This article discusses the importance of using an “intentionally defective grantor trust” (or “IDGT”) for estate, gift, and income tax purposes. An IDGT involves setting up a trust that accumulates income (while the settlor or the grantor pays the income taxes owed on such income) and yet will not be included in his or her estate for estate tax purposes.
An Introduction to the Taxation of Grantor Trusts
U.S. federal law imposes a transfer tax upon the privilege of transferring property by gift, bequest, or inheritance. During an individual’s lifetime, his transfer tax takes the form of a gift tax. For gift tax purposes, a gift is defined as the transfer of property for less than adequate and full consideration in money or money’s worth, other than a transfer in the “ordinary course of business.” No U.S. gift tax would be owed on a gift to a beneficiary until the gifts made to the beneficiary in a calendar year exceed an applicable exclusion amount for that year ($18,000 for calendar year 2024). Upon an individual’s death, the tax takes the form of an estate tax. The estate tax is measured against a tax base that includes all the assets owned at death.
The U.S. estate and gift tax is assessed at a rate of 18 to 40 percent of the value of an estate or gift. A unified credit is available to minimize the impact of the transfer tax. The unified credit gives a set dollar amount that an individual can gift during his lifetime and pass on to his beneficiaries before gift or estate taxes apply. U.S. citizens and resident individuals are permitted a unified credit that exempts $13.61 million (for calendar year 2024) from tax. This means that U.S. citizens and residents can transfer up to $13.61 million of assets to their heirs without being assessed a gift or estate tax. It should be noted that this federal gift and estate tax exemption is temporary, and is scheduled to automatically fall at the end of 2025 to $5 million adjusted for inflation.
Individuals often estable trusts to mitigate or avoid the U.S. estate and gift tax. In order to effectively utilize a trust for estate and gift tax purposes, the trust typically cannot be classified as a “grantor trust.” A “grantor trust” is a term used in the Internal Revenue Code to describe any trust over which the grantor (or other owner) retains the power to control or direct the trust’s income or assets. The grantor typically will not be treated as the owner of a trust for federal tax purposes if all of the following are true:
1. Trust Is Irrevocable – A trust will be a grantor trust if the trust is revocable. See IRC Section 676.
2. Grantor and Grantor’s Spouse Have No Beneficial Interest – A trust will be wholly or partially a grantor trust if either the grantor of her spouse has a beneficial interest in the trust. See IRC Sections 673, 677(a)(1), 677(a)(2).
3. Trust Does Not Hold Life Insurance on Grantor or Spouse – A trust will be a grantor trust to the extent that premiums on life insurance held by the trust on the life of the grantor or her spouse can be paid from income from the trust. See IRC Section 677(a)(3).
4. Discretionary Distributions Are Limited in Specified Manner – As a general rule, a trust will be a grantor trust unless the trustee’s power to make distributions is limited in one of the following four ways.
a. No limitation for Trusts with Independent Trustees – The trustee can have full discretion regarding distributions if (1) neither the grantor nor her spouse can make any decisions regarding distributions and (2) a majority of the people who can make distribution decisions for the trust are not related or subordinate parties who are subservient to the wishes of the grantor or her spouse.
b. Ascertainable Standard Limitation for Trusts with Non-Independent Trustees – Provided that the grantor or her spouse is not the trustee, the distribution limitation requirement will be met if the trustee’s power to distribute income and principal among beneficiaries is limited by a reasonably definite standard, such health, support, maintenance, and education. See IRC Section 674(b)(5). Accordingly, a trust with a related or subordinate trustee who is subservient to the wishes of the grantor will meet the distribution limitation requirement if her power to distribute is limited by an ascertainable standard.
c. Special Rule for Separate Trusts – The distribution limitation requirement will be met, even if the grantor is the sole trustee, if: (1) the trust is a separate trust; (2) only one beneficiary is permitted to receive distributions during that beneficiary’s lifetime, unless that beneficiary consents to different distribution; and (3) either (a) the trust’s termination date is reasonably expected to occur during that beneficiary’s lifetime (e.g., a trust which terminates when the beneficiary is 35) See IRC Section 674(b)(5), 674(b)(6) or (b) the beneficiary has a limited power of appointment (i.e., a power to appoint the trust assets during her lifetime or at her death, or both, to any person she chooses, other than herself, her estate, her creditors, or the creditors of her estate).
d. Adverse Party Consent Required – The distribution requirement will be met, regardless of who is the trustee, if any distribution of trust assets can be made only with the consent of an adverse party. An “adverse” party is any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise of nonexercise of that power which she possesses respecting the trust.
