Intentionally Defective Grantor Trust – What Is It and How Does It Work?

Overview

An important concern for many farm and ranch families is how to keep the business in the family and operating as a viable economic enterprise into subsequent generations.  Of course, economics and family relationships are very important to accomplishing this objective.  So are various types of planning vehicles. 

One of those vehicles that can work for some families is an intentionally defective grantor trust (IDGT).  It allows the creator of the trust (grantor) to “freeze” the value of the transferred assets while simultaneously providing the grantor with a cash flow stream for a specified time-period.  The “freeze” is achieved by capitalizing on the mismatch between interest rates used to value transfers and the actual anticipated performance of the transferred asset. 

The use of an IDGT as part of a plan to transfer business assets from one generation to the next – that’s the topic of today’s post.

IDGT - Defined

An IDGT is a specially type of 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 as a grantor trust (as far as the grantor is concerned) under I.R.C. §671 for income tax purposes because of the powers the grantor retains.  However, those retained powers do not cause the trust assets to be included in the grantor’s estate.  The trust’s income, losses, deductions and credits are reported by the grantor on the grantor’s individual income tax return.  

The trust is “defective” because 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 (e.g., they are effective) for federal estate and gift tax purposes.  The “defective” nature of the trust meant 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 (discussed below) are paid to the grantor in-kind and makes the trust an eligible S corporation shareholder.  Rev. Rul. 85-13, 1985-1 C.B. 184; I.R.C. §1361(c)(2)(A)(i).

The IDGT Transaction

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 makes 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.  Typically, the IDGT transaction is structured so that a completed gift occurs for gift tax purposes, with no resulting income tax consequences.  That also means, however, that the transfer is a completed gift and the trust will receive a carryover basis in the gifted assets.    

The trust language is 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.  This is what makes the IDGT 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.

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 (but they have been rising), 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 (Priv. Ltr. Rul. 9535026 (May 31, 29915)) that took the position that I.R.C. §2701 would not apply because a debt instrument is not an “applicable retained interest.”  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. 

How It Works

If for example, a multi-dimensional farming operation is valued at $15 million and is transferred to a family limited partnership (FLP), a valuation discount for lack of marketability and/or minority interest might approximate 30 percent. 

Note:  A few months ago, the Treasury announced that it was not finalizing regulations that would tighten the ability to valuation discounts in such situations.  So, a discount of 30-40 percent would be reasonable for such a transfer. 

A 30 percent discount on a $15 million transfer would be $4.5 million.  So, the transfer to the FLP would be valued at $11.5 million.  Then an IDGT could be created and the $11.5 million FLP interest would be sold to the IDGT in exchange for a note with the installment payments to the grantor under the note being established based on the $11.5 million value rather than the $15 million value.  This means that, in effect, $4.5 million has been transferred tax-free the transferors’ heirs.

The installment note can be structured in various ways, with the approach chosen generally tied to the cash flow that the assets generate that have been transferred to the IDGT.    In addition, the income from the property contained in the IDGT is the grantor’s tax responsibility (with those taxes paid annually from a portion of the installment sale payments from the note), but it’s not a gift for estate and gift tax purposes.  That means, then, that additional assets can be shifted to the IDGT which will further reduce the grantor’s taxable estate at death.  The heirs benefit and the grantor gets a reduced taxable estate value.  That could be a big issue if the current level of the federal estate tax exemption goes back down starting in 2026 (or sooner on account of a political change in philosophy). 

When the grantor of the IDGT dies, the only item included in the grantor’s gross estate is the installment note.  It is included at its fair market value.  That means that the IDGT “froze” the value of the assets as of the sale date with any future appreciation in asset value occurring outside of the decedent’s estate. 

Pros and Cons of IDGTs

As noted above, 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 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

Thee installment note must constitute bona fide debt.  That is the key to 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.  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.  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.

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.  Thus, a separate bank account is opened for the IDGT in order to receive the “seed” gift and annual cash inflows and outflows.  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

Farmers and ranchers that intend to keep the farming or ranching business in the family for subsequent generations are searching for ways to accomplish that goal.  The IDGT is one tool in the planner’s arsenal to accomplish that goal.