The Case for an Intentionally Defective Grantor Trust

By Ora Pressey, CPA; John W. Morrisset, CPA; Richard A. Nightingale, CPA

Editor: Kevin F. Reilly, J.D., CPA

When two sets of tax laws use different standards to measure the outcome of a single transaction, some advisers call the result a loophole. Others call it a tax planning opportunity (and some never mention it at all). An intentionally defective grantor trust (IDGT) is a complete transfer to a trust for transfer tax purposes but an incomplete, “defective” transfer for income tax purposes. Because the trust is irrevocable for estate and gift purposes and the grantor has not retained any powers that would cause estate tax inclusion, the future value of the assets transferred is removed from the grantor’s gross estate on the date of the trust’s funding, but due to certain other powers retained by the grantor, the trust, although irrevocable, is treated as a grantor trust for income tax purposes. As a result, the grantor, though not a beneficiary, is taxed on all the trust’s income, even though he or she is not entitled to any trust distributions.

If structured properly, the IDGT will receive the gross income generated from the trust’s income-producing assets, which will accrue to the benefits of the trust’s beneficiaries. The trust also allows the grantor the opportunity to remove future appreciation from the grantor’s estate while maintaining control over the assets.

Defective Powers

The most common powers that are retained by the grantor and thus make the trust defective for income tax purposes include:
  1. Designating the grantor’s spouse as a trustee and granting such trustee authority to add beneficiaries (Sec. 674(a));
  2. Retaining the nonfiduciary power to reacquire or substitute trust assets (Sec. 675(4)(C));
  3. Authorizing an independent trustee to make loans to the grantor without adequate security (Sec. 675(2)); and
  4. Authorizing use of trust income to pay premiums for life insurance on the grantor’s or the grantor’s spouse’s life under Sec. 677(a)(3).

Mechanics of an IDGT

The transfer of assets to an IDGT may be via either a completed gift or a fair market value (FMV) sale or installment sale, both of which are disregarded for income tax purposes. The disregarded installment sale is generally used for leverage with the goal of shifting income and appreciation in excess of a favorable interest rate to the IDGT. Such a shift would occur only if total returns exceed the interest on the installment note.

Also, the installment sale technique would be beneficial where the contemplated transfer exceeds the current gift tax exemption equivalent of $1 million. Likewise, a combination of a gift (up to the taxpayer’s available gift tax exemption) and a disregarded installment sale for the balance of the transfer may present an alternative planning opportunity.

Power to Reacquire Assets

Sec. 675(4) provides that a trust is a grantor trust for income tax purposes if any person holds a power “in a nonfiduciary capacity . . . to reacquire the trust corpus by substituting other property of an equivalent value.” This retained power to substitute assets of equivalent value will not prevent the grantor from having made a completed gift for transfer tax purposes and will not trigger estate tax inclusion under Sec. 2038. (See, e.g., Estate of Anders Jordahl, 65 T.C. 92 (1975); Letter Ruling 9227013.)

This power to substitute assets offers the grantor the opportunity to preserve potential losses from depreciated assets, which would otherwise disappear at death. Since a sale to an IDGT is a disregarded event, the trust takes a carryover basis in the assets transferred. Under Sec. 1014, the tax basis of assets transferred at death is stepped up (or down) to the FMV at the date of death (or the alternate valuation date). For example, if a grantor has an asset with a basis of $6 million and a current value of $500,000, the $5,500,000 loss is eliminated at death under Sec. 1014. However, if the asset were sold to an IDGT in a disregarded installment sale, the trust’s basis would be the $6 million carryover basis. Thus, after the death of the grantor, the IDGT’s beneficiary would reap the benefit of the higher tax basis.

The IDGT may offer a more tax efficient estate-freezing tool for clients with appreciating assets and ample liquid assets when other estate planning transfers to an irrevocable trust are made with the trade-off of losing the Sec. 1014 stepup in income tax basis of the transferred assets. An IDGT drafted with the Sec. 675(4)(C) retained power to reacquire or substitute assets could avoid such a sacrifice.