5. No One Can Add Beneficiaries – As a general rule, a trust will be a grantor trust if anyone has the power to add to the trust beneficiaries, except to provide for after-born or after-adopted children. See IRC Sections 674(b)(5), 674(b)(6), 674(c), 674(d). A testamentary power of appointment does not violate this rule. A power to assign or appoint during lifetime does not violate this rule if the assignment or appointment would be adverse to the assignor or appointor.
6. Certain Administrative Powers Are Not Granted – As a general rule, a trust will be a grantor trust if certain administrative powers, as discussed below, exist with respect to the trust.
a. Power to Deal with the Trust for Less than Adequate Consideration – A trust will be a grantor trust if anyone can, without an adverse party’s consent, purchase, exchange, deal with, or dispose of the trust property for less than adequate consideration. See IRC Section 675(1).
b. Power to Make Certain Loans to Grantor or Her Spouse – A trust will be a grantor trust if anyone can, without an adverse party’s consent, lend trust assets to the grantor without adequate interest and security, unless a trustee (who is not the grantor or her spouse) is authorized to lend to any person without regard to interest or security and either (1) there is no such loan to the grantor or her spouse outstanding during the year or (2) all loans to the grantor outstanding during the year are made with adequate interest and security, and are made by a trustee who is not the grantor or a related or subordinate trustee who is subservient to the grantor. See IRC Section 675(2).
c. Other Prohibited Powers – A trust will be a grantor trust if anyone acting in a nonfiduciary capacity can do any of the following without the trustee’s approval: (1) vote the trust’s stock, if the trust’s and grantor’s position in the stock is significant from the viewpoint of voting control; (2) control or veto the trust’s investments, where the trust funds consist of securities of corporations in which the holdings of the grantor and the trust are significant from the viewpoint of voting control; or (3) reacquire trust assets by substituting assets of equivalent value.
7. No Disqualifying Replacement Powers Held by the Grantor – A trust will be a grantor trust if the grantor can remove and place the trustee in such a manner as to cause it to be a grantor trust under any of the above tests.
The Mechanics of an Intentionally Defective Grantor Trust
In some cases, a grantor trust, sometimes referred to as a “defective” trust or “intentionally defective grantor trust,” is used to plan for the gift and estate tax. “Defective” planning involves intentionally violating one of the above rules. A trust is usually made defective in one of the following ways:
Permit Grantor to Substitute Assets – The grantor is given a power (exercisable in a nonfiduciary capacity) to reacquire trust assets by substituting assets of equivalent value. See IRC Section 675(4)(C). This power is popularly used. The United States Tax Court has held, and the IRS has agreed, that the retention of this power will not cause inclusion in the grantor’s estate under Section 6038.
Permit Related or Subordinate Trustee to Make Discretionary Distributions – The trust will be defective if a trustee who is related or subordinate to the grantor, and subservient to the wishes of the grantor, can make discretionary distributions (that is, distributions which are not limited by a reasonably definite standard). See IRC Section 674(a).
Permit the Addition of a Beneficiary – The trust will be defective if a nonadverse party has the power to add a beneficiary, other than after-born or after adopted children. See IRC Section 672(c).
Defective Means to Defective Ends – Other ways of making a trust defective involve estate tax problems – such as, retaining a reversionary interest worth more than five percent, retaining a power to revoke, or retaining a beneficial interest. See IRC Sections 677, 2036.
In short, the establishment of an IDGT requires the satisfaction of contradictory concerns. On the one hand, the grantor must give up dominion and control over the assets transferred to an IDGT to avoid inclusion of the trust’s property in his or her gross estate for purposes of the estate tax. On the other hand, the grantor, whether acting alone or through a trustee, must retain one or more powers over the IDGT to trigger grantor trust status.
In order to avoid inclusion of the trust’s assets in the grantor’s gross estate for purposes of the estate tax, the grantor, at a minimum, must not have the power to revoke or amend the trust, or have the power to change the interests of the trust’s beneficiaries. The grantor should also avoid retaining any beneficial interest in the trust, and the grantor cannot have the right to use the trust’s property to discharge his or her legal obligations.
