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March 03, 2002 at 07:00 PM
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.
