Monday, March 7, 2022

Should An IDGT Be Part of Your Estate Plan?

Overview

Because of the failure of the “Build Back Better” legislation last year, the federal estate tax remains a non-concern for the vast majority of people.  But, for some larger farming operations as well as some non-ag businesses and high-wealth individuals, planning to avoid the full impact of the federal estate tax is necessary.   

Note:  If the Congress does nothing, the federal estate and gift tax exemption will fall to $5,000,000 (in 2011) dollars beginning January 1, 2026. That will subject more estates to potential taxation.

If an estate planning 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.  

The use of the IDGT for transferring asset values from one generation to the next in a tax-efficient manner – it’s the topic of today’s post.

What Is An IDGT?

In general.  An IDGT is an irrevocable 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. Normally, an irrevocable trust is a tax entity distinct from the grantor and has its own income and deductions (net of distributions paid to beneficiaries) reported on its own income tax return.  Because of the irrevocable nature of the trust, the assets transferred to the trust are generally removed for the grantor’s estate for federal estate purposes. Conversely, a grantor trust is a trust where the income is taxed to the grantor because the grantor is treated as the owner for federal and state income tax.  Thus, a separate return need not be prepared for the trust, but the trust assets are generally included in the grantor’s estate at death. 

An IDGT is characterized by having advantages of both an irrevocable trust for estate tax purposes and a grantor trust for income tax purposes.  For federal income tax purposes, the trust is designed to be a grantor trust under I.R.C. §§671-678.  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.  For example, common IDGT provisions include (1) a power exercisable by the grantor (in a non-fiduciary capacity) to reacquire trust assets by substituting assets of equivalent value. I.R.C. §675(4)(C); (2) a power held by a non-adverse party to add to the class of beneficiaries (other than the grantor’s after-born or after-adopted children). I.R.C. §674(a); or (3) a power to enable the trustee to loan money or assets to the grantor from the trust without adequate security. I.R.C. §675(2).

However, those retained powers do not cause the trust assets to be included in the grantor’s estate under I.R.C. §§2036-2042.  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.  For example, the transfer of property to the trust qualifies for the gift tax annual exclusion of §I.R.C. §2503(b)(1)-(2).  In addition, grantor trust status still applies even though the grantor retains a withdrawal power over income and/or corpus.  See, e.g., Priv. Ltr. Rul. 200606006 (Oct. 24, 2005); Priv. Ltr. Rul. 200603040 (Oct. 24, 2005); Priv. Ltr. Rul. 200729005 (Mar. 27, 2007). 

Note:  The IDGT’s income and appreciation accumulates inside the trust free of gift tax and also free of generation-skipping transfer tax (if the grantor allocates the grantor’s generation-skipping transfer tax exemption to the assets transferred to the trust). 

The IDGT transaction is structured so that a completed gift occurs for gift and estate tax purposes, with no resulting income tax consequences (because the trust is a grantor trust).  

Note:  Because the transfer is a completed gift, the trust receives a carryover basis in the gifted assets.

How Does An IDGT Transaction Work?

Gift.  One approach to funding an IDGT is by the grantor gifting assets to the trust.  If the value of the assets transferred are less than the applicable exclusion amount (presently $12.06 million for deaths or gifts made in 2022 - $24.12 million for a married couple), gift tax is not triggered on the transfer, but the applicable exclusion would be reduced by the amount of the gift.  Form 709 would need to be filed reporting the gift and showing the reduction in the applicable exclusion unified credit. 

Note:  A variant of the outright gift approach involves a part-gift, part-sale transaction.  This is done where it is beneficial to leverage the amount of assets transferred to the IDGT, preserve the applicable exclusion or retain income.    

Sale and note.  Another technique to fund an IDGT involves the grantor selling highly-appreciating or high income-producing assets to the IDGT for fair market value in exchange for an installment note (such as a self-canceling installment note).  There is no capital gains tax on the sale.  In addition, the trust is an eligible S corporation shareholder.   I.R.C.  §1361(c)(2)(A).   The grantor is also not taxed on the interest payments received from the trust.   Rev. Rul. 85-13, 1985-1 C.B. 184.  The installment sale also freezes the value of appreciation on assets sold at the Applicable Federal Rate (AFR).  This is a particularly effective strategy in a low interest rate environment. 

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 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.

Interest on the installment note is set at the Applicable Federal Rate (AFR) for the month of the transfer that represents the length of the note’s term.  I.R.C. §§1274 and 7872.

Note:  The mid-term AFR for March of 2022 is 1.73 percent (semi-annual compounding).  Rev. Rul. 2022-4, 2022-10 I.R.B.

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. 

Note:  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).

A crucial aspect of the installment note from an income tax and estate planning/business succession planning standpoint is that it must constitute bona fide debt.  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. §§2701-2702 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 (the only adjustment was a reduction of the valuation discount from 42 percent to 37 percent) 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.

