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George F. Bearup, J.D. Senior Legal Trust Advisor

Sales to Intentionally Defective Trusts

Take-Away: Like a grantor retained annuity trust (GRAT), a sale to an intentionally defective grantor trust (IDGT) also benefits from the current low interest rates. An IDGT functions differently than a GRAT, but it is an effective way to freeze the value of the Grantor’s estate for estate tax purposes. The GRAT’s annuity potentially brings appreciating assets back into the Grantor’s taxable estate. The IDGT brings non-appreciating cash, i.e. interest and note payments, back into the Grantor’s estate.

Background: At its basic level, an IDGT strategy is merely the sale of an appreciating asset to an irrevocable trust. The trust is classified as a grantor trust for income tax purposes, and thus it is treated as wholly owned by its Grantor. However, the value of the assets held in the IDGT are not included in the Grantor’s estate at the time of the Grantor’s death. This transaction results in an estate freeze since an appreciating asset is removed from the Grantor’s taxable estate and is replaced with a fixed low interest installment promissory note.

Overview of IDGT Sale: The steps to form and the benefits derived from a sale to an intentionally defective grantor trust (IDGT) follow.

  • The normal structure of an IDGT is to create the irrevocable trust and ‘seed’ the trust with some amount of liquid assets. After a period of time (e.g. weeks or months) the trust then purchases an appreciating asset from the trust’s Grantor in exchange for an installment promissory note.
  • The installment promissory note, in order to avoid an implied gift, must use the applicable federal rate (AFR) of the month of the transaction.  IRC 1274 provides the applicable rate of interest for the installment note. The applicable federal long term interest rate for August, 2020 is 1.12%, which is the AFR interest rate that must be used for a long term note in excess of 8 years.
  • The IDGT’s appreciating asset may generate enough income sufficient to service the Grantor’s installment note payments. If the IDGT’s income is insufficient, the trustee of the IDGT can either borrow funds to pay down the installment note, or use assets in-kind to pay the installments that come due under the note.
  • Because the IDGT is a grantor trust for income tax purposes, there is no income tax consequence to the Grantor’s sale of the assets to the IDGT. If the appreciating assets were sold directly by the Grantor to his/her children, that too would freeze the Grantor’s estate (exchanging an appreciating asset for a fixed interest installment promissory note) but the sale to the Grantor’s children would result in capital gain recognition.

Comparison of an IDGT with a GRAT: Each of these estate planning strategies carries both opportunities and risks. A comparison of an IDGT with a GRAT follows:

