Friday, February 09, 2007

Intentionally Defective Grantor Trusts

An intentionally defective grantor trust (IDGT) is a grantor trust for income tax purposes, but a completed gift for estate and gift tax purposes. This tax strategy manages to reduce both gift and estate taxes through a so-called estate freeze. Although this estate planning technique has been available as a planning tool for sometime, IDGTs have become more popular recently due to the relatively low interest rate environment. In establishing an IDGT, an individual sells to the trust an asset such as, stock, closely held or family business interest, real estate or limited partnership interest in a family limited partnership, at the assets fair market value in return for an installment note.

According to Mark Stone of Margolin, Winer and Evens LLP, 

a sale to the IDGT is not recognized for income tax purposes because the grantor and the trust are treated as the same entity. This treatment is based on the conclusion in Revenue Ruling 85-13, which was subsequently reaffirmed in PLR 9535026. The grantor in this PLR sold assets to an IDGT in exchange for a 20-year promissory note. In addition to concluding that the sale is not recognized for income tax purposes, the PLR concluded that the trust purchasing the assets would assume the respective grantor’s basis in those assets transferred. Because the sale in the PLR was consummated with a note, the PLR also concluded that the interest component of the note had no income tax consequence to either the payer or the payee.

...the grantor will not recognize any gain on the sale. As a grantor trust, the grantor will be responsible for paying income taxes on the trust’s activity. The grantor is responsible for this tax liability because of a legal obligation imposed by statute under Section 671. The grantor’s payments of tax on the trust income not only will satisfy the grantor’s legal obligation, but will provide another form of a "tax-free gift" to the trust’s remainderman beneficiaries. This treatment presents the grantor tremendous planning opportunities, since the trust’s assets will not be depleted by taxes.
To illustrate the tax planning opportunity afforded in this scenario, let us assume a taxpayer makes a one-time gift of $1 million to a trust that earns a 9 percent taxable return and that the taxpayer is subject to a 40 percent effective tax rate. Based on these facts, the trust would earn $90,000 of income in year one and accrue a tax of $36,000. Upon payment of this income tax, the grantor’s estate tax liability would be reduced by $18,000 ($36,000 x 50%) in the first year, with comparable savings available to the grantor’s estate in subsequent years. This is in addition to the estate tax reduction of the initial $1 million gift.
In some instances, the grantor may not have the desire or financial resources to pay the income taxes. If either of these conditions exist, the trust may provide the trustee of the defective trust the discretion, but not the obligation, to remit a tax reimbursement payment for any taxes paid by the grantor on income generated by the trust.
A risk of establishing an IDGT is the asset in the trust underperforms the Applicable Federal Rate (AFR). The AFR is the rate established for the note. The result could be the grantor needs to repay the note and pay the interest, otherwise the asset sale is recharacterized as a gift.

There are securities laws considerations as well. Some assets, such as holdings in private equity securities, are not eligible due to restrictions in limiting the sale of investments to qualified purchasers or accredited investors. A trust also needs $5 million in assets or a qualified bank trustee to meet this requirement according to Everett P. Ingalls of Pierce Atwood LLP.

A number of additional factors must be considered when evaluating the appropriateness of establishing an IDGT. Before establishing an IDGT, an individual must consult their legal and/or accounting advisors. More detail can be found in an article published in the Journal of Financial Planning at this link.

The IDGT: The Effective Defective Grantor Trust
FPA Journal
By: Mark Stone, CPA, PFS, CFP, MST
September, 2002

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