Planning in Turbulent Times: IDITs

Author:
Alev T. Lewis, CPA, PFS, MST
Senior Vice President
Bank of America
Westlake Village, CA

Editor’s note: If you would like further information about this column, please contact Ms. Lewis at (805) 557-3710 or alev.t.lewis@bankofamerica.com . The author thanks Roger Stinnett, Senior Manager, Ernst & Young LLP, for his assistance.

Intentionally defective irrevocable trusts (IDITs) offer taxpayers an estate-freeze and wealth transfer technique appropriate for these uncertain economic times. They also offer taxpayers an estate planning opportunity, despite the events of September 11, current market instability and recently enacted estate legislation.

What Is an IDIT?

An IDIT is an irrevocable trust that takes advantage of a disparity between the income and estate tax treatments of a trust containing certain powers under Secs. 674 and 675. It is considered a grantor trust for income tax purposes, but it is not includible in a grantor's estate for estate tax purposes. A grantor can sell appreciating assets to an IDIT in exchange for a note, freezing his or her estate and transferring wealth by converting an appreciating asset into a fixed-yield asset (e.g., an interest-bearing note).

How Does It Work?

A grantor initially seeds an IDIT with cash or property that creates a taxable gift. The asset is then sold to the IDIT in exchange for an installment note. Because the IDIT is intentionally made defective to qualify as a grantor trust, the grantor does not recognize gain or loss on a sale of an asset to the IDIT; see Regs. Sec. 1.1001-2(c), Example (5); Rev. Rul. 85-13; and Bernard Madorin, 84 TC 667 (1985).

Similarly, the grantor pays no tax on the interest payments received on the note; however, he or she pays tax on all of the trust's income. If the grantor dies during the note's term, the IRS might argue that the gain should be recognized (Madorin). However, the grantor's estate may be able to defer the gain under the Sec. 453 installment-sale rules, until the note is fully paid off (Sun First Nat'l Bank of Orlando, 607 F2d 1347 (Ct. Cl. 1979)).

An IDIT enhances wealth transfer opportunities, because it allows a grantor to discount assets transferred or sold due to lack of marketability or a minority interest, which reduces the assets' fair market value (FMV), the amount of the taxable gift and the promissory note. Further, the grantor can also benefit by using a family limited partnership or dynasty trust (or both) in combination with an IDIT.

Some points about IDITs include:

• Initial cash or property used to seed an IDIT is a taxable gift.
• Future appreciation (above the note rate) on property sold to an IDIT is removed from a grantor's estate.
• S corporation status is not affected by a stock sale to an IDIT.
• Transactions between a grantor and an IDIT are not taxable events for income tax purposes. No gain or loss is recognized on a sale of an asset to an IDIT.
• A promissory note (not property sold to an IDIT) will be includible in a seller's gross estate if he or she dies during the note's term. However, gain might be recognized if the seller dies before the note is paid.
• Cost basis in an asset sold to an IDIT is the grantor's carryover basis at his or her death.
• If grandchildren are beneficiaries, a portion of the generation-skipping transfer (GST) tax exemption could be allocated to an IDIT when the trust is first funded.
• A grantor is not obligated to report the sale to an IDIT, but gift-tax-return disclosure is required to start the statute of limitations.

Who Should Use an IDIT?

An IDIT is an excellent wealth transfer vehicle for taxpayers who:

• Are tolerant or comfortable with uncertainty about IRS challenges.
• Are elderly or subject to health risks (however, tax issues may arise if death occurs during the note term).
• Need to allocate a portion of the GST tax exemption.

Planning Strategies

Despite the steady decline in estate tax rates anticipated over the next eight years, the estate tax will return in 2011. Even though high-net-worth taxpayers hope for permanent tax repeal, most agree that this seems unlikely. The uncertainty of repeal, coupled with turbulent times, however, make an IDIT a viable estate planning tool. For example, a grantor can benefit from low asset valuations and low interest rates. He or she needs only a smaller amount of seed money, thus reducing gift tax. Similarly, if the grantor intends to allocate his or her GST tax exemption to an IDIT, only a smaller amount of the exemption is needed for the gift. Finally, because low interest rates cap annual interest payments on a promissory note, the grantor can manage cashflow better until the note's maturity.

Grantors should consider the following assets when considering a sale to an IDIT:

• Closely held companies that are acquisition targets (either an S or a C corporation);
• C corporations likely to undertake an initial public offering;
• Publicly traded stock experiencing a temporary decrease in value due to market volatility; and
• Those with temporarily depressed values that have solid growth potential.