  • Reliability: A GRAT is expressly authorized by statute. [IRC 2702.] In addition, there are multiple Regulations that implement how the GRAT is structured, i.e. an IRS roadmap is available in order to stay out of trouble. There is no comparable IRS roadmap with regard to an IDGT. As a result, there is not much  guidance on how an IDGT can or should be structured or administered which suggests more caution is required in using an IDGT.
  • Initial Seed Gift: A GRAT can be zeroed-out, meaning that no gift tax needs to be paid for the gift (if any) to the remainder beneficiary of the GRAT. With an IDGT, there is a strong belief that there must be a ‘seed gift’ to the IDGT in order to forestall IRS arguments that the Grantor retained a right to the income generated by the transferred asset held by the IDGT, i.e. an implied retained income interest, thus exposing estate inclusion under IRC 2036. As such, so the argument goes, if there are assets in the IDGT besides the asset that is sold to it, then there is no IRC 2036 ‘trap’, but the initial transfer of ‘seed’ assets to the IDGT is a normally a taxable gift. Most savvy commentators suggest that the ‘seed’ gift should be at least 10% of the fair market value of the asset that is to be sold to the IDGT. [Note, this initial ‘seed’ gift might be obviated if the beneficiaries of the IDGT personally guaranty the installment promissory note given to the Grantor.]
  • Undervalued Property: If the IRS challenges the value of the assets transferred to a GRAT, there exist rules that will automatically adjust the amount of the annuity payment that the Grantor receives from the GRAT, either to reduce or eliminate the value of the ‘gift’ of the remainder interest in the GRAT. With an IDGT a challenge by the IRS to the value of the asset sold could result in a taxable gift to the IDGT, or worse, a claim that IRC 2036 applies to the entire transaction, bringing the value of the entire IDGT corpus back into the Grantor’s taxable estate at death. This risk can be mitigated to some extent with the use of a defined value formula sale  of the hard-to-value asset to the IDGT.
  • Termination of Grantor Trust Status: There is little guidance on the income tax consequences of the termination of grantor trust status with an IDGT. Again, due to the lack of guidance on IDGTs in general, it is not clear if, when the grantor trust status is terminated, gain will then be recognized. Grantor trust status can be terminated while the Grantor is still alive, e.g. a release of the power to substitute assets, or upon the Grantor’s death. This risk might be eliminated if the Grantor substitutes high basis assets with the IDGT in exchange for the low basis IDGT assets prior to the Grantor’s death. With a GRAT, the death of the Grantor during the annuity payment period will result in some, or most, of the GRAT’s asset value included in the Grantor’s taxable estate; if the GRAT ceases to be a grantor trust while the Grantor is still alive, a taxable gift occurs on that event.
  • Grantor’s Death: If the Grantor dies during the annuity payment period of a zeroed-out GRAT, much of the GRAT’s corpus will be included in the Grantor’s taxable estate (the amount necessary to pay the annuity for the balance of the identified annuity payment period.) The GRAT really only works well when the Grantor survives the annuity payment period. With an IDGT, if structured correctly, the IDGT should not be includible in the Grantor’s estate, regardless of when the Grantor dies. The risk associated with the death of the IDGT Grantor might be mitigated somewhat if the installment promissory note is paid while the Grantor is alive, or with the use of a self-cancelling installment note, i.e. the unpaid balance is forgiven on the Grantor’s death.
  • Interest Rates: The interest rate used to value the Grantor’s retained interest in a GRAT is IRC 7520, which is 120% of the mid-term AFR rate. If the GRAT’s assets do not appreciate faster than the IRC 7520 rate when the assets are transferred to the GRAT, the GRAT will not produce satisfactory results. In contrast, the interest rate used with the installment promissory note given in exchange for the Grantor’s sale of the appreciated asset to the IDGT uses the IRC 1274 AFR rate. If the IRC 1274 interest rate is lower than the IRC 7520 rate, less value will be returned to the Grantor’s estate (and exposed to estate taxation on the Grantor’s subsequent death.)
  • GST: The ultimate beneficiaries of either a GRAT or an IDGT determine if the generation skipping transfer tax (GST) is a concern. With the sale of an appreciating asset to an IDGT, the is no exposure to the GST since a sale, not a gift, is involved; the assets held in the IDGT will not be included in the Grantor’s taxable estate. If there is a seed gift to the IDGT, then the Grantor’s GST exemption can be allocated to that transfer at the time of the transfer of the ‘seed’ gift to the IDGT. With a GRAT, the Grantor is unable to allocate any of the Grantor’s GST exemption amount to the transfer to the GRAT until after the annuity payment period ends, which is the estate tax inclusion period, or ETIP. Therefore, if the GRAT is successful because its assets appreciate at a rate above the IRC 7520 hurdle rate, some of the Grantor’s GST exemption will be allocated (‘wasted’) sheltering that GRAT-duration appreciation.

Conclusion: Both a GRAT and a sale to an IDGT can greatly benefit from the prevailing low interest rate environment as estate freezing strategies. Each trust has its own unique strengths and weaknesses. The tax consequences of using a GRAT are more clear than if a sale is made to an IDGT. Yet arguably an IDGT could remove more assets from the Grantor’s taxable estate than a GRAT, but that may not always be the case depending on how the transferred asset performs. Investment-wise. If skip persons are the intended beneficiaries, probably an IDGT is a better strategy to pursue than a GRAT.