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.