How Intentionally Defective Grantor Trusts Are Used To Reduce
An intentionally defective grantor trusts (IDGT) is a type of trust that allows you to transfer assets to a trust removing the assets from your taxable estate while also minimizing the amount of Federal Estate and Gift Tax that will be due as a result of the transfer. In many instances, the transfer to the trust is structured as a sale for fair market value, removing the assets from your taxable estate but still providing you with a stream of revenue from the trust for a period of time.
An IDGT is an irrevocable trust established so that you – the grantor – pay income taxes on the trust’s earnings instead of using money from the trust; this characteristic is also commonly known as a “grantor trust.” The requirement that you pay income taxes on the trust’s earning is the “intentionally defective” part of the trust. With a regular irrevocable trust, the trust itself would be responsible for pay income taxes on its earnings. As the grantor, you will have to pay tax on the IDGT’s income and gains when you have retained certain powers over, or interests in, the income and/or principal of the trust. For income tax purposes, the IRS considers the retention of these powers and interests to be equivalent to ownership of the trust but in addition to being responsible for payment of income taxes, any deductions of the trust are attributed to you as the grantor as well. For income tax purposes, transactions between the grantor and the grantor trust are ignored.
The trust will be considered a “grantor trust” if the grantor has any of the following powers and/or interests in the trust:
- A reversionary interest in the trust principal or income exceeding 5% of the value of that portion of the trust.
- A power of the grantor or a “non-adverse” party (someone who does not have a substantial beneficial interest in the trust that would be adversely affected by the grantor’s exercise or non-exercise of the power) to control the beneficial enjoyment of the trust.
- Reservation of important administrative powers to the grantor or a non-adverse party other than in a fiduciary capacity. This includes dealing with the trust for less than full and adequate consideration or being able to borrow from the trust without adequate security or interest.
- Reservation of the power to revoke to the grantor or a non-adverse party.
- Reservation of the power to distribute income to, or for the benefit of, the grantor.
Having the grantor pay taxes on an irrevocable trust’s income and gain seems counterintuitive but can actually result in huge estate tax savings. The main reason a grantor would create an IDGT is to remove the assets in the trust from his estate. If structured properly, IDGT’s are useful for transferring wealth because, for estate tax purposes, the grantor is not considered as owning the IDGT. So when income taxes are paid by the grantor rather than from the trust fund, more money is kept in the trust and will go to the beneficiaries outside of the grantor’s estate. In all, the grantor will have removed from his estate the value of the trust assets, any future appreciation on those assets, and the amount of money used to pay income taxes on the earnings of the trust assets. Using an IDGT is especially desirable when you believe the asset that will be transferred to the trust will increase greatly in value in the future.
To avoid ownership for estate tax purposes, the grantor can retain only certain powers listed above. It is important that the reservation of these powers does not result in the assets owned by the IDGT being included in your taxable estate at your death. The powers and/or interests in the trust should be carefully structured so that the grantor is only responsible for income taxes and does not cause an Estate Tax liability. For example, if the grantor retains an administrative power to substitute the trust corpus with property of equal value, he will be deemed the trust owner for income tax purposes but not for estate tax purposes. Other powers that will achieve this result include the power to add charitable beneficiaries and the power to borrow assets from the trust.
Another benefit of using the IDGT is asset protection. If structured properly, so that the grantor does not retain a level of control that would establish his legal or equitable ownership of the trust, assets placed in the trust can be protected from levy from creditors’ claims or ex-spouses. You can also add levels of protection for your beneficiaries by adding spendthrift clauses and making distributions discretionary, so that the funds are not wasted by a beneficiary who cannot responsibly manage money
Once you have established and funded an IDGT, you can take advantage of additional wealth transferring techniques to add value to the trust and further reduce your estate, including the following:
I. Loan to Trust
One technique is to make a loan to the trust. The grantor lends money to the trust and charges interest at the lowest rate permissible and still have economic substance, essentially, equal to the current applicable federal rate (AFR). The trust then pays back the principal of the loan, plus interest equal to the AFR. The grantor does not incur any gift taxes because he made a loan to the trust. If the grantor loans the money at the right time, he can lock in a low AFR so that the funds can appreciate at a greater rate than the AFR. The trust will get to keep the full amount of earnings above the AFR because the grantor will be responsible for the payment of the income taxes due on such earnings. The grantor has also removed the value of those appreciated earnings over the AFR from his estate without incurring any Federal Estate of Gift taxes. Moreover, by making a loan, the grantor also ensures his own current financial security because he will be receiving payments on the loan, which can also be used to pay the income taxes on the IDGT’s earnings.
II. Sale of Assets to Trust
Another strategy is for the grantor to sell assets to the IDGT in exchange for a promissory note. The trust can pay for the asset through installments of principal plus interest or by interest only with a final balloon payment of principal. The interest on the note is set equal to the AFR, as in the loan strategy described above. This way, the assets can appreciate in the trust, and the value of the appreciation over the interest rate is removed from the grantor’s estate and will go to the beneficiary tax free. In addition, the grantor will avoid any capital gains tax he may have incurred on a sale of the asset otherwise, because he is selling to the grantor trust he created, which the IRS views as his alter ego for income tax purposes; No gain or loss is recognized. When using the installment sale method, the grantor will gift 10% of the value of the assets to the IDGT as an initial “seed gift,” which the IRS has recognized as giving the IDGT economic substance. The grantor would only have to use his Federal Estate and Gift Tax exemption on the seed gift, after which the assets in the trust can grow without any Federal Estate and Gift tax consequences.
III. Valuation Discounts of Family Business Interests
IDGTs are especially useful tax saving vehicles where the grantor has a family owned, closely held business and desires to transfer it to the children. In addition to all the benefits described above, the grantor can take advantage of valuation discounts of family business interests. The value of shares of a closely held business can be discounted for reasons such as lack of management control or lack of transferability. This allows the grantor to sell shares of the business to the trust at a discounted value in exchange for a note. Once again, the trust benefits from any difference of appreciation over the interest rate. But, the trust also owns shares worth their full value, while only being obligated to pay the cheaper, discounted value under the note. The grantor benefits from the fact that he has removed the full value of the shares from his estate, while holding a note worth considerably less than the full value of the shares. Thus, the value of his estate will be decreased. However, it is important to note that the Treasury has proposed regulations that would severely limit the ability to obtain a discount for transfers of interest in family owned businesses. The regulations have not been approved yet, but could be in the near future.
An intentionally defective grantor trust can be an effective and efficient way to minimize potential estate taxes when transferring wealth to children and future generations.