Freezing and Reducing your Taxable Estate with Intentionally Defective Grantor Trusts (IDGTs)
Likely the most effective and popular advanced planning techniques are the use of a Grantor Retained Annuity Trust (“GRAT”) or an Intentionally Defective Grantor Trust (“IDGT”). The general idea of both techniques is to transfer assets expected to appreciate in an amount that exceeds the current month’s Applicable Federal Rate or Section 7520 (120% of the AFR) rate and pass the excess growth to non-charitable beneficiaries, all while using little or none of the individual’s basic exclusion. In this part, I will discuss IDGTs.
An Intentionally Defective Grantor Trust is a strange concept, but it makes perfect sense to estate planners. In many cases, a “grantor trust” is revocable and the grantor maintains ownership of the assets within it and, therefore, the assets are included in the grantor’s taxable estate. When engaging in gift and estate tax planning most trusts will be irrevocable because the goal is to remove the assets from the taxable estate of the grantor. In general, an irrevocable trust becomes separate and distinct from the grantor. And although any general or limited powers of appointment or other language which could amount to incidents of ownership and cause inclusion in the grantor’s taxable estate should be avoided, there is a technical way by which the trust drafter can allow the trust assets to remain owned by the grantor for income tax purposes yet make the trust irrevocable and the assets not owned by the grantor for estate tax purposes. Therefore, we term this type of trust an intentionally defective grantor trust. This dynamic is permitted due to the “grantor trust” rules developed by the IRS in the 1960s when trusts actually paid a lower income tax rate than individuals. Congress was attempting to prevent assets being transferred to trust for income tax benefits. Ironically, the trust income tax rates are now typically much higher than individual tax rates.
General Benefits of Gifting to an IDGTs
What’s the benefit of creating this type of trust? First, an IDGT is designed to remove the assets within it from the taxable estate of the grantor. Second, much like GRATs discussed previously, the assets in the IDGT remain the grantor’s for income tax purposes and thus the grantor remains responsible for the income taxes on the appreciation within the trust which further reduces their taxable estate without gift tax consequences. The grantor’s marginal tax rate is often lower than that of a non-grantor trust. Accordingly, in some cases, an IDGT may be used as a more sophisticated mechanism for using an individual’s basic exclusion by gifting to the IDGT and allowing the assets to appreciate outside of the grantor’s taxable estate without detrimental income tax consequences for the beneficiaries. Instead, the grantor pays the income tax and further reduces their taxable estate.
Installment Sale to IDGTs
In cases where an individual wishes to preserve their basic exclusion or has already used it, a sale between the grantor and the IDGT can be structured. In this scenario, the grantor would likely make a small gift to the IDGT to ensure liquidity for a sale and then transfer significant assets with high appreciation potential to the IDGT in exchange for a promissory note secured by the transferred assets. The promissory note would provide for interest only payments at the IRS applicable federal rate with a balloon payment at the end of the term. In normal circumstances, a sale would trigger capital gains tax consequences, but with an IDGT, the grantor is considered the owner for income tax purposes and, therefore, no gain or loss is realized. The grantor is taxed only on the appreciation of the assets within the trust and not the interest payments from the trust as the sale is disregarded for income tax purposes. Ideally, the appreciation of the assets transferred will be sufficient to make the installment payments to the grantor. At the end of the term of the note, the principal is returned to the grantor via the balloon payment but all appreciation which exceeds the IRS assumed interest rate remains in the IDGT without gift or estate tax consequences.
Downsides and Risks with IDGTs
One risk with an installment sale to an IDGT is that if the grantor dies before the note is paid, although the unpaid balance of the note will be in the grantor’s taxable estate, and any growth exceeding the assumed interest rate will remain outside of the taxable estate and allocated to the beneficiaries, deferred capital gains taxes may be due on the unpaid portion of the note, and potentially the appreciation, because the death of the grantor terminates the grantor trust status of the IDGT.
Secondly, in the case of an installment sale, if the assets fail to outperform the IRS assumed interest rate, then all the assets will be returned to the grantor at the end of the term and if the trust defaults on the note even more complications could arise.
Additionally, a gift to an IDGT is not eligible for the annual gift tax exclusion of $18,000 (2024). However, an IDGT can be drafted to include a “Crummey” limited withdrawal power to get around this issue. By doing so and properly adhering to the formalities of such, gifts under $18,000 to an IDGT would be eligible for the annual gift tax exclusion.
Furthermore, per Revenue Ruling 2023-2, assets in an irrevocable grantor trust are not eligible for a step-up in basis at the grantor’s death. Therefore, if assets are gifted to an IDGT, they receive the grantor’s carry over basis and would not receive a step-up as they would if inherited from the grantor. Accordingly, high basis instead of low basis assets should be transferred to an IDGT. In other words, a grantor should gift acquired assets to an IDGT before they appreciate and not after. When assets are gifted to an IDGT, the step up in basis at grantor’s death is lost. Although the maximum capital gains tax rate of 20% is lower than the income tax rate for many individuals and is half of the max 40% gift and estate tax rate, this still must be considered when planning with IDGTs.
Lastly, one disadvantage of an installment sale to an IDGT is that there are no specific regulations in the Internal Revenue Code for this strategy as there are with GRATs. Therefore, some legal uncertainly exist with their effectiveness under IRS scrutiny.
To learn more about estate tax planning, contact our office.