For trust drafting purposes, an IDGT could potentially include the following provisions in the trust instrument:
1. A statement of intent to the effect that the individual establishing the trust, is the grantor of the trust, and the trust is intended to be a Grantor Trust under Sections 671-678 of the Internal Revenue Code and that the trust should not be included in the settlor’s or grantor’s estate under Sections 2036-2038 of the Internal Revenue Code.
2. A provision to make the trust “defective” under Section 6754(4)(C) of the Internal Revenue Code, such as “The Grantor shall have the right, at any time exercisable in a non-fiduciary capacity, without the approval or consent of any person acting in a fiduciary capacity, to acquire any property then held in trust by substituting other property of an equivalent value on the date of substitution, pursuant to Internal Revenue Code Section 675(4)(C); provided that in the event of the exercise of this power of substitution, the Grantor shall certify in writing to the Trustee that any substituted property is of equivalent value to the property previously held in the Trust for which it is substituted.
3. A provision in the trust that does not provide for powers such as:
A. The grantor shall not have any right to demand that the trust pay her income taxes or reimburse her for the taxes paid on the income earned by the trust.
B. The grantor should not have the right or power to utilize the assets of the trust to satisfy any legal obligation of the Grantor.
C. The assets of the trust shall not be available to satisfy the claims of any creditor of the grantor.
Escape Hatch
It may be possible to draft an IDGT with a provision that contains an “escape hatch” which enables the trust to cease being a defective trust during your lifetime. This will involve releasing powers which cause the trust to have defective status and having the trustee resign.
Funding the Trust
There are two ways in which to fund an IDGT. The simpler method is for the grantor to transfer property by gift to the IDGT. Like any other gift, the property is “frozen” for estate tax purposes, such that its future growth will not be included in the grantor’s gross estate. The gifted property’s value as of the transfer date is applied against the grantor’s lifetime gift and estate tax exemption. See IRC Sections 2502(a) and 2505(a).
In many cases, grantors would like to give partial interests of real property to an IDGT.
In such cases, it may be possible to obtain a discount on the value of the assets transferred to the IDGT. Valuation discounts are of paramount importance in the final determination of the fair market value of assets transferred to a trust for purposes of determining gift tax.
Since a grantor’s gift tax liability associated with the transfer of assets to an IDGT is based upon the fair market value of the assets at the time of transfer, it is extremely important that such assets are assigned accurate values, including appropriate valuation discounts. For federal gift tax purposes, Treasury Regulation Sections 20.2031-1(b) and 25.2512-1 define the fair market value standard as “the price at which the property would change hands between a hypothetical willing buyer and hypothetical willing seller, neither being under compulsion to buy or sell, and both having reasonable knowledge of the relevant facts.”
Although the goal in valuation for federal gift tax purposes is an objective determination of the value of the assets transferred, the hypothetical willing buyer/seller standard necessarily results in a subjective analysis in which analogies, methodology, and expert opinion play a major role.
For purposes of the federal wealth transfer tax system, a “valuation discount” is not really a discount in the sense that the taxpayer is receiving a bargain at the expense of the government. Rather, the valuation discount is an appropriate factor in determining the fair market value of an asset. A valuation discount can be thought of as one or more factors that a hypothetical willing buyer would consider in determining a fair price to pay for an asset that is includible in a decedent’s estate. That is, if certain factors exist that would affect the hypothetical buyer’s use and enjoyment of such an asset, the hypothetical willing buyer would demand some sort of discount to compensate him for purchasing such an asset. A valuation discount can be contrasted with a valuation “premium.” That is, if one or more factors exist that would enhance a hypothetical buyer’s use and enjoyment of an asset, the hypothetical seller would demand an increased purchase price. An example of such a premium is a control premium for a majority interest in a business price. Theoretically, the fair market value of a controlling interest in a business is greater than the net asset value of the business represented by the shares of stock. This is so because an individual with a controlling interest in a business may direct the day-to-day affairs of the business.
If a grantor transfers a fractional interest in real property to an IDGT, it may be possible to obtain a significant discount to take into consideration the “lack of control” of the real property being transferred to the IDGT. In order to determine the valuation discount that may be applicable to any property a grantor wishes to transfer to the IDGT, a qualified real estate appraiser should be consulted.
In the case of property transferred to the IDGT by gift, that property receives a “carryover” basis – i.e., a basis equal to the grantor’s basis in the property.
