The “Intentionally Defective” Grantor Trust
Note: This is an advanced topic. It is included as I have not found it unusual to work with people who, although they are “retired”, still maintain business interests of high value. But please understand that this information is provided as an overview of this planning technique. I am not an attorney. I do not practice law. If this seems like something that would apply to your situation, you need to make a beeline to an estate planning attorney.
That being said, here are some of the large estate owner’s problems…
Usually, assets are owned that are appreciating in value. Before these assets can be passed to children and/or grandchildren, they are subject to heavy estate tax shrinkage if the estate exceeds the amount that can be transferred free of income tax. Consequently, good planning dictates eliminating these assets from estate taxation.
However, these assets normally are generating significant income that the estate owner does not want to give up. If the highly appreciating asset is a business interest, control may not want to be lost or given away. Secondly, the gift tax cost of giving these assets away may be prohibitive.
Modest gifts can be covered with the annual gift tax exclusions ($12,000 per year per recipient for an individual and $24,000 per year for each recipient for a married couple) and the unified credit ($2,000,000 per individual for 2007 and 2008). But when these limits are exceeded, gift taxes on transfers are currently set a 45%.
For the estate owner who has rapidly appreciating assets, the use of these limiting techniques is like “bailing out a boat with a spoon”.
If the rapidly appreciating asset is a business interest, the problem is transferring control, eliminating friction with other stockholders who may not take kindly with having to deal with shareholders who are not an active part of the business and converting an illiquid asset (and one which may produce little or no income) to money that can be used to support living expenses for spouses and subsequent generations.
The traditional solution is a buy-sell agreement funded with life insurance. However, often the asset is growing so quickly in value that insuring the value is like a dog chasing its tail. Additional insurance continually needs to added at an increasing cost and often in the midst of insurability problems.
Enter the intentionally defective grantor trust (IDGT).
An intentionally defective grantor trust is an estate freeze technique that removes appreciating assets from the taxable estate.
How does an IDGT work?
Instead of making gifts, assets are sold to a special kind of trust (IDGT). There is no tax on the sale of the property to the IDGT. Even if the asset has a very low cost basis, there is no capital gain tax.
The sale is in exchange for a promissory note. The note is often structured as interest only to the grantor-seller with a balloon principal payment at the end of the note’s term. This allows maximum growth and leverage within the IDGT for future generations. However, other payment terms are possible as well.
Life insurance is typically used to repay the note at the seller’s death, to recover the cost of repayment if the note was repaid during the seller’s life or to fund any estate taxes due.
Before the sale, appropriate discounts for lack of marketability and control can be taken to leverage the transaction for the trust beneficiaries’ benefit. This is accomplished by restructuring the asset into an entity such as a family limited partnership. For example, if assets of $10 million are targeted to use in the plan, and if the valuation discount is 40%, then the sale is in exchange for a promissory note in the amount of $6 million.
Thus, $4 million has been moved to the trust beneficiaries that will never be exposed to estate taxation through the use of a valuation discounting leveraging technique. Note that the trust will earn interest on the full $10 million.
The estate has been “frozen” at the value of the note, as only the value of the note is included in the grantor-seller’s estate. All future appreciation is immediately excluded from the seller’s estate and accrues to the benefit of the trust beneficiaries.
For the estate owner who wants to retain control of a business entity, the property sold to the trust can be an interest that is not entitled to vote. Examples are nonvoting stock in a C or S corporation or a nonvoting interest in a limited liability company or family limited partnership.
Flexibility of the IDGT is demonstrated and particularly favorable results for the trust beneficiaries occur when the business is eventually sold to a competitor or goes public. If valuation discounts are planned for and taken prior to the sale of the business interest to the IDGT, the instant growth that would occur in a public offering would avoid estate transfer taxation.
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