Background: With all of the talk these days about the expected fundamental changes in the tax laws Congress might adopt this year, there has been a renewed (or perhaps an accelerated) interest in the use of an intentionally defective grantor trust (IDGT). While no one actually can predict what the final tax laws will look like, a concern is that many clients who should continue to plan their estates and shift their wealth to minimize taxes are sitting on the sidelines waiting for the finalization of the promised tax law changes. One strategy that some clients should continue to pursue, regardless of what tax law change Congress finally gives to us, is the use of an IDGT.

Definition of an IDGT: A short definition of an IDGT follows. The settlor creates an irrevocable trust. In the trust instrument, the settlor retains certain limited powers. One commonly retained power is the settlor’s right to substitute assets with the trust’s assets, as long as the exchanged assets are of equal value. Because of this retained ‘swap right’ held by the settlor, the irrevocable trust is classified as a grantor trust for income tax reporting purposes, which means that all of the irrevocable trust’s income is taxed to the settlor. When the settlor dies, or when the settlor irrevocably releases this retained right of substitution, the trust then ceases to be a grantor trust. At that time, the trust will begin to pay its own income taxes, to the extent the trustee does not distribute the trust’s income to the trust beneficiaries, when the trust beneficiaries then pay the income taxes.

Benefits of an IDGT: Several benefits can be derived through the use of an IDGT, and the sale of the settlor’s appreciating assets to it, which benefits might become even more appealing in the face of Congressional tax reform.

  • No Capital Gains Tax: If the settlor sells appreciated assets to the IDGT, in exchange for an installment promissory note, the settlor does not recognize any capital gains on that sale. The grantor trust is treated as the grantor, so that the sale is treated as a sale to oneself, the result of which is in no capital gain recognition. In short no capital gain tax  is recognized or paid by the settlor on the sale of his/her asset to the IDGT. This sale to an IDGT removes the appreciated asset from the settlor’s taxable estate. All future appreciation of the sold asset also is not included in the settlor’s taxable estate, which is important if we end up continuing to have some type of federal estate tax; in addition,   some states still impose a state estate tax, like New York which imposes a 14% state estate tax,  which can be avoided or reduced if the settlor no longer owned the appreciating asset.  If the currently discussed  tax law changes coming from Congress and President Trump become law, we may end up substituting the existing federal estate tax with a capital gains tax due on the owner’s death. Thus, if the client continues to hold appreciated assets until his/her death, there could be an immediate capital gain tax due on the client’s death, even if the appreciated asset is not actually  sold.  Consequently, if the IDGT owns the appreciated asset, and not the settlor, then the appreciation imbedded in the IDGT’s assets will not be exposed to the discussed ‘deemed sale on death capital gains tax.’ Note, too, that the sale of the appreciated assets in exchange for an installment promissory note in effect ‘freezes’ the settlor’s estate, because an appreciating asset is replaced with a non-appreciating fixed face value, amortized over time,  installment promissory note held by the settlor until his/her death. Either way, with a continuation of a federal estate tax which taxes the fair market value of assets owned by a client, or a deemed sale of appreciated assets on the client’s death, the IDGT works effectively  to minimize those taxes.
  • Income Tax Burn: Yet another estate planning benefit derived from a sale of appreciating assets to an IDGT, although candidly many settlors struggle to embrace this  benefit, is the income tax reporting required of a grantor trust. As noted, because the settlor’s sale is to an IDGT, the settlor is required to report all of the IDGT’s income as the settlor’s own taxable income. Thus, the settlor ends up paying the income tax associated with the IDGT’s income. This is often called a tax burn. This is where some settlors struggle to see the benefit- they end up paying income taxes on somebody else’s income. The settlor’s taxable estate is burned to pay the IDGT’s income tax liability. This burn over time reduces the settlor’s taxable estate if there continues to be a federal estate, or state estate tax,  imposed on the size of the settlor’s estate at his or her death. If the promised change in tax laws comes in the form of reduced income tax rates, arguably this legal obligation to pay the IDGT’s income tax burden will be at a lower marginal income tax rate. [The messages coming from Washington DC seem to propose an elimination of the 39.6% income tax rate, and the elimination of the 3.8% net investment income (NII) tax, replaced with the highest marginal federal income tax rate of 33% [down from 39.6%.] If the settlor (or his or her estate) is going to pay a tax, better that it be paid at a 33% federal income tax than a combined 43.4% income and NII tax rate.
  • No Gift Tax: A third benefit derived from the sale of appreciating assets to an IDGT in exchange for an installment promissory note is that the settlor’s payment of the IDGT’s income tax burden is not treated as a gift by the settlor to the beneficiaries of the IDGT. Thus, if a settlor has already used up his or her federal gift and estate tax lifetime exemption, but still wants to continue to transfer wealth transfer tax-free to his or her heirs, the payment of the IDGT’s income tax liability by the settlor will shift more wealth from the settlor’s estate (he/she is paying the IDGT’s income tax burden) to the IDGT where the settlor’s heirs are the trust beneficiaries (who indirectly benefit from the tax free growth of assets held in the IDGT.) It is generally thought that despite the expected tax reform that Congress is considering,  there will be a continuation of the federal gift tax, which is thought to be needed to prevent parents shifting taxable income from their high income tax bracket  to their children’s lower income tax brackets. Thus, while the federal estate tax may soon disappear, we may still have to contend with some limitations on lifetime gifting by wealthy clients to their heirs. The IDGT strategy meets this potential continued federal gift tax hurdle because the settlor’s payment of the IDGT’s income tax burden is treated as a non-gift by the settlor. In sum, the assets held inside the IDGT can grow in a tax-free environment for the settlor’s descendants who are the trust’s beneficiaries. [Admittedly, it is misleading to call the IDGT a tax-free environment because the settlor is paying the IDGT’s income taxes, but from a wealth shifting perspective, the IDGT  exploits compounded growth if it makes few distributions to the beneficiaries which is common with a dynasty-type trust which is created to last for several generations to avoid future transfer taxes and to protect assets held in trust from the beneficiaries’ creditors and divorces, while the settlor pays all of the IDGT’s income taxes so long as the settlor is alive (and the trust continues to be classified as a grantor trust.)

