Our office regularly advises clients on various trust designs including irrevocable trusts.

One of the irrevocable trusts that we use is the Intentionally Defective Grantor Trust (IDGT) to further a client’s estate planning and tax planning goals.  The main purpose of such a trust is to freeze the value of an asset that is expected to increase in value rapidly over time.  At the same time, the IDGT is a grantor trust and therefore the income earned on the trust is taxed to the grantor individually at the grantor’s tax rates rather than at the trusts compressed (higher) income tax rates.  

 

How does it work? The grantor seeds the trust with 10% of the value of the asset as a whole, so for example, 10% of a closely held family business LLC.  Since this is a gift to the trust, it would require using the grantor’s estate and gift tax exemption, so a gift tax return would need to be filed and the gift would reduce the lifetime exemption.  The result is that the increase in the value of the 10% interest is excluded from the estate for estate tax purposes.  In addition, the grantor will be responsible for paying the taxes on the income and, importantly, the payment of the income tax is not considered a gift to the trust which is equivalent to adding more value to the trust without any corresponding tax consequences.  

 

What’s the next level? In addition to the gift (above), it is common to also sell assets to the trust and utilize a promissory note by the trust back to the grantor.  Picking up from the prior example, the grantor could sell the remaining 90% of the LLC to the trust in exchange for a note by the trust at the applicable federal rate (AFR).  This transaction and the payments of interest are not taxable to the grantor and there is no capital gains because the trust is a grantor trust (which is alter ego to the grantor for tax purposes).  The note does need to be repaid over time, but the real value in this technique is that the growth of the company in the trust is outside of the estate for estate tax purposes. 

 

What else? A few important points to be aware of with the IDGT is that the trust should be able to generate sufficient liquidity to pay the installment note.  Also, the income earned by the company is not directly payable to the grantor, who may be the founder of the company, however, the grantor would be receiving a significant flow of income by virtue of the promissory note and the interest and principal payments of the note.  The grantor can be giving authority to remove and replace the trustees and in so doing allow the grantor to continue to exert the right amount of influence.  Also, in certain cases the grantor can utilize valuation discounts where gifting and/or selling fractional shares of the company.

 

The IDGT is certainly not for everyone, but in the right circumstances, it can be an invaluable tool when it comes to shifting the appreciation of assets outside of the taxable estate of the client while providing liquidity to the grantor down the road and keeping income taxes down.