Planning with Intentionally Defective Trusts

By: Randall A. Denha, J.D., LL.M.

Imagine setting up a trust that is defective for income taxes, but effective for transfer tax purposes.  Would you do it?  Under the right circumstances, an intentionally defective irrevocable trust (IDIT) can be a very effective estate tax planning tool. These trusts are set up to purposely fail certain technical tests in the tax law, but yet they still have the approval of the IRS and allow individuals to pass more assets on to their heirs.  Estate planning with IDITs—despite the name—has many advantages. In fact, this well-established technique isn’t defective at all; the term “defective” describes the effect of income taxation rules on these instruments.

What Is an IDIT?

An IDIT is an irrevocable trust most often established for the benefit of the grantor’s spouse or descendants. The trust is irrevocable by design in order to remove the underlying trust assets from the grantor’s estate. It needs to be established with a non-interested party as trustee to avoid its accidental inclusion in the grantor’s estate. Also, in order for the grantor to maintain income tax liability, the trust instrument must contain certain tax provisions found in the Tax Code in order to make it tax “effective” for estate tax purposes but tax “defective” for income tax purposes (i.e., the trust income will be taxed at the grantor level, rather than the trust level).

Here are some of the most commonly used grantor trust provisions in the Tax Code:

• Reacquiring trust assets. Pursuant to IRC Section 674(c), the grantor retains the power to reacquire assets from the trust and substitute them for other assets of equivalent value. This retained interest does not prevent the grantor from making a completed gift to the trust.
• Borrowing from the trust. IRC Section 672(a) allows the trust to contain a provision giving the grantor or other nonadverse party the power to take loans from the trust without adequate interest or security. To trigger grantor trust status, this power must be retained by the grantor and not given solely to the trustee.
• Changing the beneficiaries. Under IRC Section 674(a), the trust may give the grantor the power of disposition, which affects the beneficial enjoyment of the trust income or principal. For example, the grantor could retain the power to add noncharitable beneficiaries or to direct distributions to existing beneficiaries.

It’s essential that the drafter of an IDIT instrument be aware of all the exceptions to the grantor trust provisions that could have the negative consequence of either losing grantor trust status or causing the trust to be counted in the estate of the grantor.

Funding Options

To fund an IDIT, a grantor has two options: make a completed gift to the trust or engage in an installment sale to the trust.

A completed gift. Gifts are the most common way to fund an IDGT. The grantor makes an irrevocable, completed gift of the desired assets to the trust. Gifting appreciating assets reaps the most benefit—the income can be retained by the trust and passed to the beneficiaries. Plus, the grantor avoids additional transfer taxes on the asset even if there is a significant increase in value.

If the gift exceeds the annual exclusion amount for the year in which the gift is made ($15,000 for 2019), however, transfers to an IDIT are taxable gifts that will reduce the grantor’s unified gift and estate tax credit.

An installment sale. One way to avoid a gift tax implication is for the grantor to sell the appreciating asset(s) to the trust, typically in an installment sale. In return, the grantor receives an interest-bearing promissory note payable by the trust. Because the IDIT is a grantor trust, no tax is due on any gain from the sale—the grantor is treated as having sold something to him- or herself. The grantor keeps the ability to maintain an income stream from the installments, or the interest payments are made to the trust to grow the value of the trust corpus for the beneficiaries. If the value of the promissory note is equivalent to the value of the property sold, there is no gift tax liability.

IDIT Tax Saving Strategy

If you own appreciating assets and want to get the future appreciation out of your estate, an intentionally defective irrevocable trust could be just what the doctor ordered. The strategy works as follows:

1. You establish the IDIT as a legal entity under applicable state law and name the trust beneficiaries (generally your children and grandchildren). Typically, you also make a gift of some cash to the IDIT to create some immediate liquidity for the trust (this is called “seed money”).
2. You then sell appreciating assets to the IDIT in exchange for a note payable from the IDIT (in other words, an installment sale). Since the IDIT is ignored for federal income tax purposes, the sale has no federal income tax significance (you are treated as selling the assets to yourself, which is not a taxable transaction). Very cool!
3. To pay back the note owed to you, the IDIT uses cash from your gift of seed money, from income and gains generated by the trust’s assets, and, if necessary, from asset sales.

Intentionally defective irrevocable trusts are sometimes called intentionally defective grantor trusts. These are two names for the same arrangement.

4. Any income, gain, and deduction items related to the IDIT’s assets are reported on your personal federal income tax returns, because you are still considered to own the assets for federal income tax purposes. You are allowed to pay the income taxes with money from your own pocket.

In order to pay taxes you need not dip into the trust. This allows you to leave more value in the IDIT for the future benefit of the persons you’ve named as the trust beneficiaries. In effect, you’re allowed to make gifts of money to cover the trust’s income tax bills without triggering any adverse federal tax consequences. Essentially, the income earned by the trust is earned free of income tax liability to anyone other than the grantor. The benefits of tax-free growth only increase as time passes and the assets appreciate. Furthermore, because of the compressed tax rate schedule for trusts, the grantor is usually in a lower tax bracket than the trust, which makes funding the IDIT with appreciating assets also suitable for income tax savings. Note that the IDIT instrument should not require the trust to reimburse you for income taxes generated by its assets. Such a requirement would cause the trust’s assets to be included in your taxable estate, which would ruin the whole strategy behind the intentionally defective irrevocable trust concept.

5. At the end of the day, the IDIT will have paid off the note owed to you, but the trust will still have a net worth equal to the appreciation in the value of the assets you put into it. The IDIT’s net worth will ultimately go to the beneficiaries you’ve designated, and the net worth amount will not be included in your estate for federal estate tax purposes.

The example above illustrates some of the benefits of creating an IDGT and funding it with appreciating assets. This approach serves both as an estate-freezing technique—by giving the beneficiaries the benefit of the appreciation without incurring additional transfer taxes—and as a way to remove assets completely from the grantor’s estate by putting them in an irrevocable trust.

The income taxes paid by the grantor further reduce the value of the estate, and these taxes are not considered additional gifts to the trust or its beneficiaries. In addition, if the grantor engages in a sale of assets to the trust in exchange for a promissory note, there is no recognition of gain or loss.

When drafted and funded appropriately, IDGTs can be a very useful estate planning tool. They can effectively freeze the value of assets transferred to the trust, giving maximum tax savings to the grantor. And when the trust is finally distributed, the beneficiaries can enjoy the benefits of the tax-free growth of the assets.