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.      

Pros and Cons of IDGTs

Value freezing.  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. 

Note:  Any valuation discount will increase the effectiveness of the sale for estate tax purposes. 

Payment of income tax liability.  If the grantor uses funds from outside the IDGT to pay the tax liability on income generated by the assets in the IDGT, that has the effect of leaving more assets in the IDGT for the remainder beneficiaries that would result if the trust were a standard irrevocable trust.  It also reduces the grantor’s taxable estate in an amount equal to the income taxes that the grantor pays and helps to preserve the trust by not reducing it with the trust’s payment of the income taxes. 

Because the grantor pays the income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income, the grantor is not treated as making a gift of the amount of the income tax to the trust beneficiaries for gift tax purposes.  Rev. Rul. 2004-64, 2004-27 I.R.B. 7.  However, there is a difference in the estate tax treatment depending on the trust’s language.  For instance, if the trust’s language (or state law) requires the trustee to reimburse the grantor for the income tax attributable to the inclusion of the trust’s income in the grantor’s taxable income, then the full value of the trust’s assets is includible in the grantor’s gross estate via I.R.C. §2036(a)(1) for federal estate tax purposes  This is true even though the trust’s beneficiaries are not treated as making a gift of the amount of the income tax to the grantor.  Id.   Conversely, if the trust language gives the trust the discretion to reimburse the grantor for that portion of the grantor’s income tax liability attributable to the trust’s income, the discretion (whether exercised or not) will not (by itself) cause the value of the trust’s assets to be includible in the grantor’s gross estate.  But such discretion combined with other facts (such as a pre-existing arrangement regarding the trustee’s exercise of discretion) could cause inclusion of the trust assets in the grantor’s estate.  Id. 

Life insurance.  An IDGT can purchase an existing life insurance policy on the life of the grantor without subjecting the policy to taxation under the transfer-for-value rule. Rev. Rul. 2007-13, 2007-1 C.B. 684.

Grantor’s death during term of note.  On the downside, if the grantor dies during the term of the installment note, the note is included in the grantor’s estate. 

Income tax basis.  One would normally think that there is no stepped-up basis in trust-owned assets upon the grantor’s death because the trust is effective for estate tax purposes with the transfer of the assets having been transferred to the trust and not included in the decedent's estate at death.  Hence, no basis step-up (or down) at death to fair market value at that time.  The basis of the assets is in the trust (not in the estate).  It doesn’t matter what the grantor sells the asset to the IDGT for.  It’s a gift not a sale.  The trust takes the grantor’s basis.  

But is the basis really this clear?  It is not. It might be the case that a stepped-up basis can be achieved while simultaneously keeping the assets out of the grantor's estate.  The rationale is that up until the time of the grantor's death, the grantor is treated as the owner of the assets.  At death, the assets are transferred to the trust – they are acquired from a decedent and, hence, a basis step-up is achieved under I.R.C. §1014.  There's the argument for a basis increase in the assets owned by the trust after the grantor dies.

Where is the IRS on this?  In 2009 the National office of IRS issued a CCA 200923024 saying that there is no gain recognition when assets leave a grantor trust at death – there is no deemed sale at death.  But, the IRS followed that up with another CCA 200937028 saying that you do not get a step-up in basis for assets in a grantor trust when the grantor dies.  But, in 2012, the IRS issued a Private Letter Ruling saying that there is a stepped-up basis on assets in a grantor trust when the grantor dies.  PLR 201245006.  In 2015, IRS threw up its hands and said it wouldn't issue any more rulings while it "studied the matter."  It is still studying the matter.  Rev. Proc. 2015-37.
 
For those really concerned about the basis issue, one strategy (not for the faint of heart) the grantor can obtain a loan equal to the fair market value of the assets in the trust so that the grantor can buy the assets back from the trust.  The loan transaction will not trigger gain recognition and will achieve a basis increase when the grantor dies.  After death, the trust buys the assets from the estate that now have a stepped-up basis.  At the present level of the estate tax exemption there wouldn't be any federal estate tax (based on the values you provided) and no state estate tax for the vast majority of estates.

Cash flow.  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. 

Funding.  There is possible gift and estate tax exposure if insufficient assets are used to fund the trust.  As noted above, 10 percent seed funding is recommended to reduce the risk that the sale will be treated as a transfer with a retained interest by the grantor.    

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.  It can be used to shift large amounts of wealth to heirs and create estate tax benefits.  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.  In other words, the trust language must contain sufficient provisions requiring the trust to be deemed a revocable trust for income tax purposes, but an irrevocable trust (as a completed transfer) for estate tax purposes. 

Given the highly technical nature of the IDGT rules, it is critical to get good legal and tax counsel before trying the IDGT strategy.

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