If you advise high-net-worth clients, you should take note of your calendar. We are at the midpoint of 2011, and 2012 will be here before you know it. Have you discussed the unprecedented wealth transfer opportunities now available to your clients? If not, you should make it a priority for your practice because change, once again, is coming.
The Tax Relief Act of 2010 provided individual taxpayers with, among other things, the ability to gift $5 million free of gift tax. But the provisions in the Act are due to expire on the last day of 2012. It is unclear whether any provision will be extended into 2013 and beyond, so it is important to take advantage of the generous exemption while we are certain of its availability.
The $5 million lifetime gift tax exemption represents a 400% increase over the 2009 exemption of $1 million. Still, many high-net-worth clients continue to seek strategies to leverage the exemption in order to pass along the greatest amount of wealth for the smallest cost. Although several “estate-freeze” strategies can be implemented to maximize the exemption, one strategy in particular deserves consideration for your wealthiest clients: a sale to a defective trust.
The IDGT Strategy’s Components
A sale to an intentionally defective grantor trust (IDGT) is a strategy with two primary components. The first component is the IDGT. An IDGT is termed “defective” because, although a transfer of property to the trust is considered complete for gift and estate tax purposes, the grantor is still deemed the owner of the property for income tax purposes. Consequently, he or she is responsible for any income tax liability associated with trust assets.
Payment of income tax liability by the grantor allows the trust to grow without the drag of taxes against the trust corpus. In addition, by paying those taxes, the grantor further reduces his or her taxable estate. In short, he or she creates a trust for the benefit of heirs that will grow essentially without tax liability and that is essentially a tax-free gift.
Another significant benefit of the IDGT’s grantor trust status is evident in the second component of this strategy, the installment sale. A sale by the grantor to a grantor trust is not a recognition event for income tax purposes because the trust is deemed to be the “alter ego” of the grantor; therefore, it is as if the grantor were making a sale to him- or herself. The nonrecognition of income upon the sale is a primary factor in the ultimate success of a sale to an IDGT.
How to Implement the Strategy
Once the IDGT is drafted, the grantor must transfer assets to “seed” the trust. The initial funding of the trust is required