Intentionally Defective Grantor Trust (IDGT) Sales
Tax planning for the very large estate.
December 17, 2007
by Robert Keebler, CPA/MST
Since Hurricane Katrina, there has been a resurgence of interest in estate planning for the very large estate. Wealthy Americans are realizing that President Bush’s agenda of repealing the estate tax is in grave danger and that there will likely be some estate tax for the foreseeable future. Historians will recount that, throughout U.S. history, the estate tax has been repealed and re-enacted four times. Perhaps coincidently, or perhaps not so coincidently, each time was when the United States was at war.1 Furthermore, the federal estate tax is not the client’s only worry. Many states have “de-coupled” and have an estate or inheritance tax of their own. In some states, the combined federal and state estate tax rates still exceed 50 percent. While fewer of your smaller clients will need estate planning services now that a married couple can exempt $4 million from the estate tax, many wealthy families continue to look for creative planning strategies to reduce their estate tax. Given the tidal wave of interest we are presently seeing in sophisticated estate planning techniques for moving very large amounts of wealth, this is a good time to explain some of the cutting edge techniques and to bring readers up to date on them.
Perhaps the most popular strategy for very large estates is the sale to an intentionally defective grantor trust (IDGT). Here’s how it works. The taxpayer first creates an irrevocable trust for his heirs and structures it to be a grantor trust for income tax purposes by retaining one or more of the powers in Code Secs.673 through 677. Care must be taken in selecting which powers to use because most the powers listed in these sections would also cause the trust assets to be included in the seller’s estate at death under Code Sec. 2036(a)(1) and/or Code Sec. 2038. Probably the safest power to use is a Code Sec. 675(4) power to substitute assets of equal value. The IRS recently ruled in LTR 2006030402 that retention of this power did not cause estate inclusion. Another possibility that is sometimes mentioned is a Code Sec. 675(2) power to borrow without adequate security or interest.
Basic Transfer Tax Benefit
The taxpayer then sells assets to the IDGT that are expected to produce a high total return in exchange for an installment note paying the lowest rate of interest possible. The minimum interest rate is the applicable federal rate (AFR), which is based on the interest rates offered on federal obligations and varies according to the term of the note. The reason for maximizing the gap between the return on the transferred assets and the interest rate paid by the trust on the note is that this excess represents a tax-free transfer from the seller to the heirs. The tax-saving mechanism is very simple — the value leaving the estate exceeds the value coming back into the estate.
Additional Benefits Flowing From Grantor Trust Status
The grantor trust status of the IDGT provides important additional benefits. Under Code Sec. 671, the seller is treated as the owner of the trust for income tax purposes and must pay the tax on the IDGT’s income. Payment of the trust’s income tax by the seller is, in effect, an additional tax-free transfer from the seller to the trust. The result is exactly the same as if the seller made a tax-free gift to the trust and the trust used the money to pay the trust’s tax liability. Because the trust pays less tax, more remains to accumulate in the IDGT for eventual distribution to the seller’s heirs. The gift tax benefit of grantor trust status is illustrated in the following example:
Example. John and Virginia transfer $2 million of S Corporation stock to a defective trust for the benefit of their children and grandchildren. They pay no gift tax because of the unified credit. On an annual basis, the S Corporation stock generates taxable income of $250,000. Because the trust is defective, John and Virginia are required to reflect this amount on their own joint tax return and pay the income tax due on this amount. Assuming a 40-percent tax rate, they are able to shift an additional $100,000 to the trust each year for the benefit of their children and grandchildren ($250,000 x 40%).
Given the real substance of the transaction, taxpayers long feared that the IRS might try to block the tax benefits by treating the income tax payments as taxable gifts from the grantor to the trust. The IRS studied the issue for a number of years, but finally rejected this argument in Rev. Rule. 2004-64.3
There are also important income tax benefits. Under Rev. Rule. 85-13,4 the seller and the trust are treated as the same taxpayer. This means that no gain is recognized on the sale and that the interest payments received on the note are not income to the seller because the seller is, in effect, just making payments to himself.
