One of the primary goals of estate planners is to reduce estate taxes, and for the last few years at least, nothing has helped them accomplish that goal better than grantor retained annuity trusts (GRATs). These trusts have become so popular, in fact, that they are sometimes called the "chicken soup" of estate planning.

But, as many estate planners already know, GRATs may soon be taken off the menu in many cases. Changes are afoot in Congress that would significantly restrict the tax advantages of these trusts and put an end to some popular tax reduction strategies they made possible.

There is, however, another "soup" that estate planners will probably turn to more frequently if the proposed GRAT restrictions are enacted. It's not as popular to sell assets to intentionally defective grantor trusts (IDGTs), but these trusts have their own advantages in certain circumstances, and are sometimes even more efficient than their GRAT cousins.

Gaining In Popularity
While a sale to an IDGT involves slightly greater complexity than a GRAT, it offers potentially greater transfer planning opportunities. Like the GRAT, this strategy has been gaining popularity.

A sale to an IDGT generally happens in three steps. First, the grantor forms a specially designed grantor trust (the IDGT). Second, the grantor makes a taxable gift of cash or marketable assets to capitalize the IDGT (which allows the trust to make the down payment on the sale). Third, the grantor sells a limited partnership interest (or minority interest in a limited liability company) to the IDGT in an installment sale (this asset is discounted because of its lack of marketability and the seller's lack of control).

In exchange for the partnership interest, the grantor receives a down payment and takes back a promissory note from the IDGT.

The sale must be commercially reasonable to be respected by the IRS so that the agency does not treat it as a gift. A qualified valuation professional should be retained to determine the appropriate valuation discounts for the limited partnership or limited liability company interest being transferred to the trust. A substantial down payment from the trust back to the grantor is necessary to give the promissory note efficacy-10% to 20% is often cited, but this is based on speculation, not authority. The promissory note from the IDGT is often structured as an interest-only note for a term of years with a balloon payment due upon expiration of the term. The interest rate on the note should be equal to the minimum applicable federal rate at the time of the sale. The note should be secured by the partnership interests and/or personal guarantees of the beneficiaries. A self-canceling installment note or private annuity can also be used.

A grantor trust is treated for income tax purposes as if the trust assets are owned by the grantor (i.e., the grantor, and not the trust, is taxable on the trust's income and capital gains) even though the corpus and income benefit the trust beneficiaries. In Revenue Ruling 2004-64, the IRS clarified that a grantor's payment of a grantor trust's tax liabilities does not constitute an additional gift to the trust. It is therefore advantageous from a transfer tax perspective to make the grantor taxable on a trust's income because the grantor's payment of the trust's taxes essentially allows the grantor to make additional tax-free gifts to the trust with each payment of the trust's tax liabilities, further depleting the grantor's estate.

An Irrevocable Trust
An IDGT is an irrevocable trust that is a grantor trust for income tax purposes, but still allows the trust assets to be excluded from the grantor's taxable estate. Grantors must be careful when drafting the trust instrument to achieve the intended tax consequences. Some of the powers that may be included to accomplish the desired results include giving non-fiduciaries (including the grantor) the power to reacquire the trust corpus by substituting other property of an equivalent value, giving the grantor or another eligible party (such as the grantor's spouse) power to borrow from the trust without adequate interest or security, and giving the grantor power to use trust income to pay premiums on life insurance for the grantor or for his or her spouse.

The IRS' Revenue Ruling 85-13 says, in effect, that a grantor can transfer or sell highly appreciated property to an IDGT without any income tax consequences.

The sale technique freezes the value of the assets in the IDGT at the discounted purchase price so that all future appreciation inures to the trust beneficiaries. So if the assets transferred to the IDGT appreciate and earn income each year at a rate that is higher than the interest rate on the promissory note, that excess growth or income will pass to the beneficiaries free of gift or estate taxes. Like a GRAT, this technique can be particularly advantageous when interest rates and asset values are low. It should be easier for a sale to succeed in generating a tax-free gift, however, because the minimum rate for the note (assuming the term is for nine years or less) is by definition lower than the 7520 rate used for a GRAT (the 7520 rate is currently at an all-time low-2% for November).

The maximum leverage is achieved if the grantor outlives the note term. But it is not necessary for the IDGT grantor to survive the term to obtain significant estate tax benefits (in GRATs, by contrast, the assets revert to the estate if a grantor dies before the end of the trust term). If the grantor dies before the loan is repaid, only the value of the note will be included in the grantor's estate (although there is a question about whether the gain may be realized at death). After the sale, the grantor will have removed all of the appreciation and income in the assets of the partnership from his or her estate. The grantor can also easily allocate a generation skipping tax exemption to any gift made to the trust, which the grantor couldn't do with a GRAT. Furthermore, the grantor further reduces his or her taxable estate by paying all of the taxes on the trust's income and capital gains, increasing the after-tax growth to the next generation.

But there are some disadvantages in selling assets to an IDGT. When the grantor makes the initial gift to the IDGT to fund the down payment and "capitalize" the trust, she may use a portion of her lifetime gift tax exemption or even have to pay gift tax. There is no step-up in basis for the underlying assets, just as there isn't in a GRAT. The trust's basis in the assets purchased will be the same as the grantor's basis in the property before the sale. Like any other loan, this transaction contains economic risk. If the investments contributed to the IDGT do poorly and are not sufficient to make the required interest and principal payments on the note, the grantor may have a receivable that is greater than the value of what remains in the trust to pay off the note.

The IRS does not sanction the sale structure the way it does a GRAT: The component parts may be sanctioned by themselves, but the entire structure taken together as a wealth transfer device is not. In addition, if the IRS successfully challenges the value of the gift or sale portion of the transaction, it is possible that it might use up more of the lifetime gift tax exemption or that gift tax may be due (although there are certain safeguards that can be used to reduce these risks).

Conclusion
While some clients may currently prefer GRATs because they are less complicated and involve less gift tax risk, GRATs are likely to become a much less effective planning technique if, as expected, Congress places restrictions on them. If that happens, sales to IDGTs will replace GRATs as the "chicken soup" of estate planning. There may be greater risk involved when implementing sales to IDGTs, but clients should ultimately benefit since this risk can be managed and sales often provide greater tax benefits and planning opportunities.

Lisa S. Presser is a partner and the head of the Private Client Group at Drinker Biddle & Reath LLP in the firm's Princeton, N.J., office. Lance T. Eisenberg is an associate in the Private Client Group in the firm's Florham Park, N.J., office. Presser and Eisenberg specialize in trust, estate planning and administration.