This is a part in a series of articles I have written on various types of irrevocable trusts.
Intentionally Defective Grantor Trust
What is a sale to an Intentionally Defective Grantor Trust (IDGT)? Why would a trust be “intentionally defective”? And what is so popular about this strategy?
Intentionally Defective Grantor Trust
An IDGT is a schizophrenic trust. For purposes of income taxes, the trust is a pass-through. Instead, the taxpayer who created the trust is responsible for paying any income taxes associated with the assets within the trust. But for purposes of estate taxes, the assets belong to the trust. Put another way, the unique feature of the IDGT is that the assets of the trust are excluded from the taxpayer’s estate taxes, but included (intentionally) in the taxpayer’s income taxes. The trust, consequently, is “effective” for estate taxes but “defective” for income taxes.
The reason why this defect is intentional and sought-after is that this trust tends to be in the sweet spot when it comes to overall tax efficiencies. For example, since the taxpayer, and not the trust, pays the income taxes, this allows for the assets in the trust to grow income-tax free (and estate-tax free), and this technique simultaneously allows for the taxpayer to “burn” the size of their own taxable estate by paying taxes on behalf of the trust. Each dollar spent by the taxpayer in taxes on behalf of the trust is reducing the size of the taxpayer’s estate, which is subject to estate taxes at death otherwise. Taxpayers therefore are able to reduce their personal estate taxes at death, and the trust – which is not subject to estate taxes – continues to grow tax-free. Normally when someone pays taxes on behalf of another, the IRS considers that a gift. But when it comes to the IDGT, the taxpayer is paying taxes on behalf of himself, since the taxpayer is the owner of the IDGT when it comes to income taxes. Thus, much to the chagrin of the IRS, no gift taxes apply when the taxpayer is paying taxes on behalf of the IDGT!
You Can Thank Congress
While many practitioners prefer to just refer to the IDGT as a “grantor trust,” the term “intentionally defective” highlights the discrepancy built within the Tax Code. Consequently a transfer of property to trust may be incomplete for income tax purposes but complete for gift and estate tax purposes (IDGT), or it may be a completed transfer for income tax purposes but incomplete for gift and estate tax purposes (NING trust). The reason for this divergence is that the Tax Code’s definition of what is a “grantor trust” only applies to income taxes, but this definition does not apply to gift or estate taxes.
As is often the case, when Congress tries to fix one thing, they usually screw up another. When grantor trust rules were created in the late 1960’s, Congress was trying to crack down on wealthy people shifting their assets into trusts in order to pay what was then a lower tax rate. Congress’s solution to plugging the loophole was to create conditions (known as “grantor trust” rules) whereby a transfer of assets to a trust would still lead to the same tax rate, because the taxpayer is the owner of the trust for income taxes.
Unfortunately for Congress, while this loophole was closed, it opened up another: the sale to a grantor trust, which is not recognized as having any income tax consequence even though it is a sale, because – thanks to Congress – the taxpayer is selling assets to a trust in which the taxpayer is the owner for income tax purposes. Because you cannot sell something to yourself, there is no tax on a sale to an IDGT.
Selling to an IDGT
Understanding this simple principle, practitioners have been able to leverage the IDGT in many ways.
One common technique is selling assets from the taxpayer to the IDGT, in exchange for a promissory note. To accomplish this, we can break down the process into two steps.
Step 1: A Gift to Trust
The client first would “seed” money to the IDGT, by making a gift of about 10% of the value of the installment purchase price. This is a critical first step that cannot be overlooked. If there was no initial gift, the trust would then rely only on the income generated by the asset sold to repay the client. The IRS would argue that the transaction is a transfer with a retained interest rather than a bona fide sale, as most individuals would be reluctant to sell an asset to someone who has no means of repayment. Therefore, the seed gift provides the IDGT with economic substance and legitimacy that is independent of the asset being sold.
Step 2: The Sale to Trust
Client then sells one or more appreciated assets to the IDGT in exchange for a promissory note (“Note”) in the amount of the purchase price, which may provide for installment payments over a period of time, with interest at the minimum required IRS interest rate or annual “interest only” payments with a “balloon” payment of principal at the end of the term. Typically, the property sold to the IDGT secures the Note.
For the reasons stated earlier, the sale transaction between the client and the IDGT has no federal income tax consequences, and no gain or loss is recognized on the sale of the assets to the IDGT. The taxpayer is not required to report the sale on his federal income tax return, and is not taxed separately on the interest payments received from the IDGT. Instead, the taxpayer will only continue to be taxed individually on all income generated by the IDGT as if it did not exist.
The amount gifted into the trust can now grow within the trust tax-free, both from an income tax and estate tax perspective! If the taxpayer dies during the term of the Note, the amount in the IDGT is outside the taxpayer’s taxable estate. Furthermore, when the taxpayer seeds the initial money into the trust, it is recommended that he allocates GSTT to this gift, so that none of the assets in the IDGT are subject to GST taxes.
Which Assets are Ripe for an IDGT?
Income producing assets are ideal, including limited partnership interests, commercial real estate, S-corporation stock, securities and other income-generating assets.
The Gift that Keeps Giving
In essence, establishing an IDGT and then having the taxpayer sell their highly appreciating stock to it, in exchange for a promissory note, means he has transformed his personal ownership of the company shares from a potentially high-return, high growth family business interest into a low-yield non-appreciating bond that he holds and lives off of until paid in full, especially in light of today’s historically low AFR rates used to determine the interest rate on intra-family installment sales.
Moreover, if the taxpayer dies holding the unpaid Note receivable, further planning could be
undertaken so that some portion or all of the unpaid Note is paid over to a donor advised fund for charity. This might entitle the taxpayer’s estate to a large estate tax charitable deduction on the value of the unpaid Note. Additionally, the trustee may use some of the seed gift and income generated from the asset to purchase a life insurance policy, which will generate tax-free proceeds at death to repay the Note and infuse liquidity into the taxpayer’s estate.
To the extent that the appreciating assets inside the IDGT outgrow the relatively low hurdle AFR interest rate on the Note, there is neither gift nor estate nor GST tax to the taxpayer on the delta. Instead, the delta grows untaxed inside the IDGT for multiple generations.
Finally, the “sale to IDGT” strategy may likely be further leveraged by obtaining valuation discounts on shares in closely-held companies to be sold to the IDGT (because they are not publicly traded and possibly because the shares earmarked for the IDGT will be recapitalized into non-voting shares). This means that instead of the sale price for the shares sold to the IDGT being say $1.00, after an appraisal it is possible that with a 25% valuation discount, the sale price might be $0.75 per share.
For these reasons, the sale to an IDGT can be a superior planning tool under the advice of competent counsel.