Using An IDGT For Wealth Transfer and Business Succession

Overview

For many people, the federal estate tax is not a concern.  But, for a farming operation, other small business operation, and high-wealth individuals, it is.  If a goal is transferring business interests and/or investment wealth to a successive generation, one aspect of the estate plan might involve the use of an Intentionally Defective Grantor Trust (IDGT).  The IDGT allows the grantor to “freeze” the value of the transferred assets while simultaneously providing the grantor with a cash flow stream for a specified time period.  

Today’s post looks at the use of the IDGT for transferring asset values from one generation to the next in a tax-efficient manner

What Is An IDGT?

An IDGT is a specially designed irrevocable grantor trust that is designed to avoid any retained interests or powers in the grantor that would result in the inclusion of the trust’s assets in the grantor’s gross estate upon the grantor’s death.  For federal income tax purposes, the trust is designed to be a grantor trust under I.R.C. §671.  That means that the grantor (or a third party) retains certain powers causing the trust to be treated as a grantor trust for income tax purposes.  However, those retained powers do not cause the trust assets to be included in the grantor’s estate.    Thus, a sale (or other transaction) between the trust and the grantor are not income tax events, and the trust’s income, losses, deductions and credits are reported by the grantor on the grantor’s individual income tax return.

This is what makes the trust “defective.”   The seller (grantor) and the trust are treated as the same taxpayer for income tax purposes.  However, an IDGT is defective for income tax purposes only - the trust and transfers to the trust are respected for federal estate and gift tax purposes.  The result is that the grantor does not have gain on the sale of the assets to the trust, is not taxed on the interest payments received from the trust, has no capital gain if the note payments are paid to the grantor in-kind, and the trust is an eligible S corporation shareholder.  See, e.g., Rev. Rul. 85-13, 1985-1 C.B. 184; I.R.C. §1361(c)(2)(A).

How Does An IDGT Transaction Work?

The IDGT technique involves the grantor selling highly-appreciating or high income-producing assets to the IDGT for fair market value in exchange for an installment note.  The grantor should make an initial “seed” gift of at least 10 percent of the total transfer value to the trust so that the trust has sufficient capital to make its payments to the grantor.  The IDGT transaction is structured so that a completed gift occurs for gift tax purposes, with no resulting income tax consequences.  Because the transfer is a completed gift, the trust receives a carryover basis in the gifted assets.

The trust language should be carefully drafted to provide the grantor with sufficient retained control over the trust to trigger the grantor trust rules for income tax purposes, but insufficient control to cause inclusion in the grantor’s estate.  It’s a popular estate planning technique for shifting large amounts of wealth to heirs and creating estate tax benefits because the value of the assets that the grantor transfers to the trust exceeds the value of the assets that are included in the grantor’s estate at death.  This is why an IDGT is generally viewed as an “estate freeze” technique.

What about the note?  Interest on the installment note is set at the Applicable Federal Rate for the month of the transfer that represents the length of the note’s term.  The installment note can call for interest-only payments for a period of time and a balloon payment at the end, or it may require interest and principal payments.   Given the current low interest rates, it is reasonable for the grantor to expect to receive a total return on the IDGT assets that exceeds the rate of interest.  Indeed, if the income/growth rate on the assets sold to the IDGT is greater than the interest rate on the installment note taken back by the grantor, the “excess” growth/income is passed on to the trust beneficiaries free of any gift, estate and/or Generation Skipping Transfer Tax (GSTT).

The IDGT technique became popular after the IRS issued a favorable letter ruling in 1995 that took the position that I.R.C. §2701 would not apply because a debt instrument is not an applicable retained interest. Priv. Ltr. Rul. 9535026 (May 31, 1995).  I.R.C. §2701 applies to transfers of interests in a corporation or a partnership to a family member if the transferor or family member holds and “applicable retained interest” in the entity immediately after the transfer.  However, an “applicable retained interest” is not a creditor interest in bona fide debt.   The IRS, in the same letter ruling also stated that a debt instrument is not a term interest, which meant that I.R.C. §2702 would not apply.  If the seller transfers a remainder interest in assets to a trust and retains a term equity interest in the income, I.R.C. §2702 applies which results in a taxable gift of the full value of the property sold.  For instance, a sale in return for an interest only note with a balloon payment at the end of the term would result in a payment stream that would not be a qualified annuity interest because the last payment would represent an increase of more than 120 percent over the amount of the previous payments.  For a good article on this point see Hatcher and Manigualt, “Using Beneficiary Guarantees in Defective Grantor Trusts,” 92 Journal of Taxation 152 (Mar. 2000).

