by James Huang
A popular estate planning vehicle for transferring wealth to descendants during one’s lifetime is the “intentionally defective grantor trust” (IDGT), also referred to as an “intentionally defective irrevocable trust” (IDIT). Through this type of irrevocable trust, transferors can significantly increase the amount they shield from estate tax upon their deaths. This increase is achieved by virtue of how a trust can simultaneously exist, or not exist, depending on which tax perspective one takes in viewing it. In the case of IDGTs, transfers between the trust and the person (or grantor) who creates it are respected for gift and estate tax purposes, but disregarded for income tax purposes.
Income Tax Payments
When a grantor transfers property to an IDGT, the grantor “freezes” that property’s transfer date value for estate tax purposes. As a result of this freezing, all future growth on that property, whether due to earnings or capital appreciation, in excess of the frozen value will be excluded from the grantor’s gross estate and, thus, will not be subject to estate tax upon the grantor’s death. Admittedly, the same “freeze” can be achieved by gifting the property directly to the intended beneficiaries. But what distinguishes IDGTs from this approach is that, by transferring the property to an IDGT, the grantor can increase the amount passed to beneficiaries without any adverse gift or estate tax consequences.
This increase is achieved by the grantor paying the income taxes owed on the property while it is in the IDGT. Making these payments out of their own funds, the grantor enables the property to grow in the IDGT without any reduction for income taxes that would have been payable by the trust if it were not an IDGT. In Revenue Ruling 2004-64, the Internal Revenue Service (IRS) confirmed that these income tax payments are not indirect gifts by the grantor. Because the IDGT is a “grantor trust,” its property is treated for income tax purposes as still owned by the grantor, who remains liable for the income taxes due on such property. IRC § 671. Accordingly, any taxes paid by the grantor on such property’s income cannot be gifts since the grantor is discharging their own obligation to make such payments.
Aside from increasing the return earned by IDGTs, income tax payments by the grantor have two key additional benefits. First, the payments themselves further shrink the grantor’s gross estate. Second, the income tax liability imposed on the grantor may be less than what would have been imposed on the trust if it were not an IDGT and, instead, were treated as a separate taxpayer. This is because the income tax brackets for trusts are more compressed than those for individuals. For 2019, the top marginal tax rate of 37% applies to income exceeding $12,750 for trusts, but $510,300 for unmarried individuals.
Each IDGT requires the satisfaction of contradictory concerns. On the one hand, the grantor must give up dominion and control over the IDGT to avoid inclusion of the trust’s property in the grantor’s gross estate. IRC §§ 2036–2042. On the other hand, the grantor, whether acting alone or through the trustee, must retain one or more powers over the IDGT to trigger grantor trust status. IRC §§ 673–677.
In order to avoid inclusion in the grantor’s gross estate, 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 avoid retaining any beneficial interest in the trust, and cannot have the right to use the trust’s property to discharge the grantor’s legal obligations. Moreover, IDGTs typically have trustees who are independent third parties to further separate the trust from the grantor. In this regard, some IDGTs expressly prohibit the grantor, or anyone related or subordinate to the grantor, from ever becoming a trustee. Rev. Rul. 2008-22; see Rev. Rul. 95-58.
In order to trigger grantor trust status, one of the more frequently used methods (or “grantor trust defects”) is to give the grantor the power to reacquire the IDGT’s assets by substituting assets of equivalent value. IRC § 675(4)(C). The IRS specifically blessed this power in Revenue Ruling 2008-22, holding that, in cases where the grantor can exercise the substitution power in a non-fiduciary capacity, there would be no gross estate inclusion so long as the trustee has a fiduciary obligation to ensure compliance with the terms of the trust (e.g., the exchanged assets are in fact of equivalent value), and the power cannot be used to shift benefits among the trust’s beneficiaries. See also Rev. Rul. 2011-28. An additional reason for this power’s popularity is that it offers a way to adjust the composition of assets in the IDGT as needs and circumstances change.
Another often used grantor trust trigger is to give the trustee the power to make loans to the grantor without adequate security. IRC § 675(2). Although the tax code provision also allows loans without adequate interest, the practice is to require such loans to bear interest at or above the “applicable federal rate” (AFR), a benchmark rate published monthly by the IRS. See IRC §§ 7872(f)(2) and 1274(d). This is to avoid having any foregone interest on the loan treated as a gift to the grantor. Other common grantor trust triggers include giving the trustee the power to add beneficiaries who are not the grantor’s after-born or after-adopted children (IRC § 674(a) and (c)), giving the trustee the power to distribute or accumulate income for the benefit of the grantor’s spouse (IRC § 677(a)(1)–(2)), and giving the trustee the power to use income to pay premiums on life insurance policies on the grantor or their spouse (IRC § 677(a)(3)).
