Intentionally Defective Grantor Trusts

Sophisticated estate tax planners have long used the seemingly oddly named intentionally defective grantor trust (IDGT) as an effective tool. The IDGT can freeze the value of an asset for estate planning purposes, while effectively transferring funds out of the estate free of gift taxes. The IRS, with one caveat, recently reaffirmed this planning technique, in Rev. Rul. 2004-64.

How IDGTs Work

Example: Individual G creates an irrevocable inter vivos trust as the grantor, using an unrelated third-party trustee. He then sells to the trust an asset which is likely to appreciate, in return for an installment note (usually with a balloon payment), bearing an interest rate at the applicable Federal rate (AFR). The trust beneficiaries are G’s heirs. To make certain that the asset’s fair market value is reflected by the installment note, G has the asset appraised. This ensures that the transfer is not treated as a gift under Sec. 2512(b).

By intentionally retaining a minor power (discussed below), G triggers the Sec. 671 grantor trust rules, causing the trust’s net income to be taxed to G (in the same way as a revocable living trust). Some of the more commonly retained minor powers that trigger these rules include G’s rights under Sec. 675(4) to substitute property of equal value for the property originally transferred, and to borrow from the trust without adequate security under Sec. 675(2).

Although the trust is disregarded for income tax purposes (i.e., all income from the trust asset is reported by G directly on his individual return, and the gain on the sale, as well as the interest income/expense on the installment note, is completely disregarded), the transfer is respected for estate tax purposes (i.e., the asset is no longer in G’s estate); for such purposes, G owns an installment note.

Because G must report the asset’s income, he must pay the related income tax. Thus, while the asset’s future appreciation and any income received from it grow shielded from estate tax, G continues to pay the income tax on the earnings accruing to the beneficiaries. By paying an expense which is economically that of the beneficiaries, the IDGT in effect allows G to make additional gifts without paying gift tax or using his annual exclusion. As a result, an asset with annual taxable income (as well as potential future appreciation) is more suitable for an IDGT than, for example, raw land or a non-dividend-paying stock.

Rev. Rul. 2004-64

For any grantor trust established after Oct. 3, 2004, Rev. Rul. 2004-64 will nullify the technique described above by including the trust assets in the grantor’s estate under Sec. 2036(a)(1) if the trust’s governing instrument or local law requires it to reimburse the grantor for the income tax he or she paid on the trust income. If the trust’s governing instrument or local law provides only that the trustee has the discretion to reimburse the grantor for taxes paid, this will not cause the trust assets to be included in the grantor’s estate, unless it can be shown that there was a pre-existing arrangement between the grantor and the trustee for such reimbursement. Thus, trust documents should be drafted by legal counsel experienced with IDGTs and local trust law.

IDGTs vs. GRATs

An IDGT can often be more advantageous than the commonly used grantor retained annuity trust (GRAT), because it does not require the grantor to live a set period of time to remove the appreciating asset from the estate (as is required under a GRAT). Additionally, the AFR interest paid under the installment note, which flows back into the grantor’s estate, is less than the 120%-of-AFR annuity payment required under the GRAT rules.

Conclusion

Sophisticated taxpayers who wish to engage in an asset freeze, while transferring additional sums free of gift tax, should consider an IDGT. Once the taxpayer has received full payment on the principal and interest on the installment note, however, no cashflow from the trust will be available to pay the trust income tax, unless the trustee has the discretion to make reimbursements (and does, in fact, make them).

In addition to overcoming this “psychological” burden, the taxpayer must have the financial ability to use this strategy.

From Curt J. Welker, CPA, PKF San Diego, San Diego, CA