Helping a client benefit from an intentionally defective grantor trust

An intentionally defective grantor trust (IDGT) is an estate planning technique that may benefit a practitioner’s wealthier clients. However, current legislative proposals, if enacted, could nix this tax planning technique as early as 2022. Thus, if a practitioner is considering an IDGT for a client, time is of the essence.

An IDGT is a trust set up by a grantor (i.e., an individual) that is treated as separate from the grantor for federal estate and gift tax purposes but is treated as owned by the grantor for federal income tax purposes. These trusts are referred to as IDGTs because the grantor intentionally includes in the trust agreement a right or power (such as the grantor’s ability to switch out and substitute assets for other assets already in the trust) that causes him or her to be treated as the owner of the trust for income tax purposes. The grantor pays income tax on the trust’s income, but the appreciation that builds up in the trust’s assets is excluded from the grantor’s estate.

How these trusts are used

An example of a tax planning scenario where the use of an IDGT would be beneficial is one in which a wealthy individual holds appreciating assets, such as real estate or stock, and wants to shelter the future appreciation of those assets from estate taxes. The individual can sell the appreciating asset to an IDGT at fair market value (FMV) in return for a promissory note that bears interest at the applicable federal rate. The Supreme Court decision in Fidelity-Philadelphia Trust Co. v. Smith, 356 U.S. 274 (1958), sets forth certain criteria that must be met in order to avoid having an asset sold to a grantor trust from being included in a decedent’s estate. As relevant to IDGTs, the interest payments on a promissory note from the IDGT to the grantor cannot be tied to the income generated by the asset sold to the trust. Thus, if the asset does not generate sufficient cash flow, grantors typically also gift cash to the IDGT as a cushion to meet the trust’s interest payment obligations.

For instance, assume P bought 100,000 shares of XYZ Company, a startup, for $1 per share back in 2010, but the stock is now worth $100 per share and P receives $200,000 each year in dividends. P has an untaxed gain on the stock of $9.9 million, and the assumption is that amount will keep growing. If P sells the stock in October 2021 to an IDGT in exchange for a $10 million 15-year promissory note bearing interest of 3%, and also contributes $1 million in cash, P will realize estate tax savings if the total return on the stock (dividends plus appreciation) exceeds the interest payments on the promissory note. Thus, IDGTs are most appropriate for situations involving highly appreciating assets in times when interest rates are low. P can use the cash contributed to the trust to pay the trust’s taxes or, alternatively, P can satisfy the income tax liability of the trust out of P’s separate assets in order to preserve trust assets for the beneficiaries.

Alternatively, a grantor can gift assets to the IDGT. In that case, the FMV of the gift will be applied against the grantor’s estate tax exemption ($11.7 million for an individual and $23.4 million for a couple in 2021). In this case, the gift tax value is frozen at the time of the transfer, and any subsequent appreciation accrues to the trust (and ultimately the trust beneficiaries) without further gift or estate tax consequences to the grantor.

It’s important to note that the benefits of using an IDGT depend on the trust being properly structured by an experienced lawyer in order to avoid having amounts involved in the transaction brought back into the grantor’s gross estate. For example, if a grantor retains certain powers over the trust, the gift will not be considered a completed taxable gift, with the effect that the assets transferred to the IDGT will not be excluded from the grantor’s estate.

Current proposals before Congress

Provisions in proposed legislation currently being negotiated in Congress include a reduction in the estate and gift tax exemption. As currently drafted, that reduction would not kick in until 2022. Thus, funding an IDGT to take advantage of the current exemption amounts should be done before the end of the year.

Additional proposals being considered would more closely align the income tax and transfer tax rules for grantor trusts by imposing transfer tax consequences on certain assets held in or distributed from a grantor trust. One proposal provides that, for any portion of a trust with respect to which the grantor is the deemed owner:

1. The gross estate of a deceased deemed owner of such portion would include all assets attributable to that portion at the time of the deemed owner’s death;
2. Any distribution (other than to a deemed owner or the deemed owner’s spouse) from such portion to one or more beneficiaries during the life of the deemed owner of such portion, other than in discharge of an obligation of the deemed owner, would be treated as a transfer by gift for gift tax purposes; and
3. If during life the deemed owner ceased to be treated as the deemed owner of such portion, all assets attributable to such portion would be treated as having been transferred by gift for gift tax purposes at such time.

The provision would require that adjustments be made for any amounts included in the gross estate or treated as transferred by gift under (1), (2), or (3) to account for amounts treated previously as taxable gifts with respect to previous transfers to the trust by the deemed owner.

In the case of any transfer of property between a trust and a person (whether or not the grantor) who is a deemed owner of the trust (or portion thereof), the proposal provides that the person’s treatment as the owner of the trust is disregarded in determining whether there is a sale or exchange for income tax purposes. Thus, such a transfer might result in the realization and recognition of gain. As currently drafted, the proposal would be effective for (1) trusts created on or after the date of enactment, and (2) any portion of a trust established before the date of enactment that is attributable to a contribution made on or after such date.

— Barbara Bryniarski, CPA (inactive), MST, is an executive editor at Parker Tax Publishing. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld, senior editor, at David.Strausfeld@aicpa-cima.com.

Editors’ note: For further discussion of these issues, see Hubers, “The Grantor Trust Rules: An Exploited Mismatch,” 52 The Tax Adviser 694 (November 2021).