A sale of an asset to an IDIT is advantageous for several reasons when compared to other strategies. First, the interest rate used to value other types of trusts (e.g., a grantor retained annuity trust) can be higher than the interest on an IDIT note. The interest rate on such a note is pursuant to Sec. 7872. A note with a three-to-nine-year term will bear interest at the Federal midterm rate (Sec. 1274(d)(1)(a)).

Second, an IDIT can issue an interest-only note with a balloon payment of principal at the end of the note's term. This helps “back load” a majority of the payments to the grantor. The IDIT has to pay only interest on the balloon note until maturity. This helps the grantor manage cashflow and preserve the appreciation of the trust assets for the benefit of younger generations. A promissory note with a balloon payment allows for future asset growth without depleting assets to pay the grantor.

Example: T owns an asset valued at $10,000,000. He wants to sell the asset to an IDIT in return for a promissory note and is willing and able to make a taxable gift. He establishes the IDIT and seeds it with $1,000,000 (10% of the asset to be sold). This creates a taxable gift. (Note: the amount of the seed money does not create a safe harbor; it is deemed sufficient capitalization for a sale of this type.) T then sells the asset to the IDIT for $10,000,000 in exchange for a $10,000,000 five-year balloon note bearing 4.6% interest (the Federal midterm rate). The IDIT makes annual interest payments to T of $460,000. The asset sold to the IDIT grows at a 10% annual rate. This leaves the IDIT with approximately $4,907,264 after paying off the $10,000,000 loan at the end of five years.

Help for Ailing IDITs

If a taxpayer sells assets to an IDIT, but the assets do not appreciate as expected or, due to uncontrollable events, there is a decrease in cashflow and asset values decline (or both) and the IDIT cannot make interest payments, it could use several techniques to meet a shortfall.

Borrowing from third parties. To make interest payments, an IDIT can borrow funds from an unrelated third party in an arm's-length transaction. However, under Regs. Sec. 25.2702-3(b)(1)(i), the IDIT cannot issue a note to the grantor to satisfy the interest payment requirements. If interest rates are low, making payments with borrowed funds will ensure that assets with future appreciation potential will remain in the trust. A lender will incur income tax consequences on such a loan, but the loan's personal nature will preclude an interest deduction.

If the note is paid off before the end of the IDIT's term, the grantor will not suffer adverse income tax consequences. However, if he or she dies during the IDIT's term, or the IDIT terminates while the third-party note is still outstanding, the grantor will have to recognize gain to the extent of the amounts outstanding.

Selling covered calls. If an IDIT holds publicly traded stock with a temporarily depressed value, it can write covered calls—a yield-enhancement strategy. A call option allows a purchaser to buy the underlying stock at a predetermined price (i.e., a call strike price) on a future date. Acting as a seller, the IDIT receives a premium for granting the buyer this right, which can provide cash to meet short-term needs and help enhance the underlying stock's overall yield. The IDIT forgoes any appreciation above the call strike price; however, if the stock price is less than the call strike price on the day the option becomes due, the call option will not be exercised. The IDIT will keep the premium, as well as the shares, and retain the underlying stock's growth potential.

Substituting assets. Under Sec. 675(4), a grantor can substitute assets of equal value that have higher cashflow and greater appreciation potential than the original asset. If this is done in the early stages of the IDIT's term, asset values can be preserved.

Potential Problem

With a balloon note, principal payments are mainly back-loaded. If a balloon note is nearing its term, but the underlying assets have depreciated below the note's face value, there is a risk of nonpayment. This exposes the grantor to the ultimate IDIT risk: if no balloon payment is made, the IRS might be able to characterize the transaction as equity or as a transfer to a trust with a retained interest and, under Sec. 2702, consider the transferred asset's full value as a gift. To avoid this treatment, the grantor can buy the asset back from the IDIT. Because the IDIT is treated as a grantor trust for income tax purposes, the grantor will not recognize any taxable income on this sale.

Conclusion

A thorough consideration of all the possibilities makes an IDIT an appealing estate planning tool and can give taxpayers experiencing difficult economic times realistic expectations of the results to be achieved with an IDIT. Those who carefully weather the storm will be poised to reap the benefits of economic upturns, ensuring that future generations will inherit a larger portion of their wealth.