Intentionally defective irrevocable trust: A powerful tax planning tool

| 1/14/2021
Intentionally defective irrevocable trust: A powerful tax planning tool

Intentionally defective irrevocable trusts (IDITs) typically are used when individuals want to transfer income-producing and highly appreciating assets (such as S-corporation stock or real estate) out of their estate, often while taking into account valuation discounts (as applicable). The unique characteristic of IDITs is that they are treated differently for estate and gift tax purposes than they are for income tax purposes. IDITs work well in a low interest rate environment, so they are particularly attractive right now.

How IDITs work

When a grantor creates an irrevocable trust that intentionally violates the income tax grantor trust rules of the IRC, the trust is treated for income tax purposes as if it does not exist. For estate and gift tax purposes, however, the trust is treated as if it does exist.

The grantor must gift cash or other assets to the trust to provide it with sufficient net worth to be considered a qualified purchaser. Sufficient net worth typically is 10% of the value of the assets to be sold to the trust.

Next, the grantor sells property – discounted when appropriate – to the trust in exchange for a promissory note. Under the note, the trust is required to pay the grantor principal and interest (at the IRS’ minimum required interest rate). Upon the grantor’s death, only the note balance and any accrued (unpaid) interest is included in the grantor’s taxable estate.

Income from the trust is treated as the grantor’s income for income tax purposes. However, the grantor should be able to pay any additional income tax due with cash received from the trust under the note. The additional tax the grantor pays reduces the grantor’s estate – a phenomenon known colloquially as “tax burn.”

For example:

Assume a grantor sells stock in an S corporation worth $11 million to an IDIT in exchange for a 15-year promissory note. Before the sale, the grantor makes a $1.1 million cash gift to the trust. Assuming the sale takes place in December 2020 when the IRS-required interest rate for a note term greater than nine years is 1.31%, the trust would be required to make payments back to the grantor in the amount of $812,519 per year for 15 years. (Any period of time could be selected, but typically the period should be long enough to reduce the payments to an amount that could be fulfilled using normal distributions from the S corporation.) The net tax savings to the grantor depends on the appreciation rate of the stock during the term of the trust. If, for example, the stock and other investments in the IDIT grow at a rate of 10%, the assets received by the grantor’s heirs will be worth $24,728,956 (with the “cost” of the transaction being the $1.1 million gift). Using a 40% estate tax rate, this represents an estate tax saving of $9,451,582.

If the grantor decides that he or she does not want to continue to pay income tax on the earnings of the trust (which might happen either when the note is paid in full or when the assets inside the trust are about to be sold at a significant gain), the grantor can turn off the grantor trust status of the trust by waiving, disclaiming, or renouncing the power that caused the defect that resulted in the trust being treated as a grantor trust in the first place.

However, there is a potential trap for the unwary. In trusts where the grantor’s spouse has certain powers, it might not be possible for the grantor to turn off the grantor trust status if the spouse also does not waive or release his or her rights in the trust. Also, there might be an income tax gain if the remaining unpaid balance on the promissory note exceeds the tax basis of the assets inside the trust at the time the trust ceases to be a grantor trust.

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Benefits of an IDIT

The benefits of the IDIT technique include the following:

  • The grantor pays no gift tax on the sale of property to the trust because it is a bona fide sale and the fair market value of the promissory note received from the trust is equal to the value of the property sold to the trust.
  • The grantor will not recognize any gain on the sale of the property to the trust for income tax purposes because the trust is “intentionally defective.” Likewise, the grantor will not be taxed on the receipt of the interest income on the note during the grantor’s lifetime.
  • The property sold to the trust and its post-sale appreciation will not be included in the grantor’s taxable estate. Only any note balance remaining at the grantor’s death is a taxable asset.
  • During the time the trust is a grantor trust for income tax purposes, the grantor will pay income tax on the trust’s activities rather than the trust being responsible for this tax. Payment of this tax will result in “tax burn” (that is, it will reduce the grantor’s net worth) without being considered a taxable gift, which can be a powerful benefit for estate tax purposes.

To maximize the benefits of the IDIT technique, the post-sale appreciation of the property sold to the trust must exceed the interest received on the note. Therefore, the property sold to the trust should be highly appreciating property, such as closely held S-corporation stock, marketable securities, family limited partnership interests, or real estate. As noted earlier, the IDIT sale technique works best when interest rates are low. The IRS minimum rate for a note with a term of four to nine years for December 2020 is 0.48%; it is 1.31% for notes with terms nine years or longer.

Going forward

An IDIT is a very powerful technique that should be considered for individuals who have highly appreciating assets and who need or want an income stream for a period of time after selling asset(s). Taxpayers should consult their tax advisers to determine if using an IDIT makes sense for them.

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Sally E. Day
Sally Day
Managing Director