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.

First « 1 2 » Next