How does this create tax and estate planning opportunities?
The sale of the appreciating asset to the IDGT is not taxed to the grantor for income tax purposes. This is because, for income tax purposes, the grantor and the trust are treated as one.
As a result, both the note payments as well as the interest payments made to the grantor will not be subject to federal income tax.
At the end of the trust’s term, the trust assets will not be included in the grantor’s estate. The assets, as well as any appreciation, will pass to the trust’s beneficiaries free of tax.
If the grantor dies before the note is paid, only the unpaid balance of the note is included in the grantor’s estate. Any appreciation in the value of the trust assets goes untaxed.
During the term of the trust, any income earned by the trust on the assets held by trust is taxed to the grantor. For an additional benefit, the grantor should pay the income tax on the income earned in the IDGT from other sources held by the grantor.
This results in an additional reduction in the grantor’s assets for estate tax purposes and also increases the assets passed to the beneficiaries.
What are some other benefits that the IDGT provides?
The assets sold to the IDGT should have the potential of substantial appreciation. If those assets are, for example, an interest in a closely held corporation or a limited partnership interest, those assets may be valued at a discounted value and be deemed sold at fair market value.
Discounts may be taken for lack of marketability and for lack of control. Thus, the value of the asset sold for a note may be significantly reduced via discounting.
However, it should be noted that the IRS has in the past challenged unusually large discounts.
Is the defective grantor trust for everyone?
IDGT’s are not for everyone. IDGT’s are not specifically supported by any specific Internal Revenue Code sections. The planning techniques are based on interpretations of IRS rulings and case law. They are not IRS risk free.
Individuals who are not risk adverse must carefully consider the potential downsides in their planning.
In addition to considering the federal tax consequences, individuals should check their respective state statutes regarding grantor trusts. Some states do not recognize grantor trusts and, therefore, the sale to the trust of the potential appreciated asset would be taxed by the state either at the time of the sale or as the payments are received on the installment note.
Also, the rules are different in community property states, so individuals should obtain competent assistance in planning, structuring and implementing an IDGT.
Richard Nelson is the director of the Tax Strategies Group at Kreischer Miller. Reach him at (215) 441-4600 or [email protected].