Pros and Cons of IDGTs

An IDGT has the effect of freezing the value of the appreciation on assets that are sold to it in the grantor’s estate at the low interest rate on the installment note payable.  Additionally, as previously noted, there are no capital gain taxes due on the installment note, and the income on the installment note is not taxable to the grantor.  Because the grantor pays the income tax on the trust income, that has the effect of leaving more assets in the IDGT for the remainder beneficiaries.  Likewise, valuation adjustments (discounts) increase the effectiveness of the sale for estate tax purposes. 

On the downside, if the grantor dies during the term of the installment note, the note is included in the grantor’s estate.  Also, there is no stepped-up basis in trust-owned assets upon the grantor’s death.  Because trust income is taxable to the grantor during the grantor’s life, the grantor could experience a cash flow problem if the grantor does not earn sufficient income.  In addition, there is possible gift and estate tax exposure if insufficient assets are used to fund the trust.  

Proper Structuring of the Sale to the IDGT

A key point is that the installment note must constitute bona fide debt.  That is the crucial aspect of the IDGT transaction from an income tax and estate planning or business succession standpoint.  If the debt amounts to an equity interest, then I.R.C. §§2701-2702 apply and a large gift taxable gift could be created or the transferred assets will end up being included in the grantor’s estate.  In Karmazin v. Comr., T.C. Docket No. 2127-03 (2003), the IRS took the position that I.R.C. §§2701 and 2702 applied to the sale of limited partnership interests to a trust which would cause them to have no value for federal gift tax purposes on the theory that the notes the grantor received were equity instead of debt.  The case was settled before trial on terms favorable to the taxpayer with the parties agreeing that neither I.R.C. §2701 or I.R.C. §2702 applied.  However, IRS resurrected the same arguments in Estate of Woelbing v. Comr., T.C. Docket No. 30261-13 (filed Dec. 26, 2013).  The parties settled the case before trial with a stipulated decision entered on Mar. 25, 2016 that resulted in no additional gift or estate tax.  The total amount of the gift tax, estate tax, and penalties at issue was $152 million. 

Another concern is that I.R.C. §2036 causes inclusion in the grantor’s estate of property the grantor transfers during life for less than adequate and full consideration if the grantor retained for life the possession or enjoyment of the transferred property or the right to the income from the property, or retained the right to designate the persons who shall possess or enjoy the property or the income from it.  But, again, in the context of an IDGT, if the installment note represents bona fide debt, the grantor does not retain any interest in the property transferred to the IDGT and the transferred property is not included in the grantor’s estate at its date-of-death value.

So, as you can imagine, all of the tax benefits of an IDGT turn on whether the installment note is bona fide debt.  Thus, it is critical to structure the transaction properly to minimize the risk of the IRS taking the position that the note constitutes equity for gift or estate tax purposes.  That can be accomplished by observing all formalities of a sale to an unrelated party, providing sufficient seed money, having the beneficiaries personally guarantee a small portion of the amount to be paid under the note, not tying the note payments to the return on the IDGT assets, actually following the scheduled note payments in terms of timing and amount, making the note payable from the trust corpus, not allowing the grantor control over the property sold to the IDGT, and keeping the term of the note relatively short.  These are all indicia that the note represents bona fide debt.       

Administrative Issues with IDGT’s

An IDGT is treated as a separate legal entity.  That means that a separate bank account must be opened for the IDGT so that it can receive the “seed” gift and annual cash inflows and outflows. The grantor’s Social Security number is used for the bank account.   An amortization schedule will need to be maintained between the IDGT and the grantor, as well as annual books and records of the trust.

Conclusion

Structured properly an IDGT can be a useful tool in the estate planner’s arsenal for moving wealth from one generation to the next with minimal tax cost.  That’s especially true for highly appreciating assets and family business assets.  But, again, it is critical to get good legal and tax counsel before trying the IDGT strategy.