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Financial Planning > Trusts and Estates > Estate Planning

Estate Planning: Time Running Out on $5 M Gift-Tax Exemption

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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


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.

Although there is no specific guidance on the issue, many practitioners believe that a minimum funding of 10% of the fair market value of the asset to be sold is required. As such, before execution of a $50 million sale, the trust, upon creation, would have had to be funded with at least $5 million.

The “seed” funding of the IDGT is a taxable gift. The grantor can use all or a portion of the applicable exclusion amount for lifetime gifts to absorb the gift tax liability otherwise associated with the trust funding. If grandchildren are named as beneficiaries, the grantor can also allocate an equivalent amount of his or her generation-skipping transfer (i.e., GST) exemption to the trust.

With the IDGT sufficiently funded, the grantor will sell assets to the trust and receive an installment note as consideration for the sale. The term of the installment note may vary, but, in order to avoid any further gift tax liability, the interest rate charged on the note must have a minimal rate equal to 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. Once again, the grantor status of the IDGT highlights a significant planning benefit. First, the sale between a grantor and a grantor trust does not result in the recognition of gain. In addition, the installment payments, including the interest component, from the trust to the grantor do not result in income tax to the grantor.

For this strategy to be most effective, the assets sold to the trust must grow at a rate of return that is greater than the AFR that determines the interest paid back to the grantor. In basic terms, if the rate on the note is 4% but the trust assets appreciate at 10%, the appreciation above 4% is effectively removed from the estate. To optimize the strategy, the sale should include assets with the greatest chance of rapid appreciation, such as private business interests and pre-IPO stock.

Given the increase in the lifetime gift tax exemption and the uncertainty of future tax law, an installment sale to an IDGT could be an excellent way to maximize the current opportunity available.

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Investors should consult a tax preparer, professional tax advisor, and/or a lawyer.


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