IDGT Seed Gift: One of the perceived drawbacks to selling appreciated asset to an IDGT  is the belief that there must be assets in the IDGT equal to approximately 10% of the value of the appreciated assets that the settlor intends to sell to the IDGT. Thus, if I intended to sell $1.0 million of an appreciating closely held business to the IDGT in exchange for an Installment Note with a face value of $1.0 million, according to this belief,  there must be another $100,000 placed in the IDGT, often called the seed gift. How that $100,000 gets into the IDGT is that I have to make a taxable gift of $100,000 to the IDGT. This 10% ‘rule of thumb’ is not found in the Tax Code. The apparent theory behind this 10% seed gift requirement is that in order for the Installment Note given to the settlor as part of the sale transaction to be respected by the IRS, the IDGT must receive some other source of a minimum funding to service the Note, hence the seed gift concept, to support the creditworthiness of the Installment Note given to the settlor in the sales transaction. The thought is that in order to provide adequate ‘economic substance’ for the sale transaction, the IDGT must be seeded with at least 10% of the fair market value of the purchased asset to legitimize the sale. Some advisors will not even proceed with a sale of appreciated assets to an IDGT  in the absence of a 10% seed gift, which can become problematic if the settlor has already used his/her lifetime federal gift tax exemption in full, which may leave the settlor with the ‘Hoben’s Choice’ of having to make a taxable seed gift to the IDGT to assure the ‘economic substance’ of the intended purchase transaction.

