An intentionally defective grantor trust (“IDGT”) is a trust whose income is taxed to the grantor but whose contributed assets are excluded from the grantor’s estate for estate tax purposes. The word “defective” is an historical misnomer as there is nothing defective about these trusts.
The IDT accomplishes four goals:
- Irrevocable transfer. The grantor irrevocably transfers the “fair market value” of assets out of his or her estate to minimize or eliminate estate taxes by using the unified credit, which is at an historically high level. The assets are also subsequently excluded from the beneficiaries’ estates, unless there are general powers of appointment provided in the trust agreement for the beneficiary.
- Freeze out. The appreciation of asset value following contribution to an IDGT is also excluded from the grantor’s estate.
- Valuation deduction A “valuation deduction” is allowed on the asset transferred if, for instance, the transfer is of a minority or illiquid interest. This reduces the unified credit amount applied against the transfer allowing preservation of the unused amount and further maximizing the use of the credit.
- Estate planning. An IDGT allows transfers to beneficiaries without a will. This avoids probate while implementing your intentions as to assets following your death.
- Further freeze – out. The grantor pays income tax on the trust’s income without reducing the unified credit and further reducing his or her estate, while maximizing trust assets. This may become burdensome to grantor; therefore, a “toggle” in the trust is necessary to switch this power on and off.
The first concept in planning an IDGT requires a working knowledge of grantor trust rules in IRC Subchapter J (incl. Secs. 671-678). This subchapter provides that if certain powers are present in a trust agreement, the grantor of the trust will include all trust income, expenses, and tax attributes on the grantor's personal tax return. Grantor trusts are treated for tax purposes as being not separate from the grantor. Correspondingly, all transactions between the grantor and the IDGT are disregarded for all income tax purposes; thus, the income tax transfer-for-value rule of IRC 101 also does not apply. (Rev. Rul. 85-13, 1985-1 C.B. 184, Rev. Rul. 2007-13, 2007-1 C.B. 684.)
The second concept in planning an IDGT requires a completed taxable gift to accomplish the estate exclusion, thus excluding the fair market value of the assets transferred and their subsequent appreciation in value, the freeze out. The issue is that a transfer to trust can be deemed an incomplete gift if the grantor retains certain powers over the trust, which must be avoided to obtain estate exclusion the purpose of the IDGT
A grantor trust may be revocable or irrevocable; however, an
IDGT must be an irrevocable trust funded through a completed
Recommended Grantor Trust Provisions Maintaining Completed Gift.
The IDGT is an irrevocable trust that takes advantage of a disparity between the income and estate tax treatments offered generally through the use of IRC Sections 674 and 675, which allow a completed gift while the grantor retains certain “strings” allowing control over those assets. The following are grantor trust provisions which do not disturb a completed gift and which we provide in our trusts; however, you must select which powers you would like to retain:
Borrowing without adequate security or interest. The
trust may contain a provision giving grantor the power to take
loans from trust without adequate interest or security. To
trigger grantor trust status, this power must be retained by
the grantor and not given solely to the trustee. (IRC 675(2)).
A section titled “Power to Enable Grantor to Borrow” is
provided in our document as follows:
During Grantor’s lifetime, the Trust Protector may grant to Grantor the power to borrow income or principal of the trust without adequate security. If exercised, the Trust Protector must grant the power in writing and specify the terms upon which Grantor may borrow and the amount of income or principal that Grantor may borrow upon those terms.
Substituting assets of equivalent value. The grantor
retains (in a non-fiduciary capacity and without the approval
or consent of any person acting in a fiduciary capacity) the
power to reacquire assets from trust and substitute them for
other assets of equivalent value. This also allows oft
otherwise omitted basis planning under IRC 1014. (IRC
675(4)(C); IRC 2036; 2038(a) and 2042; Rev. Rul. 2008-22; Rev.
Rul. 2011-28; PLR 200603040, 9413045, 9247024). A section
titled “Power of Substitution” is provided in our
document as follows:
During Grantor’s lifetime, the Trust Protector may direct the Trustee to transfer any of the trust property to Grantor in exchange for property of equivalent value within the meaning of Rev. Rul. 2008-22 as amplified by Rev. Rul. 2011-28. If a Trust Protector is not then serving, Grantor reserves the right to reacquire any trust property by substituting other property of equivalent value; however, Grantor may not reacquire any property that would cause Grantor to have an incident of ownership, as defined in Section 2042 of the Internal Revenue Code, with respect to any insurance policy on his of her life held as part of the trust property; furthermore, Grantor may not exercise this power with respect to any stock treated as voting stock under Section 2036(b) of the Internal Revenue Code.
