Intentionally Defective Grantor Trust,
With Provision

Structure, how it works, benefits, considerations, and implementing language.

by Alan R. Eber

Excerpted from Asset Protection Strategies & Forms

An IDGT is a trust that is “defective” solely for income tax purposes. The fact that the grantor trust rules are different for income tax and for gift and estate tax creates planning opportunities. For estate and GSST purposes, transfers to IDGTs will be completed gifts and outside the estate. However, for income tax purposes, the existence of the trust is ignored and the grantor is treated as the owner of the trust.

The IDGT is one of the most powerful estate planning strategies available, particularly when it is dynastic and used with other wealth shifting techniques.

An asset can be “sold” to an IDGT income and capital gains tax-free. Provided it was sold for a note or Self Canceling Installment Note (SCIN) of equal value there will be no gift tax. All future income (not including the interest paid on the Note) that the asset generates will be taxed to the seller. The tax the seller pays on future income in the IDGT further reduces the seller’s estate. The asset in the IDGT appreciates outside the seller’s estate.

IDGTs provide asset protection for assets transferred to them. Although the settlor is treated as the trust owner for income tax purposes, he is not so treated for legal or equitable ownership purposes. Unless the settlor retained control, IDGT assets are not available to his creditors. The IDGT should be drafted with all the standard asset protection features (e.g., it should have a spendthrift clause, it should be discretionary, etc.).

The payment instrument received by the seller is subject to the settlor/seller’s creditors. However, the note could be partially protected by making it interest-only, provided this does not reduce its value and cause a gift tax to apply.

FORM:

4-26 IDGT: Grantor Trust Provision

§4:201     How an IDGT Transaction Is Structured

An IDGT can accomplish tax goals and afford the settlor asset protection. The IDGT transaction usually takes the following form:

(click to enlarge) 

§4:202     How an IDGT Transaction Works

The IDGT is formed as a grantor trust, which is not included in the grantor’s estate for estate tax purposes.

There is a sale of property to the IDGT in exchange for an Installment Note, or a SCIN (Self-Canceling Installment Note), depending on the cash flow being generated in the IDGT.

This sale is nontaxable under a Revenue Ruling that holds that gain on the sale by the grantor to a grantor trust is not recognized. [Rev. Rul. 85-13.] Similarly, interest on the note is not taxed. In addition, the IDGT can satisfy its obligation with appreciated assets without income tax consequences (technique to take advantage of basis step-up at death).

Generally, this technique is used to sell non-controlling interests in entities such as LLCs and S corporations to the IDGT, taking advantage of valuation discounts. Other presumptively undervalued assets are also excellent potentials, provided enough cash flow is generated to pay the installment note or SCIN.

There is no gift tax if the Fair Market Value of the note or SCIN received equals the Fair Market Value of the property sold to the IDGT. Therefore, no gift tax exemption or GSTT exemption needs to be allocated to the trust.

Income on property held by the IDGT is taxed to the grantor. This shifts additional assets to the IDGT, and further depletes the grantor’s estate.

Title to trust assets are not held by the settlor. Therefore, those assets are not subject to the claims of his creditors, although the note from the trust will be.

At the grantor’s death, all that is included in his estate is the Fair Market Value of the note or perhaps nothing if an SCIN. Thus, the IDGT effectively freezes the value of assets and all future appreciation is outside the settlor’s estate for estate tax purposes (although the unrecognized gain on the sale is recognized at the settlor’s death [Crane v. C.I.R., 331 U.S. 1 (1947)]).

§4:203     Benefits of an IDGT

An IDGT may be set up for children that allows them to:

• Access income from the IDGT.

• Have the assets available for their use and enjoyment.

• Decide who will receive the property at their death or during their lifetime if they want to give it away.

• Manage and control the property.

• Have the property protected from their (and the settlor’s) creditors and spouses in case of divorce.

• Save taxes.

§4:204     An IDGT Cannot Be Self-Settled

An estate owner cannot set up and fund a structure for himself that would enable him to access, enjoy, and manage the assets and also obtain creditor protection and tax relief.

If this were done, the creditors would be able to reach the maximum amount that could be paid to the settlor.

§4:205     Considerations Before Using the IDGT

The step-up in basis is lost since the sale to the grantor trust is tax neutral. However, non-depreciable property of equal value perhaps could be substituted by the grantor to keep the step-up on appreciating assets.

Parties may be better off having the grantor pay the tax on the sale.

The grantor is taxed on trust income and may be unable to bear the tax costs in the future.

Termination of grantor trust status can cause recognition of gain on an outstanding installment note.

§4:206     Powers That Will Make a Grantor Trust but Avoid Estate Tax

A key feature of the IDGT is including trust provisions that will cause the trust to be a grantor trust, yet not be included in the grantor’s estate for estate tax purposes.

The following powers are exercisable solely in a nonfiduciary capacity without approval or consent of any person acting in a fiduciary capacity.

Sprinkle Power

A sprinkle power held by a grantor, the grantor’s spouse, or trustees, more than half of whom are “related or subordinate” [see IRC §672(c)] and subservient to the wishes of the grantor, will cause the trust to be a grantor trust.

A related or subordinate party is a nonadverse party. An adverse party is a person who has a substantial beneficial interest in the trust that would be adversely affected by the exercise or nonexercise of the power he or she possesses.