Seed Gift Myth: An article recently published by a nationally prominent estate planning attorney, Richard Oshins, and an equally prominent law professor (also Chairperson of the respected Notre Dame Tax and Estate Planning Institute) Jerome Hesch, have concluded that there is no legal basis to insist upon a 10% seed gift when selling an appreciated asset to an IDGT.  Instead the authors advocate what they call the reality of sale approach to sales to an IDGT. The authors persuasively point out that in a long line of Supreme Court decisions the ‘test’ required is only the need to determine whether or not it is reasonable to assume that the note given to the settlor will be paid in accordance with its express terms. If the parties to the sale transaction can show that the IDGT trustee is expected to have the necessary funds to timely meet its obligations under the installment note given to the settlor, then the ‘economic substance’ test is met. These same Supreme Court decisions also imply that there is no need for the parties to the IDGT purchase-sale transaction to show that there is a non-tax motivation for the transaction, or that there must be  some pre-tax profit readily available to the IDGT.

An example where a seed gift would be required is if the settlor sold raw land, albeit appreciating, to an IDGT in exchange for an installment promissory note. Arguably there would be no source of liquidity in the IDGT with which to pay the interest or principal installments due on the installment promissory note given to the settlor. In contrast, if the subject of the sale to the IDGT was commercial real estate with a strong and steady stream of rental income paid to the IDGT Trustee, there might be more than sufficient liquidity in the IDGT to service the payments due to the settlor under the installment note, thus completely obviating the need for any 10% seed gift to the IDGT.

The authors also advocate that from the seller’s perspective, there is some intrinsic value associated with the business transaction with a grantor trust. They point out that the seller may actually get a ‘three-fer’ in an IDGT transaction.

  • First, since the settlor has sold appreciated assets to a grantor trust, the settlor arguably has less need for liquidity since the settlor is not obligated to pay capital gains taxes on the sale of the asset to the IDGT. In a normal transaction a seller will factor in the seller’s capital gain tax obligation when negotiating the terms of the sale- but there will be no capital gain tax paid when the sale is to a grantor trust;
  • Second, the asset that is sold to the IDGT is normally appreciating in its value, so it is expected that if the collateral given to secure the installment promissory note is the same asset that was sold by the settlor, that collateral will be expected to continue to grow in value while at the same time the principal balance on the installment note will be diminished through regular payments to the settlor;  in short, the collateral security equity cushion that secures the payment of the settlor’s installment note will increase over time; and
  • Third, the buyer of the appreciating asset, the IDGT trustee, will be viewed as a tax-advantaged buyer, in that it the IDGT trustee does not pay any income taxes on all of the income generated by the IDGT. Thus, without any income tax erosion of the income accumulated in the IDGT (so long as the trust is classified as a grantor trust) that favored tax status makes the IDGT trustee a more desirable purchaser, and arguably placed in a much better financial position to timely pay all of the obligations that come due under the installment promissory note compared to a conventional (i.e. taxed) purchaser of the asset. This last observation exploits the conventional IRS valuation ‘test’ in that it ignores the identity of a willing buyer -willing seller when negotiating the terms of the sale. This obviously ignores the equally obvious fact that while the IDGT may be tax advantaged (it does not pay income taxes), it is the poor settlor who is stuck paying the IDGT trustee’s income tax liability. I guess I am not completely sold on the merits of this last perceived benefit that dispenses with the need for a seed gift to the IDGT.

Guarantees: It should also be noted that another option that some advisors use when faced with a seed gift requirement, i.e. the sale of high growth, low yield assets to the IDGT with inadequate cash flow to service the settlor’s installment note, is that the trust beneficiaries can also provide personal guarantees to the IDGT trustee’s installment promissory note given to the settlor. If the reasoning behind the seed gift theory is to make the sales transaction economically viable, i.e. the availability of outside financing,  a personal guaranty from the trust beneficiaries will support the economic decision of the settlor to sell on the terms of the installment note without the need for a seed gift, not to mention reflect typical behavioral patterns  in the business world  often require the party who purchases the asset in exchange for a promissory note to provide a personal guaranty for a part of [but not necessarily the full face amount of] the installment note.

The point in all of this is that some clients who are sitting on the sideline waiting for tax law changes should continue to embark on estate planning techniques. Some techniques, like the sale of a IDGT or the aggressive use of short term Grantor Retained Annuity Trusts (GRATs) ought to continue to move forward with their planning, as there are few risks associated with these techniques, and most of them are still effective, regardless of the tax law change, to shift wealth without much tax exposure.