The other method of funding an IDGT is an installment sale where the grantor can sell the fractional interest in the real properties or any other assets the grantor wishes to contribute to the IDGT in exchange for a promissory note. To avoid a gift tax, the note should bear an adequate interest rate when the note is executed. See IRC Section 1274. The use of an IDGT raises the possibility that the grantor will be treated as having retained an interest in the trust for purposes of estate tax. If the grantor is treated as having retained an interest in the IDGT, the trust assets of the IDGT will be included in his or her estate for estate tax purposes. This issue may be resolved by prefunding the IDGT before notes are executed. A grantor may prefund an IDGT with meaningful assets to support the position that the trust has economic substance independent of the sale (i.e., the trust has sufficient assets that it can repay the loan). The seed money can be transferred through gifts to the trust, or a guarantee. The IRS has indicated such funding should equal or exceed ten percent of the purchase price of the asset being acquired through an installment sale. With that said, there is some authority holding that the grantor could recognize taxable gain on the installment note on death when an IDGT trust ceases to be a grantor trust. One possible solution is for you to utilize Self-Canceling Installment Notes (or “SCINs”).
SCINs are a technique that is sometimes used to avoid the inclusion of a note receivable in the holder’s estate. See IRC Section 453B(f). For example, let’s assume that Dad sells Blackacre 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 Blackacre would have had 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. The buyer may pay a premium for the property to be sure that the original sale is not a partial gift. See IRC Section 7822. A SCIN is not generally includable in the seller’s estate. The trust’s basis in the property transferred to it through a note or SCIN remains the same as your basis in the property. For income tax purposes, SCINs are subject to the installment sales rules. Although these rules are complex, the general rule is that the interest rate on the installment sale note must at least equal the appropriate applicable federal rate with semiannual compounding. As an alternative to paying a premium on the value of property being transferred through a SCIN, the “borrower” may pay a premium interest rate.
In regards to a higher interest rate, there is no exact formula provided by the Internal Revenue Code, its regulations, or case law. Theoretically, some appropriately weighted combination of principal risk premium and interest risk would likely be acceptable to the IRS. A weighted combination risk premium may be determined using the following two-step formula:
1) Start with a principal risk premium and interest rate risk premium using the appropriate market rate of interest. The risk premium is the rate of return on an investment over and above the risk-free or guaranteed rate of return. To calculate risk premium, a hypothetical calculation must first calculate the estimated return and the risk-free rate of return. The estimated return, or the expected return refers to the amount of profit that the investor expects from a particular investment. The estimated return is a projection and is not a guaranteed return. Investors can calculate the estimated return by multiplying the potential outcomes by the percent chance of them occurring and those calculations together. The risk-free rate is the rate of return on an investment when there is no chance of financial loss.
2) An interest rate risk must be selected somewhere between the market rate and the risk-premium-adjusted interest rate computed. The estimated return on a risk-free investment is equal to the risk premium. For example, if the estimated return on a risky investment is 10.62 percent (High Yield Corporate Bond) and the risk-free rate is 2.51 percent (ten year Muni Bond Yield), then the risk premium is 8.11 percent.
This does not mean the interest rate on a SCIN is 8.11 percent. A number of factors are considered in determining the interest rate premium for a SCIN. The age of the Lender is a significant factor in determining the interest rate of a SCIN. For purposes of determining the interest rate of the SCIN, Your age may result in a significant reduction of the interest rate. If the Borrower has excellent credit and strong future earning potential, the interest rate can be further discounted.
Conclusion
The IDGT is “effective” for gift and estate tax purposes because it excludes the assets in the IDGT from your gross estate for estate tax purposes, but “defective” for income tax purposes because the grantor is treated as owning the trust’s assets for income tax purposes.
The first step to creating an IDGT is to identify the assets that the grantor would like to contribute to the trust. Once the assets are identified, it will be necessary to have the assets professionally appraised. After the trust is created and a trustee is selected, the grantor should make a gift to the IDGT equal in value to 10 percent of the value of the property you plan to transfer to the trust through either an installment note of SCIN. This gives the sale transaction substance and prevents the grantor from having a retained equity interest in the IDGT, which could cause its value to be included in the grantor’s gross estate for estate tax purposes if the grantor died before the terms of the installment notes are completed. Next, the grantor would sell your real estate assets to the IDGT in exchange for promissory notes. Each note would pay the grantor interest each year calculated by multiplying the outstanding principal value by the AFR in effect when the note was issued.
Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
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.