Sales to IDGTs: A Hearty Recipe for Tax Savings

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1 Sales to IDGTs: A Hearty Recipe for Tax Savings Intentionally defective grantor trusts may replace GRATs as the chicken soup of estate tax planning. BY LISA S. PRESSER, LANCE T. EISENBERG AND KRISTEN A. CURATOLO ONE OF THE PRIMARY GOALS OF ESTATE planners is to reduce estate taxes, and for the last several 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. Recently, Congress has considered changing the minimum period for a zero-tax GRAT to ten years. Such a change would significantly restrict the tax advantages of these trusts and eliminate some popular tax reduction strategies they made possible. Fortunately, there is another soup that estate planners may turn to more frequently if the proposed GRAT restrictions are enacted. While it may not be as popular to sell assets to intentionally defective grantor trusts (IDGTs), these trusts have the potential to yield greater advantages in certain circumstances than their GRAT cousins. Gaining In Popularity At the end of 2012, when the federal exemption equivalent amount was at an all-time high and there was great uncertainty about Congress s next move, many tax practitioners identified both GRATs and IDGTs as effective tax reduction strategies that Congress could eliminate with a pen stroke. Even after the gifting frenzy of 2012, IDGTs remain an excellent method of removing future asset appreciation (above the current section 7520 rate) from the grantor s estate. With a federal exemption equivalent amount that is currently $5,340,000 (or $10,680,000 for married couples) and indexed for inflation, the tax savings strategy offered by an IDGT is ripe as ever. While a

2 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 in 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). A gift of seed money equal to at least 10% of the anticipated purchase price is often cited. This is based mostly on commentator analysis, but also on the fact that the IRS required the applicants for Private Letter Ruling to commit to a trust equity of at least 10% of the installment purchase price. Third, the grantor sells assets that are income producing or expected to appreciate in value to the IDGT in an installment sale. A limited partnership interest or minority interest in a limited liability company is often used since these assets can be discounted because of their lack of marketability and the seller s lack of control. Diagram: Creating and Funding an IDGT Grantor creates a trust that makes Grantor the taxpayer for income tax purposes Grantor makes a taxable gift of cash/assets to fund IDGT Grantor sells LP interest, or LLC interest, to IDGT in an installment sale 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 value of the property transferred to the IDGT, including any appropriate valuation discounts for limited partnership or limited liability company interest. 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 non-borrowed trust assets (e.g., 2

3 in the form of a down payment) and/or personal guarantees of all the trust beneficiaries. A selfcanceling installment note or private annuity may 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 , 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. Practitioners must be careful when drafting the trust instrument to achieve the intended tax consequences. For example, while Revenue Ruling provides that while a trustee s discretion to reimburse a grantor for his or her tax liability does not alone cause the inclusion of the trust in the grantor s gross estate, the Ruling adds that this is subject to local law. While some states have passed legislation to ensure that a creditor of a grantor cannot reach assets of the trust solely because of a trustee s ability to reimburse a grantor for taxes paid, many states (such as Wisconsin) have not passed such grantor-friendly legislation. As a result, practitioners must review their jurisdiction s laws before drafting a trust that empowers a trustee with discretion to reimburse a grantor for his or her tax liability, or else a grantor s creditors may be able to gain access to the assets of the trust. Some of the powers that may be included to accomplish the desired results include giving nonfiduciaries (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) the power to borrow from the trust without adequate interest or security, and giving the grantor the power to use trust income to pay premiums on life insurance for the grantor or for his or her spouse. 3

4 Revenue Ruling 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 section 7520 rate used for a GRAT (the section 7520 rate is currently 2.2% for October 2014). The maximum leverage is achieved if the grantor of the IDGT outlives the note term. But it is not necessary for the 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 generationskipping transfer tax exemption to any gift made to the trust, which the grantor cannot 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. However, 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. Similar to a GRAT, there is no step-up in basis for the underlying assets. 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 perform poorly and are not sufficient to make the required interest and principal payments on the note, the 4

5 grantor may have a receivable that is greater than the value of what remains in the trust to pay off the note. Additionally, the IRS does not sanction the sale structure the way it does a GRAT. While the component parts of an IDGT are sanctioned by themselves, the entire structure of an IDGT as a wealth transfer device has not been blessed by the IRS. Also, 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). As a sale to an IDGT is a viable estate tax reduction technique, Congress has considered eliminating the advantage of IDGTs by imposing a gift tax on distributions from an IDGT and including the remaining assets in an IDGT in the grantor s estate upon the death of grantor. However, for now, the window of opportunity to utilize the estate tax benefits afforded by IDGTs remains open. 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 enacts restrictions on them. If that happens, sales to IDGTs will replace GRATs as the chicken soup of estate planning. There may be greater uncertainty involved when implementing sales to IDGTs, but clients should ultimately benefit since this uncertainty 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 a partner at Berkowitz Lichtstein in the firm s Roseland, N.J. office. Kristen A. Curatolo is an associate in the Private Client Group at Drinker Biddle & Reath LLP in the firm s Florham Park office. Presser, Eisenberg, and Curatolo emphasize their practice in trust, estate planning and administration. 5