The IDGT is a technique for enhancing the wealth transfer benefits of gifts otherwise made for estate planning purposes.
The Internal Revenue Code contains a series of provisions, known as the grantor trust rules. These rules were initially designed to prevent taxpayers from artificially splitting their taxable income among family members (mostly children) through the use of trusts. Under these rules, if a trust contains any of various prohibited clauses, the trust’s income will be taxed to the grantor even though he or she does not receive it or benefit from it.
Rules & Reporting
Under the current lower income tax rate structure, coupled with the “kiddie tax” on young children’s investment income, there is often little, or no advantage in splitting income within the family. But the grantor trust rules provide an outstanding opportunity for wealth transfer planning.
In short, a parent can place assets in an irrevocable trust for children that contains a clause that causes it to be “defective” by “flunking” the grantor trust rules. But it does not cause inclusion in the grantor’s taxable estate.
Although all the trust’s income is either accumulated for the children (or grandchildren) or paid out to them currently, the Internal Revenue Code mandates that the grantor report all the income (including capital gains) on their own personal tax return and pay the resulting income tax. This payment by the grantor of the income tax on the children’s income is effectively a gift to the children, totally outside the gift and estate tax structure.
The potential benefits from an IDGT can be huge. Using round numbers, if a $2,000,000 IDGT generates $100,000 of taxable income each year, the resulting income tax will be in the range of $40,000.
Because the grantor is paying that tax rather than the trust, they remove $40,000 per year from their future taxable estate. Compounded over 20 years, the aggregate potential estate tax savings grow to more than $1,000,000.
In recent years, the IRS has grown increasingly weary to using an IDGT to have the grantor pay the tax on income in which they have no economic interest. From an equity and tax policy standpoint, their concern is justified.
However, it appears that the IRS has no supportable basis on which to challenge this result without a change in the law by Congress. Nevertheless, clients should be aware that the aggressive use of an IDGT may lead to a dispute with the IRS.
Diagram of Tax Issues
The IDGT can be used as a vehicle to make annual exclusion gifts or to utilize all or a portion of a client’s lifetime exemption. It may be beneficial for making gifts of stock in family businesses because, unlike many trusts, it will automatically be a permitted shareholder in an S corporation.
Another desirable attribute of an IDGT is that, under a 1985 IRS revenue ruling, sales and other transactions between the grantor and the trust are not taxable events for income tax purposes. This permits the grantor to purchase appreciated assets from the trust without causing a capital gain.
The ability of the grantor to purchase assets from the trust without causing a capital gain can be advantageous where an IDGT has highly appreciated assets and the grantor is elderly or for other reasons has a short life expectancy. In this case, if the grantor purchases the appreciated assets at their current market value for cash or a promissory note, upon their subsequent death, the assets will receive a step up in basis, and the potential capital gain will be eliminated.
Another method of using the favorable attributes of a IDGT is for the grantor to fund the trust through a gift and then lend additional funds to the trust, charging the lowest interest rate permitted under the tax law without being deemed an additional gift. Because of the grantor trust status, the payment of interest by the IDGT to the grantor will not have any income tax consequences to either party.
Although we have no guarantee that the advantages of using a defective grantor trust will not be restricted or eliminated by legislation, court cases, or IRS rulings, at present, the opportunity is available and compelling for clients who are attempting to maximize the tax-free transfer of wealth.