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.

Conclusion

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 mgill@speedwelllaw.com.

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.

Imagine everything you own — your estate — is a big collection of cheese. You’ve got your cheese-trust that keeps your wheels safe and distributes cheese to your loved ones when you’re gone. But trouble lurks for the unwary. If you don’t pay attention, mice might get away with some of your precious gruyère. You need a mouse trap to make sure the mice won’t get away with it. And if you don’t take proper precautions, a court is going to have to step in to find your cheese and order the mice to put it back.

Pour-over wills are the mouse trap of any estate plan employing revocable or irrevocable trusts. They ensure that an asset that doesn’t make it into your trust by the time you pass away is placed in the trust. A pour-over will is essential if you want your estate to pass quickly and efficiently to your loved ones and avoid probate.

Why You Want to Avoid Probate

Probate is the process where a court oversees the distribution of assets to the beneficiaries and creditors of a deceased person’s estate. Probate is a bad word in estate planning. But why? What’s so terrible about a court being involved in the administration of your estate?

Estate planners generally advise their clients to avoid probate because it is time consuming, tedious, and expensive. An estate that is administered by probate takes longer to settle than an estate that is settled outside of probate, usually adding at least a year to the process and sometimes more. There are more documents to file, more deadlines to comply with, and more supervision by the courts.

Courts charge a fee for supervising the distribution of assets (Virginia courts charge 0.1%, or $1 out of every $1,000), and there are filing fees each time a document is filed with the court. Additionally, the executor or administrator — the private person actually controlling assets and being supervised by the court — is allowed to charge more for their services when they are settling an estate by probate, as opposed to a trustee settling an estate under the terms of the trust document. And that’s cheese that didn’t need to be eaten.

Keeping Your Cheese Out of Probate

For estate administration purposes, there are two types of assets: probate and non-probate. Non-probate assets are shrouded from the court and the mice by a trust (or operation of law). Anything that is not included in the trust might still have to go through the probate system. A pour-over will guards against this outcome by directing any assets that aren’t covered by the trust to be placed in the trust and administered according to the trust’s terms.

But you have to be careful — certain types of cheese must make it into the trust or else the will must be probated for the assets to pass to the trust. Real estate that is titled in your name, and not your trust’s, is required to go through probate. And other titled forms of personal property – generally those you are required to title with a state entity, like your car or boat – may have to be probated if passing to your trust by the pour-over will.

Even if a probate asset doesn’t make it into the trust, there is still a chance the will does not have to be probated. In Virginia, there are special procedures in place that can be used to transfer assets to beneficiaries by waiver. Estates worth less than $50,000 qualify for the waiver procedure established under the Virginia Small Estates Act. As long as some assets make it into the trust to make it “funded,” and the assets that are left out do not exceed the threshold of $50,000, a pour-over will acts as the safety mechanism that ensures the estate avoids probate.

Conclusion

You want to make sure your loved ones get your cheese collection when you’re gone. There’s a quick and efficient way to do that, but you have to take the proper precautions during your lifetime to ensure all goes according to plan. So make sure your estate plan includes a pour-over will, because an ounce of prevention is worth a pound of cheese.

Follow the Speedwell Blog HERE

Misha is an estate planning attorney at Speedwell Law, PLLC. If you would like assistance in setting up your own estate plan, he can be reached at (703) 553-2577 or mgill@speedwelllaw.com.

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.