The Trustee has a fiduciary obligation to ensure compliance with the terms of this power by satisfying itself that the properties acquired and substituted by are in fact of equivalent value.
No provision in this agreement is to be construed in any manner that limits the Trustee’s power to reinvest trust corpus for the benefit of the beneficiaries, and the Trustee has a fiduciary duty to act impartially toward all trust beneficiaries.
The intention is that that the provisions of this subsection comply in all respects with Revenue Ruling 2008-22 as amplified by Revenue Ruling 2011-28, and that this subsection must be interpreted to ensure compliance with these rulings.
Grantor may at any time, by written notice to the Trustee, release and relinquish this right.
- Power to add charitable beneficiaries. Under IRC Section 674(a), the trust may give the grantor the power of disposition, which affects the beneficial enjoyment of the trust income or principal. For example, the grantor could retain the power to add non-charitable beneficiaries or to direct distributions to existing beneficiaries or other “limited powers of appointment” not resulting in estate inclusion.
- Income sprinkling. Non-adverse party (other than grantor) may sprinkle income among beneficiaries.
Grantor trusts affirmatively enhance many common estate planning strategies by permitting the income earned by the trust to grow free of income tax because the tax burden is imposed on the Grantor, and the payment of the trust’s income tax liability by the grantor is not a gift. Rev. Rule 2004-64, 2004-2 C.B. 7. Our trust under the section titled “Authorization to Reimburse Income Tax Liability” provides this benefit to you as follows:
Notwithstanding the provision of any state law to the contrary, Grantor has no right to be reimbursed for any income tax paid by Grantor on all or any part of the trust’s income. An Independent Trustee may from time to time, however, distribute to Grantor or his or her Legal Representative, or elect to pay directly to the taxing authorities, so much of the income or principal of the trust as may be sufficient to satisfy all or part of Grantor’s personal income tax liability attributable to the inclusion of all or part of the trust’s income in Grantor’s taxable income. In exercising its absolute discretion with respect to such distributions, an Independent Trustee may consult with tax or other advisors and the Trust Protector but is not bound to follow any recommendation made by them
The difficulty is that at some time the tax attributable to the grantor may become too onerous; therefore, the Trust Protector is allowed to release the Grantor from the liability and make the trust responsible for it, i.e., the Trust Protector may remove the trust from grantor trust status. This is the “toggle” first referenced above. The wording in the trust provides as follows:
The Trust Protector may release any or all powers described in this Section at any time by delivering written instruction to the Trustee. The release will be effective upon its receipt by the Trustee, unless the release instructs that it is to be effective upon a later date. The Trust Protector may restore any power released at any time by delivering written instruction to the Trustee. In no event, however, may the Trust Protector restore any power within the same taxable year in which the power was released.
The tax consequences of releasing or restoring grantor trust powers are discussed in Tax Planning for Family Wealth Transfers: Analysis with Forms (WG&L) at 3.02[i][vii]. The author posits that the elimination of a specific power or powers would instantly terminate grantor tax status of the trust, relying on Madorin v. Commissioner, 84 T.C. 667 (1985). Therefore, it is suggested that if there is a release of a power effective for the next taxable year, one should release it effective at midnight on December 31 of the current taxable year.
Further to this, the IRS stated in Notice 2007-73, 2007-36 I.R.B. 545 (9/4/2007) that certain toggled grantor trusts are “transactions of interest,” the involvement in which might trigger disclosure rules, list maintenance requirements and possible tax penalties under Sections 6011, 6111 and 6112 of the Internal Revenue Code. In that Notice, however, the taxpayers toggled grantor trust status on and off within a tax year to avoid recognizing gain or claim an inflated tax loss. The question arises whether this Notice evidences a general concern by the Service about toggling grantor trust powers, or whether the Service will limit the ruling to its own abusive facts. In order to give you additional protection, our trust provides that the toggling may not be exercised to toggle on and off in the same year so as to avoid this issue.
Reciprocal Trust Doctrine
This doctrine operates to avoid estate exclusion when using his and her IDGTs. To avoid this result, you must provide some variances between the terms of the two trusts.
First, one might use different types of trusts, e.g., an IDGT and a GRAT. Second and alternatively, use different distribution patterns and beneficiaries.
- Can you apply valuation discounts to the interests sold or transferred to the IDGT? Yes.
- Can the IDGT be a special needs trust? Yes.
- Can the IDT own operating businesses? Yes.
- Can you turn off grantor trust status? Yes.
- Who pay the income taxes when you die or if they “turn off” the grantor trust status? It becomes a complex trust, those then rules apply.
- Can the IDT be a spendthrift trust? Yes.
- Can the IDT own life insurance? Yes.