Funding by Gift
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. IRC §§ 2502(a) and 2505(a). If the lifetime exemption (to the extent unused), is insufficient to cover the gifted property’s value, the grantor will be liable for gift tax. Moreover, if the gift tax is paid within three years prior to the grantor’s death, the amount of the gift tax paid will be added back to the grantor’s gross estate. IRC § 2035(b).
The 2017 Tax Cuts and Jobs Act (TCJA) doubled the basic exclusion amount (a component of the lifetime exemption), increasing it to $11.58 million for 2020. Funding IDGTs by gift may allow grantors to take full advantage of this increased amount before it reverts back down to its pre-TCJA levels in 2026. In November 2019, the IRS issued final regulations confirming that gifts sheltered from gift tax due to the increased basic exclusion amount under TCJA will not have those benefits “clawed back” if that amount is lower after TCJA ends. 84 Fed. Reg. 64,995 (Nov. 26, 2019).
If the IDGT is structured to give limited withdrawal rights (i.e., Crummey powers) to the beneficiaries, the grantor can also use the beneficiaries’ respective annual gift tax exclusions to reduce the transfer value of the gifted property. While there is some concern that these withdrawal rights may cause the grantor to lose their status as sole income tax owner of the IDGT, the IRS has issued private letter rulings indicating otherwise. See, e.g., PLR 200606006 and PLR 201235006. These private rulings, however, may not be relied upon as precedents.
For income tax purposes, the transfer of property by gift to an IDGT should not be a taxable event and should be ignored. See Rev. Rul. 85-13. Nonetheless in order to avoid any income tax liability that may be triggered in connection with the transfer, including later (whether due to the grantor’s death or otherwise), the property transferred should not secure any third-party debt (e.g., a mortgage) that exceeds the grantor’s basis in that property.
Funding by Installment Sale
The other method of funding an IDGT is an installment sale where the grantor sells the property to the IDGT in exchange for a promissory note evidencing a borrowing of the property’s purchase price by the IDGT. Through this exchange, the property’s sale date value is frozen for estate tax purposes at the face amount of the note received by the grantor. The note, together with all payments later received by the grantor on the note, will be included in the grantor’s gross estate, but the transferred property and all its future growth (net of interest paid by the IDGT on the note) will not.
For income tax purposes, the sale of property to an IDGT is disregarded and does not trigger any capital gain or loss for the grantor. The basis of the transferred property remains unchanged as well. In Revenue Ruling 85-13, the IRS held that all exchanges between a grantor and a grantor trust are not taxable events since the trust does not exist as a separate taxpayer from the grantor under the grantor trust rules.
Unless an IDGT has significant assets of its own beforehand, installment sales are typically preceded by a taxable gift in which the grantor “seeds” the IDGT with cash and marketable securities equal to at least 10% of the purchase price. This seeding gift is to support the argument that the IDGT is a creditworthy borrower and has resources — other than the property being acquired in exchange for the promissory note — from which to make payments on the note. It is critical that the note evidence a bona fide debt incurred in an arm’s-length transaction, free of donative intent. Otherwise, the note may represent a disguised equity interest. If the note is recharacterized as equity, the grantor would be treated as having retained a life interest in the IDGT, causing the trust and all its property to be included in the grantor’s gross estate. IRC § 2036(a). In addition, the exchange itself may be treated as a gift of the entire fair market value of the property purported to be sold. IRC § 2702.
To make the promissory note more like debt — and less like equity — the note should have a fixed maturity date (no more than nine years) and its payments should be made at regular intervals (no less frequently than annually). Payments on the note must not be contingent or based on the performance of the IDGT’s property. The IDGT’s obligations under the note should be secured by the trust’s property. To avoid recharacterization as a gift, the note must bear interest at or above the relevant AFR for the note’s term. If the note is treated as bona fide debt, interest paid on it to the grantor will not be subject to income tax due to the IDGT’s grantor trust status and will alleviate some of the grantor’s income tax burden on the transferred assets. However, the interest paid will be includible in the grantor’s gross estate and thereby reduce the amount originally frozen for estate tax purposes.
