Next, our client would create the IDGT trust, which is designed to be excluded from the client's gross estate for federal estate tax purposes, but is also subject to a set of "grantor trust" rules for income tax purposes. By making the IDGT a grantor trust, our client may sell assets to the IDGT without recognizing a capital gain or loss and receive tax-free interest payments under an installment sale.
After making a "seed" gift to the IDGT of about 1/10 of the discounted value of the FLP, or $670,000 (which gives economic substance to the transaction) of, our client would sell the entire discounted FLP to the IDGT and take back a promissory note for the full discounted value of $6,700,000. The note would be structured as an interest-only loan, followed by a balloon payment of the face amount after five years (A longer loan term is more commonly used, but a five-year term is used here to compare results with our previous example of a five-year GRAT). The interest on the promissory note need only be 2.8 percent (even lower than the 3.4 percent used for the GRAT) to meet IRS guidelines for intra-family loans. And, as noted above, neither the sale of the FLP nor the interest payments received on the promissory note will have any income tax implications for the client because the IDGT has been designed as a grantor trust.
If we take the same 7.0 percent rate of annual appreciation that was used for the GRAT illustration-after making annual interest payments of $187,600 for five years, followed by a balloon payment of the $6,700,000 loan principal-the undiscounted remaining trust balance that would pass as a tax-free gift to the grantor's beneficiaries could be as much as $6,739,000. If the trust assets appreciate at an annual rate of 10 percent coming out of the current recession, the tax-free gift could approach a staggering $9,000,000!
Additional wealth transfer can be achieved if the trustee of the IDGT purchases survivorship life insurance on the grantor and his or her spouse using a portion of the trust assets to pay the insurance premiums. Further, by allocating some of the grantor's generation-skipping tax exemption along with the seed gift to the IDGT, the trust will have dynastic characteristics that will compound the wealth transfer objectives across multiple generations without ever being reduced by federal estate taxes.
While our examples show that the IDGT sale can yield a significantly better result than the GRAT, risk-averse clients may opt for the more modest results achieved using the GRAT knowing that the technique is sanctioned by Congress under the Internal Revenue Code. However, IDGTs have heretofore withstood the test of IRS scrutiny, even though the strategy isn't based on any IRS rule but only on an interpretation of previous IRS rulings.
An honest assessment of the relative risks and rewards of these techniques will help clients make a well-informed choice of which technique is the right one for their individual goals and objectives. The first step is to inform your higher net worth clients that these and other wealth transfer techniques and strategies are available.
For high-net-worth clients who might benefit from this unique opportunity to use these or other wealth-transfers strategies, the appropriate message just might be that opportunity is knocking, but it may not continue for much longer.
Richard A. Behrendt has been the senior estate planner at Robert W. Baird & Co. Inc. since 2006. Before that he spent 12 years working as an estate tax attorney with the Internal Revenue Service. For his work representing the government in several complex audits, Rich received the IRS' National Achievement Award in 2006. Rich is also an adjunct professor of law at the University of Wisconsin Law School, where he teaches a course in advanced estate planning.