From the September 2008 issue of Wealth Manager Web • Subscribe!

The Effective Defective Trust

As the political landscape changes, and the discussion of estate tax reform intensifies, one thing seems clear: High-net-worth clients are going to need sophisticated estate planning--regardless of which party wins the presidential office in November.

In March, while forming its budget resolution, the Senate provided some insight into the possible direction of the federal estate tax exemption and the tax rate on estates above the exemption amount. Of six proposed estate tax amendments--suggesting exemptions ranging from $3.5 million to $7.5 million per individual and tax rates from 15 percent to 45 percent--only one amendment garnered the 60 votes required for approval. The approved amendment proposed a $3.5 million exemption per individual and a tax rate of 45 percent. While this has not been enacted as law, it does provide us with a glimpse at what may lie ahead.

Few, if any, individuals believe the federal estate tax will be repealed for one year in 2010. Most believe there will be some reform prior to 2010. Time is running out, but from the continuing discussion regarding the reformation, it is obvious that high-net-worth clients will be demanding effective estate tax reduction. One technique that can have dramatic results involves an installment sale to an intentionally defective grantor trust (IDGT). As you will see, the term defective is misleading, since this technique can be very effective in generating substantial estate tax savings.

The effectiveness of a defective trust

An installment sale to an IDGT is a complex strategy with two primary components. The first component is the IDGT itself. The trust is considered defective because, although a transfer of property to an IDGT is considered complete for gift and estate tax purposes, the grantor--the taxpayer who funds the trust--continues to be considered the owner of the trust property for income tax purposes.

To ensure that the trust will be deemed a grantor trust, the drafting attorney will include a specific provision in the document which will trigger at least one of the grantor trust rules located in Internal Revenue Code (IRC) Sections 671 through 679. The attorney must be careful in selecting which grantor trust rule will be triggered, because the wrong provision may cause inclusion of the trust assets in the grantor's estate under IRC Sections 2036 through 2038.

The most common provision used to ensure grantor trust status without inclusion in the grantor's estate gives the grantor the ability to substitute trust property. This general power of administration, set forth under IRC Section 675(4)(C), allows the grantor to re-acquire the trust corpus by substituting other property of an equivalent value. This administrative power is sufficient to make the grantor the owner of the trust property for income tax purposes, without having the trust assets included in the grantor's estate.

Once the trust is properly drafted, the grantor becomes responsible for any income tax liability associated with the trust assets. With most planning techniques focused on avoiding or deferring taxes, it may seem strange to structure a trust so that the grantor must pay taxes, but in this case, there are significant planning benefits to doing so.

One benefit is the fact that the tax liability is paid from the grantor's pocket--not from trust assets. This allows the trust to grow without the drag of taxes against the trust corpus. Meanwhile, the grantor's ability to pay those taxes further reduces his or her taxable estate while creating a trust for the benefit of heirs that will grow essentially free of tax liability. In this scenario, the grantor's tax payments amount to a tax-free gift to the trust beneficiaries.

The second component is the installment sale--another significant benefit of the grantor trust status. Because the grantor trust is the alter ego of the grantor, a sale by the grantor to a grantor trust is not a taxable event for income tax purposes. Therefore, it is as if the grantor is making a sale to him- or herself. This non-recognition of income is key to the success of a sale to an IDGT.

How does an installment sale to an IDGT work?

Once the IDGT is drafted, the grantor must transfer assets--commonly referred to as seed money--to fund the trust. The initial funding is required to ensure that the trust has economic substance, and that the assets sold to the trust are not the sole source for repaying the debt associated with the installment sale. The IRS has not specifically addressed the amount required for initial funding, but many practicing attorneys believe that a minimum funding of 10 percent of the fair market value of the asset to be sold is required.

Using those guidelines, a $1-million sale would require that the trust be funded initially with at least $100,000. Be advised that the transfer of seed money to the IDGT is a taxable gift. However, the grantor can use all or a portion of his or her applicable exclusion amount for lifetime gifts (currently $1 million per individual). If grandchildren are named as beneficiaries, the grantor can also allocate an equivalent amount of his or her generation-skipping transfer (GST) tax exemption to the trust.

With the IDGT sufficiently funded, the grantor then sells assets to the trust, receiving an installment note as consideration for the sale. The term of the note may vary, but in order to avoid any further gift tax liability, the interest rate charged on the note must at least equal the specific Applicable Federal Rate (AFR) based upon the term of the loan. Once the sale is executed, the assets subject to the sale are removed from the grantor's estate. The trust must then make debt service payments to the grantor under the terms of the installment note.

The assets to be sold to the trust must be carefully considered. For this strategy to be truly effective, these assets must grow at a rate of return greater than the AFR that determines the interest paid back to the grantor. For example, if the rate on the note is 5 percent but the trust assets appreciate at 10 percent, the appreciation above 5 percent is effectively removed from the estate. Because the sale to an IDGT works best with assets that are likely to continue appreciating rapidly, many attorneys and wealth managers prefer to sell a family limited partnership, limited liability company, or other business interests to the IDGT. Take note that a grantor trust is an eligible shareholder of an S corporation's shares. This makes the sale of S corporation shares to an IDGT a popular planning strategy.

Because the ultimate fair market value of such business interests at the time of sale to the IDGT may possibly be discounted due to lack of marketability and/or minority control, this tactic can further enhance the leverage of this strategy.

Seek professional guidance

But take note: The sale of assets to an IDGT is a very complex strategy, and it is not without risk. At the present time, few sources of authority provide clear guidance in structuring this particular strategy. It is imperative that you work with an experienced attorney to implement this plan. With detailed drafting and thorough attention to detail, an installment sale to an IDGT can be one of the most effective means of reducing federal and state estate tax liability for some of your largest clients.

Gavin Morrissey, JD, is the director of advanced planning at Commonwealth Financial Network in San Diego, Calif. He can be reached at

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