July 20, 2018
Get to Know Intentionally Defective Grantor Trusts

By Erin S. Fukuto, CPA, MST, TEP

Intentionally defective grantor trusts (IDGTs—pronounced “idjits”) have become popular in estate tax planning techniques in recent years. This article will serve as an introduction for those who are unfamiliar with this type of trust entity and its use in estate tax planning stratagems.

What’s an IDGT?
An IDGT is a term used to describe a specific type of trust. Conceptually, it’s a trust entity that’s set up to be an irrevocable trust. However, in drafting the trust agreement, certain provisions are “intentionally” included or excluded. Such provisions will allow the grantor of the trust to retain certain powers. 

For example, a common power that may be retained by the grantor as a result of the defective provisions is the power to exchange assets within the trust for other 
assets of an equal fair market value. The retention of such powers by the grantor will violate the provisions for allowable grantor powers set forth in the IRC. This violation will cause the IRS to consider the trust to be “defective” and, by default, the trust will be deemed to be a grantor trust for income tax purposes, i.e., a trust that is disregarded for income tax purposes.

When the trust agreement is properly drafted, the result of this defective creation is a dichotomy in the treatment of the trust, the trust assets and the income and deductions arising from these assets. The IDGT will be treated differently for legal and estate tax purposes versus the treatment for income tax purposes. Because the trust has been created as irrevocable (and provided that none of the powers retained by the grantor would cause estate tax inclusion) it will be respected as a legally valid trust entity for estate tax purposes. 

Simultaneously, because of the intentionally defective trust provisions, for income tax purposes it will be treated as a grantor trust and ignored as a separate taxable entity. It’s these two disparate estate tax and income tax treatments that provide planning opportunities for the knowledgeable 
tax practitioner.

Installment Sale of Significant Rapidly Appreciating Assets to an IDGT
One possible transaction that can be structured using an IDGT is the sale of an appreciating asset (such as a profitable, closely-held family business) by the grantor to the IDGT. The IDGT will usually be initially funded with cash and/or other assets as a taxable gift from the grantor. The beneficiaries of the IDGT will generally be the grantor’s children. This initial taxable gift is usually necessary to provide the IDGT with sufficient seed money and assets to enter into the planned transaction. 

The grantor will then sell certain high-value, appreciating assets to the IDGT in exchange for cash and an installment note. This transaction must be structured to be defensible as a legally valid sale. The sale price must be reflective of the current fair market value and the installment note given should bear an interest rate at or above the appropriate applicable federal rate as set forth by the IRC.

When this transaction is properly structured, certain tax consequences will result. The sale will not be reportable as a taxable transaction and the IRS will treat it as one by the grantor to himself, and thus not a taxable gain event. In addition, the interest payments made pursuant to the installment note will not be taxable income since they are being paid to himself, and will not be deductible by the trust. Since the sale of the asset is not recognized for income tax purposes, all future income, losses and deductions arising from the asset will be reportable by the grantor for tax purposes as though he’s still the owner.

Concurrently, for estate tax purposes, the IDGT will be considered the legal owner of the asset sold. This means that such assets will no longer be considered to be a part of the grantor’s taxable estate. The asset’s fair market value has been locked in by the sale price and it’s now a part of the IDGT’s trust corpus. This transfer of asset has been accomplished income tax free and any future appreciation from this date forward will accrue to the IDGT and its beneficiaries and not to the grantor.

The overall result of this transaction will be to freeze the fair market value of and remove a significant, rapidly appreciating asset from a taxpayer’s estate so it will no longer be subject to potential estate taxes. At the same time, the income and deductions attributable to the asset will still flow through to the taxpayer. If done properly, this reduction of the taxpayer’s estate will not incur an immediate income or gift tax. It should be noted that since the asset has been removed from the taxpayer’s estate, then it will not receive a step-up in basis upon the death of the taxpayer.

There’s also another economic benefit realized by the grantor from this transaction. The grantor still reports and pays income taxes on the income generated by the asset that is now owned by the IDGT. The grantor can use non-IDGT assets to pay such income tax liabilities. In this way, the grantor’s taxable estate is further reduced for the payment of income taxes while the income from the asset accumulates tax-free in the IDGT’s corpus.

Transactions like this can yield significant benefits, but there are significant risks. Such tax planning techniques should not be attempted without also planning for exit strategies or unexpected events. The installment note is an important factor. 

A termination or repayment plan should be part of the transactional planning to minimize the tax and financial impact of a premature repayment need. This plan can take the form of debt forgiveness by the grantor, or contributing other cash flow generating assets to the IDGT that can be used to repay the outstanding debt. It will generally be in the taxpayer’s interest to pay off the installment note in the normal course of business as rapidly as possible. In the event of the death of the grantor before the installment note is paid off, the installment receivable will be a part of the grantor’s estate, which would negate the desired estate tax benefits from this transaction and could potentially raise additional problems.

This is a general and very simplified overview of the possibilities available for income and estate tax planning in regards to IDGTs. Note that this is inherently a complex area with many pitfalls and issues for unwary tax practitioners. There are many controversies which remain unsettled and pending with the IRS. Experienced, knowledgeable specialists should be consulted where necessary. However, having read this brief introduction, it’s hoped you won’t have to feel like one when a client asks you about an “Idjit.”

Erin S. Fukuto, CPA, MST, TEP is a partner at Raimondo Pettit Group.

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