Such a trust offers the grantor the chance to substitute the IDGT’s appreciated assets for liquid assets with limited or no appreciation at all at a later date. Thus, if the substituted appreciated assets are later included in the grantor gross estate, the heirs would receive an income tax stepped-up basis. If the power to substitute is not part of the IDGT instrument, the trustee could alternatively sell IDGT appreciated assets to the grantor for highbasis assets or cash. Because transactions between a grantor trust and its grantor are disregarded under Rev. Rul. 85-13, no gain on the sale would be recognized by the grantor.

It is possible to argue, based on the logic of Letter Ruling 9535026 and Sec. 1014(e), that carryover basis of gifts acquired by decedents within one year of death should not apply to the transfer because the swap is not a gift, but the Service and the courts have yet to confirm that conclusion. On the other hand, a transfer of assets to the IDGT via gift would result in the application of the Sec. 1015 dual basis rules to the assets transferred. Thus, a subsequent sale by the IDGT would not preserve the original built-in loss.

IDGT as S Corporation Shareholder

An IDGT may also be beneficial in the case of a transfer of appreciating S corporation stock to a trust. Under Sec. 1361, an irrevocable trust would not qualify as an S corporation shareholder unless a qualified subchapter S trust (QSST) or an electing small business trust (ESBT) election is made. Both elections come with increased complexity and compliance costs, and each has its limitations.

A QSST is a trust for only one income beneficiary that is required to or actually distributes all its income. An ESBT, on the other hand, while allowing multiple beneficiaries and income accumulation, taxes the S corporation ordinary income regardless of accumulation or distribution at the trust level at the highest fiduciary marginal rate (currently 35%). Under the Sec. 1361(c)(2)(A) exception, a grantor trust owned by a U.S. citizen is a permitted S corporation shareholder. As compared with any other irrevocable trust, such as a grantor trust for income tax purposes, a transfer of appreciating S corporation shares to the IDGT may reduce income tax compliance costs while still maintaining the desired estate freeze benefits.

Additional Nontaxable Gifts

Another significant advantage of a grantor trust can be that the grantor pays the income tax on the trust’s income. This essentially generates a nontaxable gift to the beneficiaries, thereby reducing the grantor’s gross estate at no estate or gift tax cost. In Rev. Rul. 2004-64, the Service conceded its earlier position that a grantor that does not seek trust reimbursements for an IDGT’s income taxes paid has made a constructive additional gift to the trust corpus. The ruling concluded that if the instrument or applicable law gave the trustee discretion for tax reimbursement, such discretion in itself would not cause gross estate inclusion. Under Sec. 2036(a)(1), however, should a trust instrument require reimbursement of the grantor income taxes paid, all assets would be included in gross estate. Therefore, trustee discretion is recommended to provide the IDGT grantor with a cushion for the financial risk of increasing future taxes with lower cashflows.

Added IDGT instrument flexibilities could mitigate future cashflow financial risk to the grantor. Since the grantor is not a beneficiary of the trust and thus would not be entitled to trust distributions, the designation of the grantor’s spouse as a current or future IDGT beneficiary as long as the spouse remains married to the grantor would enable the couple to receive trust distributions. The trustee would be able to distribute at least enough funds to pay the income taxes attributable to the trust’s income. Alternatively, an IDGT may contain a power-release provision that could negate the defective trust power on exercise.

Conclusion

While not for everyone, an IDGT is an effective estate-freezing tool that provides the opportunity to maintain the maximum control over the beneficial enjoyment of the transferred assets. Do not miss out on how an intentionally designed defect may benefit clients, especially when large estates with various appreciating assets are involved.


EditorNotes

Kevin F. Reilly, J.D., CPA, is a member of PKF Witt Mares in Fairfax, VA.

Unless otherwise noted, contributors are members of or associated with PKF North American Network.

For additional information about these items, contact Mr. Reilly at (703) 385-8809 or kreilly@pkfwittmares.com.

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