Intentionally Defective Trusts Are Effective In Transferring Assets

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A photograph “freezes” a moment in time, capturing a cherished family occasion, a dramatic sporting event, or a historic occurrence for posterity.

The photographic principle has a special application in estate planning, especially for anyone who wants to leave his or her family an asset that is expected to appreciate significantly over time.

By using an intentionally defective irrevocable trust (IDIT), you can take a “snapshot” of the asset at a specific moment in time, thereby freezing the value of the asset for estate-tax purposes–regardless of any appreciation in value that the asset may realize in the future.

The “defective” descriptor of these trusts is a bit of a misnomer because when used correctly, they can be highly effective in helping clients pass substantial assets to family members or other loved ones. Defective grantor trusts also provide a great deal of flexibility because they allow clients to simultaneously achieve several financial objectives.

For instance, IDITs can be used as both an estate-planning tool and a source of income for either the grantor or the trusts beneficiaries. Permanent life insurance is often placed in IDITs to accomplish just that.

IDITs address the differences in rules between the three tax systems–estate and gift taxes, generation-skipping transfer taxes, and income taxes–for the benefit of those who make use of them. Although establishing the trusts can be somewhat complex, their long-term advantages can prove more than worthwhile for those who invest the time and effort.

Assets typically placed in an IDIT include stocks, real estate, or other property that has healthy growth potential. If cash is placed in the IDIT, the trust purchases an asset with high growth potential. Generally, the transfer of the asset into the trust constitutes a sale, which means no gift tax must be paid.

Often, the trust is funded with an initial seed gift–typically 10% of the assets value. The grantor then sells the asset to the trust for its fair market value and in return receives a long-term promissory note. The note calls for the payment of only interest with a balloon payment of principal sometime in the future, perhaps 30 years or more.

The asset transferred into the trust is removed from the estate of the grantor. Regardless of any appreciation in value, no estate or gift taxes are due upon the death of the grantor. The removal from the estate of both the original value of the asset and any subsequent appreciation is why IDITs can be an ideal estate planning tool for assets that are expected to greatly appreciate in the future.

Of course, there are a few caveats. The grantor must not retain an interest in the trust. If this tax rule is broken, the entire value of the trust at the date of the grantors death is then included in the grantors estate. Should the grantor die within three years of the transfer, the value of the gift and any gift taxes paid at the transfer would be included in the estate of the grantor.

As an example of some of the benefits available through an IDIT, lets consider a case study. David, age 50, wants to pass stock issued by his employer, ACME Financial Services, to his son, Thomas. David places $10 million in stock in the IDIT and pays current transfer taxes at the rate of 50%, or $5 million. The stock appreciates at an average annual return of 10% until Davids death at age 80, leaving $23.6 million for Thomas.

Had the stock not been placed in the IDIT, the appreciated value would have triggered a higher estate tax. Although the federal estate tax is scheduled to be repealed in 2010, current budget rules mandate that the levy will return in 2011 at the current rates. If not for the IDIT, Thomas would lose half of his inheritance from the stock or $11.8 million.

But estate tax savings are not the only benefit of an IDIT. The trusts grantor or beneficiaries can also receive income from the trust. Keep in mind that any income generated by the trust is subject to income tax. In instances where the trust distributes income to its beneficiaries, the obligation for payment of the tax moves from the trust to the recipient of the income.

There are many circumstances where a client may prefer to pay income taxes. For instance, the trusts grantor can pay the income taxes for the beneficiaries without transferring additional assets and having to pay additional gift taxes. The grantors income-tax payments actually deplete his or her taxable estate by the amount of the taxes paid plus the growth on that sum.

The net effect is that the heirs receive the growth on the assets as an additional tax-free gift. In instances where the trust was created to benefit grandchildren or third generation, the grantor does not have to use his or her generation-skipping transfer tax exclusion.

The introduction of life insurance to the IDIT equation can create additional benefits for both the grantor and the trusts beneficiaries. First and foremost, the death proceeds are free of both estate and income taxes and can be used to generate the liquidity needed to cover any estate tax liability.

Although a life insurance trust is usually irrevocable to remove the death proceeds from the grantors estate, a tax “defect” can be included for income-tax purposes. This is accomplished, in most cases, by retaining the power to pay premiums for the life insurance policy and giving a trustee the power to add beneficiaries or pay trust income to the grantor or to his or her spouse.

Taking such steps enables the grantor to exercise potential income-tax deductions for interest payments on cash borrowed from the life insurance policy. If the trustee takes a policy loan, the proceeds can be reinvested to generate income. The income can be considered as deductible investment interest or passive activity interest.

Both the income and the tax deductions can pass directly to the trusts grantor. There are no deductions if the interest expenses from the loan are greater than the trusts income.

Variable universal life insurance policies can be especially attractive for such arrangements because the policys cash values are invested in equity-based investment options. Historically, equities offer greater long-term growth potential, which can enhance policy values available from the VUL policy.

Whether you use VUL or another type of permanent life insurance, however, intentionally defective irrevocable trusts can be a highly effective estate-planning strategy.

As more people take advantage of the tax-planning and income opportunities afforded by IDITs, perhaps the descriptor will change from intentionally defective to incredibly effective.

, JD, CLU is assistant vice president and director of advanced markets for Hartford Life, Simsbury, Conn. His e-mail is patrick.smith

@hartfordlife.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, March 4, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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