Although installment sales typically provide for amortizing principal payments by the borrower, promissory notes issued by IDGTs can be structured as balloon notes where no principal is due until the maturity date. Balloon notes allow the IDGT to make full use of the grantor’s principal to maximize the growth of the IDGT’s assets before having to return any principal to the grantor. If coupled with provisions permitting principal to be “paid in kind” (PIK), balloon notes can even be “rolled” into newly issued balloon notes, extending the time period even further. Balloon notes, especially those with PIK provisions, risk recharacterization as equity (and the transfer as a gift) by the IRS.
Through installment sales, grantors can transfer assets to IDGTs without any gift tax implications. Except for the initial seeding gift, a properly structured installment sale does not deplete the grantor’s lifetime exemption — though some grantors may prefer to use up the increased basic exclusion amount under TCJA before it sunsets in 2026. For grantors who have exhausted their lifetime exemptions, installment sales have the benefit of avoiding gift tax liability — though some liability will ultimately be imposed on their estates in the form of estate tax on the promissory note and its proceeds.
Depending on the type of property that is transferred, valuation discounts may be available to reduce the property’s transfer value, further enhancing the returns on the IDGT’s property passing free of estate tax to beneficiaries. These discounts can also reduce any gift tax payable by the grantor and reduce the interest payable on the promissory note. Valuation discounts typically apply to ownership interests in a closely held entity, such as a family business. As is often the case, a discount for “lack of control” is applicable to these interests because their terms restrict their holders’ ability to manage the entity, or the size of the interests transferred is not large enough to give control to their holders. A discount for “lack of marketability” is also often applicable because the interests lack a ready market and are subject to express transfer restrictions. Discounts due to lack of control and lack of marketability have been combined to lower the value of transferred interests by as much as 40%.
Given the large windfall attainable with these two discounts, some estate plans have aggressively sought to use them. A grantor would contribute marketable securities to a pass-through entity (e.g., a limited partnership or LLC) and then transfer a minority ownership interest in that entity to the IDGT. In so doing, the grantor converts marketable securities, for which no valuation discount can be claimed, into illiquid, minority interests, for which discounts can be claimed. These plans have invited scrutiny by the IRS, especially if the discounts claimed are substantial. Indeed, the IRS issued proposed regulations in 2016 to curb the use of valuation discounts, but decided to withdraw them one year later. 82 Fed. Reg. 48,779 (Oct. 20, 2017).
In the case of property transferred to a trust by gift, that property receives a “carryover” basis — i.e., a basis equal to the grantor’s basis, as adjusted for any gift tax paid by the grantor and to remove any capital loss unrealized by the grantor. IRC § 1015. In the case of a transfer by sale, the basis remains the same as the grantor’s basis because the sale is disregarded for income tax purposes. Rev. Rul. 85-13. There is, however, some uncertainty over what happens to the basis when the grantor dies. The uncertainty relates to whether the basis gets stepped up (or down) to equal the property’s then current fair market value under IRC Section 1014, even though the property is not includible in the grantor’s gross estate. For several years now, the IRS has been working on guidance addressing this topic and, in 2015, declared a moratorium on issuing any private letter rulings on the topic until such guidance is completed. Rev. Proc. 2015-37 and the 2019–2020 Priority Guidance Plan published by the U.S. Treasury on Oct. 8, 2019.
Several commentators argue that there should be a stepped-up basis upon the grantor’s death, offering various theories for their position. Nonetheless, many practitioners, taking a more conservative view, think otherwise and believe the basis should not be affected by the grantor’s death and would remain what it was before the event. In the absence of any IRS guidance, as well as any reported case law directly on point, the practice has been for the grantor to periodically exercise, if available, their substitution power under IRC Section 675(4)(C). Using this power, the grantor would replace lower-basis assets in the IDGT with higher-basis assets of equivalent value. The lower-basis assets reacquired by the grantor would be included in their gross estate and receive a step-up in basis upon the grantor’s death, while the higher-basis assets in the IDGT would result in smaller gains subject to income tax. Alternatively, the grantor can also opt to purchase the lower-basis assets from the IDGT for cash.
IDGTs are powerful estate planning tools. As with any such tool, they require careful tailoring to meet the financial situation and planning goals of their grantors. While IDGTs may not be suitable for every individual — e.g., they would not be suitable for individuals facing liquidity issues from the continuing obligation to pay income taxes out of their own funds — IDGTs remain an attractive and viable option for maximizing wealth transfers.
James Huang is a New York-licensed attorney who associates with Diosdi Ching & Liu, LLP on certain matters. He can be reached at (212) 633-7822.
This article is for informational purposes only. It is not legal or tax advice, and does not create or continue an attorney-client relationship. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.