By: Randall A. Denha, J.D., LL.M.
Here’s a great technique for transferring wealth in an advantageous and unique way: gifting an asset’s appreciation while keeping or retaining the right to income. An intentionally defective irrevocable trust (“IDIT”) is an irrevocable trust designed for the benefit of your children and future descendants. In general, the IDIT involves both a gift of assets and a sale of asset(s) for the full fair market value (FMV) of the asset to a trust. Because the sale is at FMV, there is no gift; because the trust is a grantor trust, the grantor is in essence (for income tax purposes), selling the asset to himself, with no gain or loss recognition. This holds true even though the sale removes the asset(s) from the grantor’s taxable estate for gift and estate tax purposes.
Step 1. Because the grantor is selling the asset to the trust, the first step is to ensure that the trust is a legitimate and creditworthy party to the transaction. If the grantor were to sell a valuable asset on credit to the trust with no net worth, the IRS might consider the transaction a sham. Thus, to give the IDIT net worth, the grantor should make a completed gift of a substantial sum of cash or assets to a trust; the trust’s net worth probably should be at least 10% to 20% of the value of the property being sold. This is known as the “seed money”.
The trust should be drafted so that it is “intentionally defective” for grantor trust purposes, rendering the transfer incomplete for income tax purposes, but complete for gift and estate tax purposes. This difference in the treatment of the transfer for income tax purposes and gift and estate tax purposes results in two major consequences. First, sales to this type of trust result in no income tax. The seller, as the grantor of the trust, is treated as selling the property to himself. Second, the seller, as the grantor, is responsible for paying all the income tax from the income received by the trust, which included all rental and / or interest income received by the trust. This allows 100% of the rental income to be allocated to the trust’s beneficiaries, rather than reducing the trust’s assets to pay income tax. 100% of the rental income can then be used to make payments on the promissory note.
Step 2. The grantor and the trust enter into a bona fide sales agreement in which the
grantor sells an asset to the trust on credit (i.e., in exchange for a promissory note). The trust makes annual interest and partial principal payments to the grantor using the applicable federal rate (“AFR”). Currently the AFR is very low, with a loan up to 9 years only requiring an interest rate less than 2%. The principal can also be a single balloon payment due at the end of the term of the note. Interest must be paid annually, because for gift and estate tax purposes, the grantor and the trust are separate entities and all transactions must be at arm’s-length. This is why it is necessary to establish a gift’s legitimacy by gifting to the trust the necessary seed money.
It would be hard to argue that a legitimate sale exists when the sale is to an entity that holds no other cash or assets. In addition, if the income from the asset sold to the trust is seen as the sole source for repayment of the promissory note, the IRS might argue that the taxpayer had retained an interest in the assets, thereby bringing them back into the taxpayer’s estate. Because an IDIT’s purpose is to remove assets from the taxpayer’s estate, this would obviously be an undesirable consequence.
By taking advantage of the differences between the income tax rules and the estate and gift tax rules, IDITs provide taxpayers with a unique opportunity to enjoy significant estate tax savings. Taxpayers looking to reduce their tax burden at minimal risk should give them serious consideration. The impact of defective trust planning is substantial estate shrinkage and the transfer of asset appreciation from the parents to the children and/or grandchildren. While the defective grantor trust is a cutting edge idea, it is not for everyone. It is an additional planning tool that should be considered along with other estate planning ideas.