The beauty of the IDGT is the dichotomy between who owns the trust assets for gift and estate tax purposes (the trust) and who owns the assets for income tax purposes (you, the grantor). In fact, as the trust grantor, you are responsible for paying income tax on income you never receive. An IDGT is a tool you can use when you want to augment what your heirs will inherit.
By paying the income tax on income you do not receive, you accomplish at least three significant estate planning objectives:
- You allow the trust assets to grow unencumbered by income taxes.
- You further deplete your estate — and the associated estate tax — each time you pay the tax on trust earnings.
- You, in a sense, make an additional tax-free gift to the trust each time you pay tax that would otherwise be paid by the trust itself.
The IRS has acknowledged that, so long as the trust is properly structured, your paying income tax on trust earnings is not considered a taxable gift.
But keep in mind that other transfers you make to the trust will be considered taxable gifts for gift and estate tax purposes. Another option is to sell assets to the trust. (See “Installment sales to IDGTs”, below.)
The trust can achieve IDGT status by allowing you to retain some powers over or benefits in the trust. Although each situation should be evaluated on its own, typically the trust terms permit the grantor to retain the power to reacquire trust assets in exchange for property of equal value. Your attorney can draft the trust so that the defect is structured appropriately to ensure a completed gift. Otherwise, the trust assets will likely be includible in your taxable estate.
The trust also should have some economic substance in and of itself — particularly if it will be used to transfer a significant asset such as a business. Generally, you should initially fund the trust with additional assets equal to at least 10% of the business or other significant asset you are transferring. This will lend the trust a sufficient degree of economic substance independent of the business or asset.
Suppose you are concerned that the income tax burden might become overwhelming if the assets grow significantly more than expected. To prevent the burden from becoming too large, the trust documents can give the trustee the discretion to distribute trust assets to you to pay the associated income taxes. But when the trust documents require these distributions, the IRS has ruled that the trust assets constitute part of your taxable estate.
Alternatively, the trust may permit the trustee to “fix” the trust defect, effectively breaking the income tax link between the grantor and the trust. Doing so would cause the trust to be responsible for paying its own income tax. But once the trust is no longer defective, it cannot later be made defective again. The “fix” is permanent.
IDGTs can be a wise option for transferring assets to your heirs, but they require careful drafting and thorough consideration of possible tax effects. Properly structured, an IDGT also can serve as a valuable device for implementing a succession plan.
Installment sales to IDGTs
You, as grantor, can use an intentionally defective grantor trust (IDGT) to freeze the value of assets likely to appreciate and increase your estate tax. By transferring the asset to the IDGT via an installment sale, you establish a stream of income for yourself, while passing the appreciation to the beneficiaries tax-free.
The interest rate for the sale is based on IRS rates that are usually lower than market rates. You as grantor/seller realize no income when the trust pays interest and no taxable gain on the sale. Instead, you are taxed on any income or capital gains the trust receives on its assets. Further, the transaction avoids gift taxes if the sale is made for the asset’s full value. Finally, if you die while the promissory note on the sale is outstanding, only the unpaid balance is included in your estate.