Take Care in Structuring the Sale
The main concern about IDGT sales is that the IRS might argue that the transferred assets are subject to Code Secs. 2036(a), 2701 and 2702. Although the IRS ruled that these sections did not apply to an IDGT sale in LTR 9535026,5 the rulings were conditioned on the assumption that the note retained by the seller was bona fide debt. If it was a retained income or equity interest instead, the IRS warned that all three sections could apply.
The key to qualifying the note as bona fide debt is to make sure that the trust’s debt/equity ratio is not too high. Most commentators believe that the ratio can be no more than 9/1. In other words, if the trust is funded with $2 million, a sale could not exceed $18 million. The amount the trust is funded with prior to the sale is generally referred to as “seed money.” Unfortunately, there is very little specific guidance from the IRS or from the courts on when an IDGT note crosses the line into an equity interest. Thus, tax advisors have been left wondering how much seed money is truly required.
The only case we have is a 2003 case that was settled before going to trial. In Sharon Karmazin (Tax Court Docket Number 2127-03), the IRS challenged a New Jersey IDGT sale to a trust that was carefully structured to avoid the appearance of a retained equity interest. One of the safeguards was to provide 10-percent seed money. The IRS initially raised arguments that Code Secs. 2036, 2701 and 2702 applied, but later dropped all three contentions. The only adjustment to the return was a reduction in the valuation discount on the transferred assets from 42 percent to 37 percent. The conventional wisdom following Karmazin is that whether an IDGT sale will work depends on how carefully it is structured. Thus, we may be in the same position with IDGT sales that we are with FLPs. Those that are properly structured should withstand IRS scrutiny, but those that are not properly structured will not.
Getting sufficient seed money into a trust can be a difficult problem, however. If the IDGT sale is a large one or the seller has used up most of her applicable exclusion amount, the seller will have to pay gift tax when the trust is seeded. Some practitioners believe that this problem can be solved by using beneficiary guarantees as a substitute for seed money. In LTR 9515039,6 the IRS held that such a guarantee would suffice in the context of a private annuity sale, provided that the guarantor had sufficient personal assets to make good on the guarantee. One should be very cautious in using beneficiary guarantees as a substitute for all the required seed money because there would be absolutely no true equity in the trust. It may be safer to use beneficiary guarantees to provide a portion of the required 10-percent amount. Another possibility would be to add beneficiary guarantees to trusts that already have acceptable debt/equity ratios as insurance against an IRS audit.
Another issue with beneficiary guarantees is that the IRS might take the position that they constitute a gift from the beneficiaries to the trust. Proponents of beneficiary guarantees could argue that such a guarantee should not be treated as a gift because the disinterested generosity necessary for making a gift is lacking — the beneficiaries are merely protecting their own self-interest. In any case, it might be possible to avoid gift treatment by having the trust pay a reasonable fee for the guarantee.
For taxpayers willing to accept a moderate amount of risk, IDGT sales may be the strategy of choice for large value transfers because of the combination of transfer tax and income tax benefits. The potential risk can be reduced if the trust and sale are carefully structured.
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1 The estate tax was first enacted in 1796 when we were on the brink of war with France, then re-enacted in 1861 during the American Civil War, re-enacted again 1896 during the Spanish American War and finally re-enacted again in 1916. If history holds course, we have not seen the end of the federal estate tax.
2 LTR 200603040 (Oct. 24, 2005).
3 Rev. Rule. 2004-64, IRB 2004-27, 7.
4 Rev. Rul. 85-13, 1985-1 CB 184.
5 LTR 9535026 (May 31, 1995).
6 LTR 9515039 (Jan. 17, 1995).
This article is reprinted with the publisher’s permission from the TAXES–THE TAX MAGAZINE, a monthly journal published by CCH, a Wolters Kluwer business. Copying or distribution without the publisher’s permission is prohibited. To subscribe to the TAXES–THE TAX MAGAZINE or other CCH Journals please call 800-449-8114 or visit www.CCHGroup.com. All views expressed in the articles and columns are those of the author and not necessarily those of CCH.
Robert S. Keebler, CPA, M.S.T., is a Partner with Virchow, Krause & Company, LLP, in Green Bay, Wisconsin. His views as expressed in this article do not necessarily reflect the views of the CPA Insider™ or the AICPA.