These discounts reduce the amount of the note, maximizing the value transferred to your beneficiaries.

Better than a GRAT?

In many cases, a sale to an IDGT will be preferable to a GRAT. Why? GRATs are subject to mortality risk – if the grantor fails to survive the trust term, the trust assets are subject to estate taxes. With a sale to an IDGT, if the grantor dies before the note is paid, the unpaid balance will be included in his or her estate, but the underlying assets – together with any appreciation in value – will escape taxation. Whether the grantor’s death before the note is paid will trigger income tax consequences is uncertain, though most estate planning professionals believe that it will not.

Another advantage of an IDGT is that the applicable federal rate used to determine the note payments is generally lower than the rate used to determine the size of a GRAT’s annuity payment. Plus, an IDGT offers greater flexibility to vary the size of payments to the grantor.

On the other hand, a GRAT doesn’t require you to put up seed money, and the law governing GRATs is better established. IDGTs aren’t specifically sanctioned by the tax code, so they may be more susceptible to IRS scrutiny. Also, if the IRS finds that assets sold to an IDGT were undervalued, you may be subject to gift tax on the difference. With a GRAT, revaluation is less of a risk because you may be able to avoid or minimize gift taxes by adjusting the annuity payments.

In either case, conventional wisdom says that it’s a good idea to file a gift tax return – whether the transaction is taxable or not – to start the clock on the statute of limitations for revaluation.

A flexible tool

The IDGT is a flexible tool with the potential to achieve significant gift and estate tax savings. With creativity and careful planning, it can be used to overcome a variety of estate planning challenges.

*Asset protection plans should be developed and implemented well before problems arise. Due to the fraudulent transfer laws, asset transfers that occur close in proximity to the filing of a lawsuit or bankruptcy can be interpreted by the court as a fraudulent transfer. Proper structuring of these assets is imperative please seek proper legal and tax advice prior to engaging in re-titling/structuring of any assets. Please note that laws are subject to change and can have an impact on your asset protection strategy.
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