By Anthony Diosdi
An intentionally defective grantor trust (“IDGT”) is a trust that is treated as owned by the grantor for income tax purposes, but not for gift or estate tax purposes. The benefit of an IDGT is that the value of the trust, and any growth thereon, are excluded from the grantor’s estate. At the same time, the trust is “defective” for income tax purposes. This means that the grantor would pay all of the income tax on the assets transferred to the trust without it being deemed a gift. This is accomplished by properly drafting the trust provisions so that the trust constitutes a grantor trust under one or more of the grantor trust rules found in Internal Revenue Code Sections 671 through 679 whereby the grantor will be taxed on all trust income whether or not it is distributed to him or her. But, at the same time, the grantor is not given sufficient control over the trust assets to cause the trust property to be included in the grantor’s gross estate under the retained rules stated in Internal Revenue Code Sections 2036 through 2038. In other words, the grantor needs to retain enough control for grantor trust purposes, but not enough control to cause a transferred asset to be included in his or her estate.
Installment Sales of High Return Assets to an IDGT
Gift and estate taxes form the two parts of a “unified” transfer tax system. This means that these taxes are imposed at graduated rates on the cumulative amount of taxable transfers made by one person, counting transfers made both during life and at death. Currently, the top gift and estate tax rate is 40 percent. The “unified credit” (sometimes known as the “gift credit” or the “estate tax credit,” as the case may be) allows an individual to make a certain amount of taxable transfers free of the transfer tax. This amount is currently $11.7 million.
Many individuals transfer their assets to irrevocable trusts for estate tax planning purposes. One of the significant constraints faced by individuals transferring assets to irrevocable trusts is that assets transferred into an irrevocable trust will be treated as a gift, which means either paying gift taxes, or at least using a portion of the contributor’s lifetime gift and estate exemption of $11.7 million. However, if an individual were to establish an IDGT, instead of simply gifting assets into a trust, he or she could avoid gift and estate taxes on the transfer of assets. Transfers to IDGTs are often done through interest-bearing promissory notes. Under Revenue Ruling 85-13, a sale by a grantor to his or her grantor trust in exchange for an interest-bearing promissory note is not treated as a taxable event for income tax purposes. This strategy effectively allows a grantor to exchange a promissory note for property or stock without triggering an estate, gift, or income tax liability.
For example, let’s assume that Paul acquired an office building in Seoul, Korea in 1992 for $2 million. The office building is now worth $50 million. The building also generates $5 million a year in rental income. Because of the value of the office building, Paul has an estate tax problem. This is because the value of the office building greatly exceeds Paul’s current $11.7 million exemption amount. Let’s assume that Paul sells the office building to the IDGT in exchange for a promissory note from the trust that agrees to make interest-only payments of 4 percent per year for the next 15 years (followed by a balloon payment of the principal). The trust will only need to make interest payments, which will easily be covered by the available rental income generated from the office building.
Immediately after the transaction, Paul’s net worth has not changed. Paul simply swapped from an office building worth $50 million, to a promissory note worth $50 million. Since Paul has sold the office building to “himself” for income tax purposes, there are no capital gains taxes due on the transaction, and the cost basis of the business simply carries over into the IDGT. However, going forward, the promissory note will “grow” by a 4 percent yield.
Requirements For A Legitimate Installment Sale To An IDGT
The first requirement for an installment note to an IDGT to be respected by the Internal Revenue Service (“IRS”) is that the trust should be funded with assets to support the position that the trust has economic substance independent independent of the sale (i.e., the trust has the ability to repay the loan). The funding or “seed money” to the IDGT can be made through one or more taxable gifts by the grantor to the trust. There should be at least a 10 percent cushion in the trust in order to avoid characterizing the installment note as a retained interest in the trust. In PLR 9535026, the IRS found that trust equity of at least 10 percent of the value of the installment note was sufficient to create a valid arm’s-length transaction.
Second, the grantor will sell property to the IDGT in return for an interest-bearing promissory note for fair market value along with appropriate valuation discounts. The valuation of the property or other assets transferred to the IDGT should be reasonable and substantiated through an appraisal. Valuation discounts for lack of control or lack of marketability may be considered in the valuation of assets placed into the IDGT. There are a number of ways to set-up the installment note. The most common way to structure the note is to provide for interest-only payments with a balloon payment of principal at the end of the note term. The promissory note itself must use a legitimate and not “below market” interest rate (even though the grantor may have the power to borrow from the trust later at a below-market interest rate). Under Internal Revenue Code Section 7872, a “below market” rate loan is defined as one that fails to use the published Applicable Federal Rates (“AFR”) of Internal Revenue Code Section 1274.
Finally, the promissory note must be carefully drafted so that the note is not characterized as a retained interest by the IRS. If the note can be classified as a retained interest, the rules of Section 2702 will apply. These rules will treat the entire loan as a taxable gift.
What Happens if the Grantor Dies During the Term of the Note?
Unless the note is a self-canceling installment note (“SCIN”), the value of the note will be included in the grantor’s estate at fair market value, which is presumed to be the face amount plus accrued interest. See Treas. Reg. Section 20.2031-4. The SCIN is a technique that is sometimes used to avoid the inclusion of a note receivable in the holder’s estate. See IRC Section 453B(c).
For example, let’s assume that Dad sells an office building in Miami, Florida to Daughter for a note. Daughter’s note is for a period of ten years or Dad’s life, whichever is shorter. If Dad dies before the note is fully paid, the note is not technically canceled – rather, it has been satisfied, because all payments required pursuant to its terms have been made. Therefore, there is nothing to include in Dad’s estate. However, in order for Dad not to have made a gift to Daughter at the outset, the consideration for the office building would have to be more than Dad would have received under a straight 10-year note, to reflect the fact that Daughter would not have had to pay the whole price if Dad died during the period.
A SCIN is an installment obligation that terminates on the occurrence of a certain event (often the seller’s death) before it is otherwise due. If the grantor dies during the term of the SCIN, the value of the note is zero for estate tax purposes. The purchaser’s basis will be adjusted to reflect the unpaid amount of the note, or, if the purchased asset has been disposed of, deferred gain will be recognized.
While the IDGT and SCIN strategies are now established, because an IDGT and SCIN combination effectively allows individual grantors to ‘magically’ remove high value assets from their taxable estates at little or no tax cost, future legislation could eliminate IDGT and SCIN planning options. Until a crackdown is implemented, an IDGT and SCIN strategy remains a legitimate estate planning option which if done property will not likely be challenged by the IRS.
Anthony Diosdi is tax attorney at Diosdi Ching & Liu, LLP. As a tax attorney, Anthony Diosdi advises clients in areas of tax planning and tax compliance throughout the United States, Asia, Europe, Australia, Canada, and South America.
Diosdi Ching & Liu, LLP also has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.