Wealth Transfer Planning - An Overview of Intentionally Defective Grantor Trusts
Under federal law in 2015, the estate, gift and generation-skipping transfer tax "exemptions" (i.e., the amount that can be transferred by an individual tax-free under any of these tax regimes) are "unified" at a historically high level of $5.43 million. As a result, most Americans will never have to pay a federal estate, gift, or generation-skipping transfer tax. Affluent individuals, however, will pay a top tax rate of forty percent (40%) on any amounts transferred in excess of $5.43 million ($10.86 million combined for married couples). For these individuals, an "Intentionally Defective Grantor Trust" or "IDGT" can be used to achieve potentially significant tax savings.
An IDGT is an irrevocable trust designed to accomplish wealth transfer objectives by freezing the value of an individual’s estate for federal estate tax purposes and moving future appreciation of assets out of the individual’s taxable estate. The creator of the IDGT (the "Grantor") typically names his or her descendants as beneficiaries of the IDGT. The IDGT may be structured as a dynasty trust that is designed to transfer assets from generation to generation of descendants, potentially into perpetuity, without incurring additional federal estate or generation-skipping transfer taxes as those assets pass from one generation to the next.
In order to fully understand how powerful an IDGT can be, an understanding of federal gift, estate, and generation-skipping transfer tax is necessary. In simplified terms, the "gift tax" applies to transfers (i.e., gifts) of assets made by a transferor during life to someone other than a spouse. Similarly, the "estate tax" applies to transfers of assets made by a decedent at death to someone other than a spouse. An additional tax, referred to as the "generation-skipping transfer" or "GST" tax, applies to transfers of assets made by a transferor during life or at death to individuals who are in a generation two or more below that of the transferor. Under current law, individuals are granted an exemption (i.e., a tax-free amount) of $5.43 million for each of these taxes. Furthermore, these exemptions are unified, meaning that any use of the gift tax exemption, for example, would reduce the estate tax exemption available at death on a dollar-for-dollar basis. In other words, each individual only gets one $5.43 million exemption for gift and estate tax purposes, regardless of whether it is used during life or at death. For transfers in excess of the exemption, the top tax rate that would apply is forty percent (40%).
The "sale to an IDGT" technique involves two separate and distinct transactions. In the first transaction (the "Gift Transaction"), the Grantor makes an initial transfer of assets to the IDGT, with the value of the transferred assets not exceeding the Grantor’s remaining gift tax exemption (current maximum of $5.43 million). The initial transfer of assets to the IDGT is considered a gift for federal gift tax purposes, but so long as the Grantor does not exceed the remaining lifetime gift tax exemption available to the Grantor, then the Grantor will simply utilize some or all of such exemption to avoid actually paying a federal gift tax on the transfer.
In the second transaction (the "Sale Transaction"), the Grantor sells additional assets to the IDGT in exchange for a promissory note. The promissory note generally calls for repayment of the purchase price over a nine year period, with interest accruing at a very low rate, set by the Internal Revenue Service, called the Applicable Federal Rate. The payment schedule of the promissory note provides for annual payments of interest and a balloon payment of the outstanding balance at the end of the nine year term. The assets of the IDGT that are not used to repay the promissory note (and all growth and appreciation of such assets) pass to the beneficiaries of the IDGT (usually the Grantor’s descendants). By exchanging the Grantor’s appreciating and/or income-producing assets for a promissory note accruing interest at a low, fixed rate of interest, the Grantor is able to "freeze" the value of the Grantor’s estate and move all future appreciation on, and income generated by, the gifted / sold assets out of the Grantor’s estate for federal estate tax purposes.
The assets transferred to the IDGT in both the Gift Transaction and the Sale Transaction typically consist of appreciating and/or income-producing assets. The value of the assets transferred into the IDGT is often discounted for federal gift tax purposes, reflecting "lack of marketability" and/or "lack of control" characteristics of the transferred assets. For example, nonvoting stock of a closely-held business is routinely discounted in value when gifted because it cannot readily be sold by the donee (i.e., there is no readily-available market for sale of stock in a closely-held business) and because it offers the donee no control over the business (i.e., because it is nonvoting stock). The advantage of using assets with discounted values in connection with an IDGT is that the Grantor is able to gift more value to the beneficiaries than is actually reflected for federal gift tax purposes. In other words, the Grantor is able to leverage the wealth transfer capabilities of the IDGT.
The "grantor trust" aspect of an Intentionally Defective Grantor Trust is actually a reference to an income tax feature of the trust, whereby the Grantor pays all income tax associated with the income generated by the assets held within the IDGT. The Grantor’s payment of the income tax is not considered an additional gift to the beneficiaries of the IDGT, and by having the Grantor pay the income tax instead of the IDGT or its beneficiaries, the wealth transfer effects of the IDGT are enhanced and the Grantor’s taxable estate is further diminished for estate tax purposes. The IDGT can be structured to allow the grantor trust status to be turned-off if it becomes desirable to shift income taxation from the Grantor to the IDGT and/or its beneficiaries in the future. Though the IDGT is a grantor trust, transfers of assets between the Grantor and the IDGT (e.g., as part of the Gift Transaction, the Sale Transaction and/or the repayment of the promissory note) trigger no income tax consequences for either the Grantor or the IDGT.
If you wish to discuss whether an IDGT may be appropriate for you, please feel free to contact one of the attorneys in our Estate and Business Succession Planning Practice Group.
by Brandon D. Hamm and Claire M. Osborne