Intentionally defective irrevocable trust (IDIT)
One way to take advantage of the exemption is to create an IDIT, which is a trust that is disregarded for income tax purposes but that removes the assets from the taxpayer’s taxable estate. An IDIT is funded with an initial gift, typically cash, in an amount that provides the trust with sufficient net worth to be a qualified purchaser. As a qualified purchaser, the trust can purchase highly appreciated assets (for example, stock in a family business), discounted as appropriate. In exchange, the trust provides the seller with a promissory note obligating the trust to pay principal and interest at the IRS’ minimum required interest rate, currently 0.14% for notes with a term of less than four years, 0.35% for notes with a term of four years or more but less than nine years, or 1.00% for notes with a term that is nine years or longer.
Forgiving the note and reporting the loan as a gift to the trust or gifting the note receivable to someone else (such as a family member) will use a portion of the gift and estate tax exemption equal to the amount of the loan forgiven or the amount of the receivable gifted. In either case, the IDIT provides the donor with the flexibility to determine the amount and timing of the gift.
Qualified terminable interest property (QTIP) trust
Alternatively, the note could be contributed to a separate QTIP trust, which allows the grantor to provide for his or her spouse but maintain control of where the trust assets will be distributed when the surviving spouse dies without incurring any gift or estate tax because it qualifies for the marital deduction. The QTIP trust can be drafted so the donor can elect at a later date whether it will benefit only the donor’s spouse, in which case no taxable gift has occurred, or others in addition to the donor’s spouse, in which case the nonspouse recipients will receive a taxable gift. This election can be made any time up until the extended due date of the donor’s gift tax return for the calendar year during which the gift is made. If a gift is made in calendar year 2020, the gift tax return, if extended, is not due until Oct. 15, 2021.
Planning ahead
The unusual challenges facing the economy as a result of COVID-19 make it difficult to predict with any certainty what will happen with the gift and estate tax in the near future. Therefore, it is important for individuals to consult with their tax advisers to consider planning options that can provide flexibility. Trust agreements must be drafted by an attorney, and a valuation will be needed if the trust will be purchasing an interest in a closely held business. Therefore, the sooner taxpayers begin this process, the sooner they can put a plan into effect.
