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Financial Planning > Trusts and Estates > Trust Planning

Timing Is Right For Leveraged Wealth Transfers

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Advanced planning continues to function in a tax and economic environment that places a premium on wealth transfer strategies that leverage the federal gift tax exemption, or on alternative strategies such as sales and loans that seek to avoid gift tax costs.

This year, the federal estate tax exemption jumped from $2 million to $3.5 million, and there are indications Congress may act to retain the $3.5 million exemption for several years rather than permit EGTRRA’s “sunset” provisions to proceed. Few believe Congress will increase the lifetime gift tax exemption (frozen at $1 million since 2002), other than to add a possible indexing provision. Even after release of the President’s budget proposal, no legislation is on the horizon to reduce the gift tax (with a top 45% rate) on major non-charitable gifts. Since the tax cost hinders gifts larger than the $1 million exemption, many planning scenarios devolve into a search for leveraged transfer strategies–using the fewest dollars to shift the most estate value (and growth) over to the next generation, with the least transfer tax cost.

Moreover, today’s low interest rate and the depressed-value environment, make this–ironically–an excellent time for advisors to engage in a variety of leveraged wealth transfer and business succession strategies. One such strategy is the sale of rapidly appreciating assets to an intentionally defective grantor trust (IDGT) in exchange for a promissory note bearing low interest. In appropriate circumstances, high net worth clients can remove future appreciation from their estate without capital gains taxes, and with little if any gift tax.

How the IDGT works

A grantor creates an irrevocable trust with at least one of the “grantor trust powers” described in IRC ??671 and beyond–causing the trust to be “defective” for income tax purposes. One such power is the power of a grantor to substitute assets of equivalent value for assets held in the trust. When a trust is “defective” in this sense, the usual income tax consequences of a sale between the grantor and trust are disregarded. But for gift and estate tax purposes, such transactions are effective. The concept is especially effective for owners of closely-held business interests, real estate, investment portfolios, art and collectibles, and other properties expected to rapidly appreciate or recover value after the sale.

As a precaution before the sale, the grantor typically gifts “seed funds” to the trust in an amount equal to 10% of the sale price to reinforce the economic substance of the trust. Next, the grantor and trustee enter into a binding purchase agreement. The property is sold to the trust, in return for a promissory note bearing interest set at the Applicable Federal Rate (AFR) under IRC ?1274(d). When substantiated with an appraisal, valuation discounts for the sale of minority interests in closely-held entities provide additional leverage–even as the grantor retains control of the entity outside of the IDGT.

Results of installment sale to IDGT

The results are favorable. The grantor is not taxed on any capital gain on the sale, or on interest received on the promissory note. Because it is a sale, there is no gift tax (unless the gifted “seed funds” use up the gift tax exemption). The asset and its future appreciation are removed from the grantor’s estate, although the note balance and any accrued interest remain in the estate–though the face amount of the note may be discounted. The leverage of this strategy is enhanced with today’s depressed values and low interest rates. That translates to a lower sales price, lower interest payments, and more effective discounts.

While the grantor is taxed on trust income, that cost is offset by shrinkage in the grantor’s estate, without a gift tax even though the income tax payments indirectly benefit the trust beneficiaries. In effect, the trust assets grow on a tax-deferred equivalent basis.

Retained trust income may be used to buy a life insurance policy on the grantor’s life that would be outside the grantor’s estate and beyond the reach of creditors. The death benefit can pay off any note balance, provide liquidity to the estate (to avoid the forced sale of a family business), and pass any unspent portion to the grantor’s heirs.

Cautionary concerns

While the IDGT installment sale can deliver positive results, some planning concerns and risks should be addressed.

Seeding the IDGT–If the trust is not adequately “seeded” (generally, a cash gift of no less than 10% of the asset purchase price is used), the IRS may attack the trust as undercapitalized or illusory. For large transactions, a gift of the seed funds could exhaust all or a portion of the grantor’s lifetime gift tax exemption.

Interest payments–Interest payments are typically set at the published AFR (published monthly). Interest paid currently is safer than interest deferral. To increase the strategy’s leverage, some planners use the lower AFR rates with “interest only” notes. However, commentators warn that such notes might prompt the IRS to invoke IRC ?2702, causing the retained interest payments to be valued at zero. Also, if interest on the note equals the income produced by the asset in trust, the IRS might treat the sale as a transfer with a retained interest under IRC ?2036(a)(1)–causing estate inclusion of the trust assets. To mitigate that risk, the grantor may want to consider having the trust own other income-producing properties.

Carryover basis–The tax basis of assets sold to an IDGT carries over to the trust. If the trust sells appreciated assets before the note is paid, the grantor might have to report taxable gain.

Valuation controversy–The grantor may be liable for an unexpected gift tax if the IRS successfully contests the valuation of the asset sold to the IDGT.

Underperforming assets–There is a risk that the IDGT assets fail to deliver the expected earnings and growth, with the trust remains obligated on the note.

Taxable gift–The IRS recently implied it might treat the grantor’s payment of income tax on the trust’s income as a taxable gift.

Grantor’s death–At the grantor’s death, the trust is no longer a grantor trust. If the note has not been paid when the death occurs, the income tax consequences are uncertain. This risk can be mitigated by not selling low-basis assets to the IDGT, or by limiting the term of the note. Also, a life insurance policy could be purchased on the grantor’s life with trust income, for the payment of any unexpected taxes due at grantor’s death, to pay off the note or enhance the legacy to the heirs.


With the high tax cost of large direct gifts, the timing is right for leveraged wealth transfers with an installment sale to an IDGT. Moreover, today’s low interest rate and depressed value environment make this an especially beneficial technique in the right client circumstances. The strategy should be balanced with some planning concerns as noted, so it cannot be emphasized enough that sophisticated advisors should be involved at the outset.

Dick Kait, JD, LLM, CLU, ChFC, is second vice president for advanced sales and director of premium financing at Protective Life in Cincinnati, Ohio. You may email him at [email protected]


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