An irrevocable trust is a trust in which the grantor gives up all rights in the property transferred to the trust, and retains no rights to revoke, terminate or modify the trust in any material way. In exchange, the assets transferred to the trust are not includable in the grantor’s estate for federal estate tax purposes.
In contrast, an intentionally defective grantor trust (IDGT) is an irrevocable trust in which the grantor keeps a certain power over the assets inside the trust, causing the trust’s income to be taxed to the grantor rather than to the trust itself. Despite the grantor’s retention of the power, the assets inside the IDGT remain outside of the grantor’s estate for federal estate tax purposes.
The "intentional defect" is actually a planning choice by the grantor to pay income tax on the trust income while keeping the trust assets outside of the grantor’s estate. This locks in the transfer tax value of the assets placed in the trust. And while the grantor pays income tax on the trust income, any growth in the value of trust assets occurs free of income tax.
Since the grantor pays the transfer tax on the transfer, as well as the income tax the trust would normally pay, the assets in the IDGT grow unabated, and the beneficiaries can then receive them without paying income tax.
The grantor trust powers are those powers retained by the grantor that cause the inclusion of trust income in the grantor’s gross income (outlined in IRC Sec. 673-677). Note that the grantor is treated as holding any power or interest of a spouse.
Grantor has a reversionary interest in the trust assets and/or the income if the value of such interest exceeds 5 percent (IRC Sec. 673).
Grantor has beneficial enjoyment of the trust assets and/or the income subject to a power of disposition by the grantor or a non-adverse party without the approval or consent of an adverse party (IRC Sec. 674).
Grantor retains certain administrative powers or the power to control beneficial enjoyment of trust principal or income (IRC Sec. 675).
Grantor or trustee can revoke the trust without the beneficiary’s consent (IRC Sec. 676).
Grantor or a non-adverse party could direct that trust income be: (a) distributed to the grantor or the grantor’s spouse, (b) accumulated for future distribution to the grantor or the grantor’s spouse or (c) applied to pay premiums on insurance on the life of the grantor or the grantor’s spouse (IRC Sec. 677(a)).
Income is or may be used for the support of the grantor’s spouse or is actually used for the support of a person whom the grantor is legally obligated to support, or is or may be applied in discharge of any other obligation of the grantor (IRC Sec. 677(b)).
However, retaining one of these powers does not necessarily cause the inclusion of the trust and its assets in the grantor’s estate for estate tax purposes. The power to substitute assets in a trust is a retained power described under IRC Sec. 675(4)(C) that does not include the trust in the grantor’s estate under IRC Sec. 2036, 2038 or 2042 [see Rev. Rul. 2008-22, 2008-16 I.R.B. 796; Rev. Rul. 2011-28, 2011-49 I.R.B. 830; PLR 200944002].
Federal Gift Tax: Assets transferred to the IDGT are completed gifts for federal gift tax purposes. If the trust beneficiaries are given a Crummey power (the ability to withdraw the grantor’s contribution) the gift is actually a present interest and the transfer qualifies for the annual gift tax exclusion ($14,000 in 2016 and indexed for inflation).
Federal Estate Tax: Assets the grantor transfers to the IDGT are excluded from the grantor’s estate for federal estate tax purposes.
Federal Income Tax: Because the grantor keeps a certain power or right over the trust assets, the income generated by the IDGT is taxed to the grantor. However, if the trust requires that the trustee repay the grantor for payment of the income tax attributable to the IDGT, all assets within the IDGT would be included in the grantor’s estate [IRC Sec. 2036(a)(1)].
The grantor's payment of any income tax on trust income arguably confers an economic benefit on the trust beneficiaries, since they are relieved of any income tax burden during the grantor's life. So has the grantor made a taxable gift to the beneficiaries?
An IRS revenue ruling has concluded that the grantor of an IDGT does not make a gift to the beneficiaries by virtue of paying the income tax on trust income [Rev. Rul. 2004-64, 2004-27 I.R.B. 7]. If the trustee is required by the trust instrument or state law to reimburse the grantor for any income taxes paid, the trust is includable in the grantor's gross estate as a retained interest under IRC Sec. 2036. However, the trust will not be includable merely because the trustee has discretion to reimburse the grantor under the terms of the trust or under state law, unless there is evidence of a prior understanding between the grantor and trustee or other extrinsic facts that would fetter the trustee's discretion.
One approach is the use of an installment sale between the IDGT and the grantor.
First, the grantor funds the IDGT with money and liquid assets (at least 10% of the value of the asset that will be the subject of the installment agreement).
Next, the grantor and IDGT trustee enter into an installment sale agreement whereby the grantor accepts a promissory note with a principal balloon payment at the end of the term in exchange for the transfer of assets expected to appreciate to the IDGT. The grantor does not realize any taxable gain on the sale of the appreciating assets to the trust since the grantor and trust are the same for income tax purposes. And, there is no gift tax imposed on the transfer of the appreciating assets to the trust because the grantor receives commensurate value in the form of the installment note.
The interest rate of the note is determined by the applicable federal rate and the length of the term of the note—it is necessary for the interest rate to be reasonable in order to properly claim the sale is a transaction rather than a gift. The assets within the IDGT need to appreciate at a rate greater than the applicable federal rate in order to gain an advantage for the trust and its beneficiaries.
The cash and liquid assets originally contributed to the IDGT are used to pay the interest on the note. At the end of the term of the note, the trust pays the principal.
The use of the installment note is a way to remove the asset(s) from the grantor’s estate, yet retain an income stream from the asset(s).
The IDGT features the advantage of any irrevocable trust—removing assets from the grantor’s estate for estate tax purposes and freezing their value so that any appreciation will go to the beneficiaries without transfer tax costs. The distinct advantage of the IDGT is that it places the income tax burden on the grantor rather than the trust.
Retaining the power to substitute assets offers the grantor the opportunity to preserve potential losses from depreciated assets, which would otherwise disappear upon death. Because the IDGT takes a carryover basis in the assets transferred, the grantor can substitute the appreciated assets inside the IDGT for liquid assets with limited or no appreciation at a later time. Thus, when the substituted assets are eventually included in the grantor’s gross estate, the heirs will receive a stepped-up basis in those assets for income tax purposes.
One clear drawback, of course, is that the grantor will pay income tax on income he or she never actually receives.
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