If you have assets you anticipate will increase in value, you can “freeze” the value of those assets for estate tax purposes with an Intentionally Defective Grantor Trust, an “IDGT”. Most wonder why they would want an “intentionally defective” anything, but it references the fact your estate attorney will purposefully insert language making the transfer of assets to the trust an incomplete gift for income tax purposes but a complete gift for estate tax purposes. Therefore, immediately following the transfer to the IDGT, the IRS considers the trust’s assets to be owned by your heirs for estate tax purposes but still considered owned by you for income tax purposes. These differing classifications can be very beneficial for those with estate tax concerns, rather than a need for a step-up in basis at death.
For background purposes, it’s important to know everyone has a limited exemption amount you can transfer to your heirs before either the estate tax or gift tax is imposed. The total exemption amount is reduced over your lifetime as taxable gifts are given. But the value of those gifts are determined when given, not death. Therefore, giving gifts of assets you anticipate will appreciate substantially may allow you to limit the amount of the combined estate and gift tax exemption that needs to be used and thereby limit estate taxes.
Since the federal estate tax and Maryland estate tax generally only apply to assets considered part of your estate at death, by having assets contributed to the IDGT be considered a “completed” gift, those assets are removed from your taxable estate. Further, not only are those assets removed from your estate, any further appreciation of the assets between the time each asset is contributed to the IDGT and the time of your death will not be considered part of your taxable estate. For purposes of the two federal transfer taxes (the estate tax and gift tax), a gift’s value is determined on the date it is transferred to the trust. This fixing of the value of the asset at a time earlier than death is what I earlier referred to as the “freezing” of the value of the estate.
While gift taxes may be a concern, you may be able to use your federal lifetime gift tax exclusion to reduce or eliminate any potential gift taxes. To limit the resulting gift taxes or the use of your lifetime gift tax exclusion, the transfer to the IDGT could instead be structured as a sale from you to the IDGT at the asset’s fair market value. Since, as a grantor trust, you and the trust are considered to be the same person, the sale will be tax-free. The trust would usually issue you an interest-only note with a balloon payment due in the future. The note’s interest rate can be as low as the IRS-determined Applicable Federal Rate. In a sale transaction, you would only want to contribute assets you anticipate will appreciate at a higher rate than the required interest rate, since this determines the usefulness of the transaction in lowering the estate tax burden. The interest paid to you by the trust would not be taxable income to you, since, as a grantor trust, you and the trust are considered the same person for income tax purposes.
In addition, to ensure the sale will be honored, you would want to gift additional assets equaling at least 10% of the value of the assets to be sold to the trust. The IRS states that this “seed money” is required, since a person would not typically sell something in exchange for a note to a trust with no assets.
If a note is used and the asset produces income, then the cash generated by the asset can be used to pay the note’s interest. If not, or if the income proves insufficient, then additional gifts may need to be made to the IDGT to pay the required interest.
Of course, if structured as a purchase, your estate would include the value of the note at the time of death and the interest payments, if not spent, but that amount should be less than the value of the contributed assets at the time of your death if the assets appreciate as anticipated.
In practice, the benefit should work as follows: Assume you own stock in your company worth $5,000,000. You anticipate the value of the stock will appreciate to $11,000,000 over the next few years. If you pass the stock directly to your children, then you may either use up your lifetime gift exclusion or incur federal gift taxes. If, instead, you pass the stock to an IDGT through a sale transaction, then you will have made a $500,000 taxable gift to fulfill the required 10% seed money funding. That $500,000 of assets can be used to purchase an initial portion of the stock to be transferred, and therefore the note would be for $4,500,000 for the remaining stock. At the time of your death, your estate would hold a $4,500,000 note (if interest-only) plus any interest the note paid during your lifetime that was not spent.
Further, income generated by the assets contributed to the trust may remain in the trust, but the income taxes due for such income would be taxable to you. However, this is actually a benefit since it allows you to pay the taxes, thereby reducing your estate, while the income itself will pass to your child without either income or estate taxes. The value of the transferred assets would not be subject to estate taxes, thereby allowing a transfer of $6,000,000 of appreciation to your child without federal or Maryland estate taxes. The IDGT with a sale also delayed paying a substantial portion of the transfer taxes that would be due had a direct gift been given and also allowed you to retain some control of the assets during your lifetime. Further, if the beneficiary of the trust is your grandchild, then the exemption allowed for the Generation Skipping Tax can also be leveraged.
The IDGT is a great tool for your estate attorney if you own assets you believe will increase in value before your death. The potential reduction of the value of your taxable estate, combined with the flexibility that may be allowed to you during your lifetime, makes an Intentionally Defective Grantor Trust an excellent option for those concerned about federal or Maryland estate taxes.
To discuss wills, trusts, estates, or probate matters or to see whether an Intentionally Defective Grantor Trust would be useful for your estate plan, please contact Jeff Rogyom at (410)929-4578.
Please review the Disclaimer page regarding use of this website and its information.