A related person includes grantor’s spouse, grantor’s parent, sibling, descendant, or employee, a corporation or any employee of a corporation in which the stockholdings of the grantor and the trust are significant from the viewpoint of voting control, or a subordinate employee of a corporation in which the grantor is an executive.

Such related persons, unless they are adverse parties, are presumed to be subservient. [See PLR 9508007 (trust was a grantor trust because brother was trustee with discretionary distribution powers).]

Example:

If the grantor’s son has the power to accumulate income or to sprinkle income among the grantor’s spouse and issue (other than himself), but the son has a remainder interest in any accumulated income, the son is an adverse party.

Power to Add to the Class of Beneficiaries

A power to add to the class of beneficiaries (other than to provide for after-born or after-adopted children), including, without limitation, a charitable beneficiary, will cause a trust to be a grantor trust.

Power to Reacquire Assets by Substituting Assets of Equivalent Value

A power exercisable in a nonfiduciary capacity to reacquire assets by substituting assets of equivalent value, at least where supported by facts and circumstances demonstrating that the power is in fact exercisable in a nonfiduciary capacity, will cause a trust to be a grantor trust.

§4:207     Treatment of an Installment Note During Life

Gift Tax

To avoid a gift tax, the note should bear adequate interest at the rate then in effect under IRC §1274, the federal rates.

The value of the note can be improved by securing it with trust property, but this may be counterproductive for asset protection purposes. Furthermore, it may jeopardize the estate tax objective. [See IRC §2036.]

Estate Tax

Use of an IDGT raises the possibility that the grantor will be treated as having retained an interest in the trust. The problem is especially acute when the IDGT has no other assets.

If the grantor is treated as having retained an interest, trust assets will be included in his estate for estate tax purposes. [IRC §2036. See, e.g., PLR 9436006 (trust initially funded with $1.2 million, which was 10% of purchase price of stock, was held to be a genuine sale) and PLR 9535026 (note approved provided it did not constitute equity rather than debt).]

Steps to resolve this issue:

Pre-fund the IDGT with meaningful assets to support the position that the trust has economic substance independent of the sale (i.e., the trust has sufficient assets such that it can repay the loan). The seed money can be transferred through gifts to the trust, or a carefully structured guarantee. (If the trust does not pay a fair price for the guarantee, the person giving the guarantee may be treated as making an indirect contribution to the trust, which might result in the trust not being treated as wholly owned by the grantor). Informally, the IRS has stated that other assets should equal or exceed 10% of the purchase price. [PLR 9535026.]

Pay the note before the death of the note holder.

Possibly, the beneficiaries of the IDGT can personally guarantee the note. [PLR 9515039 (personal guarantee of beneficiaries will avoid IRC §2036(a)(1) in certain circumstances).] However, this can have adverse tax consequences because a guarantee could constitute a gift, especially if default were likely.

§4:208     Treatment of an Installment Note on Death

Income Tax

The law on the treatment of installment notes on death is unsettled. There is authority holding that the grantor recognizes gain when the trust ceases to be a grantor trust.

Some potential solutions are:

• Pay-off note: These uncertainties, especially the possibility of cancellation of indebted­ness income, can be avoided by paying off the loan before death.

• Insurance: Life insurance can be obtained to provide proceeds in the event of death.

• Election out of installment reporting: The transaction can be structured so that income tax may be avoided by having the seller elect out of installment reporting. The taxpayer would report the transaction on his return, explain that under Rev. Rul. 85-13, the gain would not be recognized, that there would be carryover of basis, and that the taxpayer elected to opt out of installment reporting.

Example:

In a sale to a non-defective trust, if the taxpayer elects not to use the installment method, the entire gain would be reported in the year of sale. Nothing further would be reported at death.

Because the gain is not recognized by the trust, being a grantor trust, why would future years be affected? It would be reasonable to conclude that each successive year would stand on its own and if an estate owner were to die in year 10, for instance, we would not look back to year 1 to see if gain was recognized in determining the treatment for year 10.

Since there is no downside risk to making this election, it should be made as a matter of course.

§4:209     Payment of Taxes

Payment of taxes by the grantor of an IDGT is not a gift since one cannot make a gift by discharging one’s legal obligation.

§4:210     Formula to Avoid Loss of Tax Benefits

For the IDGT to be effective, assets must appreciate sufficiently for the estate tax savings (i.e., the freeze in value plus the payment by the grantor of income taxes attributable to trust property) to exceed the loss of step-up in tax basis.

The tax effect depends on what the parties intend to do shortly after the applicable death (i.e., hold or sell the asset).

§4:211     Generation Skipping Transfer Tax (GSTT)

You can allocate the GSTT exemption immediately to the extent that there is a gift to the trust.

Form 4-26:    IDGT: Grantor Trust Provision

Download the IDGT: Grantor Trust Provision in Microsoft Word.

Alan R. Eber is a pioneer in the asset protection field and a highly sought after speaker on estate and wealth planning and protection.  Since 1974, Mr. Eber has assisted clients in establishing a wide variety of wealth preservation structures. Currently, Mr. Eber is presenting seminars on Advanced Asset Protection and Techniques and Domestic and International Trusts for the National Business Institute (NBI), the Lorman Group, and numerous other groups.  He is the author of Asset Protection Strategies & Forms, from which this article is excerpted.