Why would a diligent, careful estate planning attorney create a trust that is intentionally defective? Good attorneys know the answer to this question, that being, of course, when it benefits their clients. If you’re like me, you’re a little startled to learn that it’s actually a deliberate estate planning technique to make a trust “defective.” But Intentionally Defective Grantor Trusts, or IDGTs for short, are well established as useful estate planning tools.
1. “Defective” sounds strange but it’s really just a reference to a legal technicality
When an asset is transferred into a trust, title to the asset is split between the trustee and the beneficiary(ies) of the trust. The trustee holds legal title to the asset, and the beneficiaries hold equitable title. The person transferring the asset into trust, who previously held both forms of title, is called the grantor. The transfer of the asset to the trust is “defective” when the grantor retains certain rights to the property, because retaining rights in property conveyed into trust causes the trust to run afoul of the IRS’ “Grantor Trust Rules.” The most common right retained is the right to recover (i.e., swap out) an asset for one of equal value, but there are other retained rights that will cause a trust to be defective.
2. It’s about who pays the taxes
Traditionally, a grantor seeks to create a trust to remove the assets from their personal taxable estate. If the grantor follows the rules and creates a valid trust, the IRS charges the trust for taxes due on the asset’s income (rather than the grantor) at the end of each year. But the IRS won’t give a defective trust that kind of tax treatment, and will instead require the grantor pay the taxes on income derived from the assets held in trust.
Originally it was viewed as a negative outcome for the grantor to have to pay the taxes on assets held in trust. But then some clever attorneys and accountants realized that if you are planning your succession, it might be desirable to you to pay the taxes on trust assets so that your successors don’t have to (via the trust, which sometimes gets taxed at a higher rate than an individual). So a person who wants to put assets into trust for asset protection purposes, but doesn’t want to saddle future generations with tax liability, might be looking for an IDGT. Assets that are appropriate for inclusion in an IDGT typically produce a stream of income that would be taxed at the end of the year – i.e. an annuity, an interest in a business, an interest in an income-producing property, etc.
3. There are several types of IDGTs and they all have a specific purpose
IDGTs can be either revocable or irrevocable trusts. There are several types of IDGT trusts that get their own acronym. A GRAT (Grantor Retained Annuity Trust) is one that is created to hold title to an annuity, or another income stream that does not vary in value from year to year, where the grantor keeps and pays taxes on the distributions. A GRUT (Grantor Retained Unitary Trust) is created to hold title to an asset that produces an income stream that varies from year to year, like an interest in a closely held company, stocks, or real estate. Lastly, a QPRT (Qualified Personal Residence Trust) removes a grantor’s personal residence from their taxable estate, but entitles them to deduct property taxes paid from their year end taxes and the property’s basis is stepped up at the grantor’s death. There is more complexity behind all these acronyms, so I would advise you conduct your own careful research into these different forms of IDGTs if you are considering making one a part of your estate plan.
4. They can expose your estate to higher scrutiny by the IRS
IDGTs are advanced estate planning tools, and it follows that an estate containing one or several would merit higher scrutiny by the IRS. The decision to create an IDGT requires balancing the potential estate tax savings against the consequences of relinquishing ownership to the next generation. Careful consideration should be given to both tax and nontax consequences to see if an IDGT is right for your particular circumstances.
5. IDGTs are powerful tax saving tools.
To illustrate, consider the following example utilizing a relatively standard IDGT. Say you are a grantor who puts a large sum of money into a trust, $100 thousand, and you retain the right to recover trust property for property of equal value, thus creating an IDGT. Then you swap out the $100 thousand for 10 thousand shares of stock in Fictional Acme Corporation (FAC) valued at $10 a share. The $100 thousand worth of stock is removed from your taxable estate, but you will have to pay the capital gains taxes on any gain realized from the sale of the FAC securities. Over the course of twenty years, FAC shares rise in value from $10 a share to $100 a share, making the trust worth $1 million. If the trustee sells the shares, your IDGT would realize the following benefits for your beneficiaries:
i. The trust corpus grew and delivered $900 thousand worth of additional value to the beneficiaries.
ii. You, the grantor, pay 23.8% long-term capital gains on the $900 thousand capital gain, but this amount ($214.2 thousand) is charged to you and is like a tax-free gift to your beneficiaries.
iii. You used $100 thousand of your federal estate tax exemption (which is $5.43 million for an individual, $10.86 million for a couple, as of 2015) but actually delivered $1 million to your beneficiaries, and they do not have to pay any taxes on that amount. Your beneficiaries do not have to sell any trust assets to pay for gift or estate taxes, so the trust retains all its value.
In recent years, IDGTs have become very popular. Corporate executives such as Sheldon Adelson and Lloyd Blankfein have used them to avoid paying hundreds of billions of dollars worth of estate taxes. Indeed, IDGTs are so powerful and so popular that President Obama has targeted them for reform in each of his Fiscal Year Revenue Proposals since 2013. However, Congress has shown no inclination to take up the issue, so IDGTs will be around for a while yet.
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Misha is an estate planning attorney at Speedwell Law, PLLC. If you would like assistance in setting up your own IDGT, he can be reached at (703) 553-2577 or firstname.lastname@example.org.
This post, including any of its contents or links, is not intended to provide you with legal advice. It provides personal perspectives on legal news and developments. Reading this post, leaving a comment, or communicating with its author by email or over the Internet does not create any attorney-client relationship.