The case for an intentionally defective grantor trust.

• Author: Pressey, Ora
• Position: Estates, Trusts & Gifts

When two sets of tax laws use different standards to measure the outcome of a single transaction, some advisers call the result a loophole. Others call it a tax planning opportunity (and some never mention it at all). An intentionally defective grantor trust (IDGT) is a complete transfer to a trust for transfer tax purposes but an incomplete, "defective" transfer for income tax purposes. Because the trust is irrevocable for estate and gift purposes and the grantor has not retained any powers that would cause estate tax inclusion, the future value of the assets transferred is removed from the grantor's gross estate on the date of the trust's funding, but due to certain other powers retained by the grantor, the trust, although irrevocable, is treated as a grantor trust for income tax purposes. As a result, the grantor, though not a beneficiary, is taxed on all the trust's income, even though he or she is not entitled to any trust distributions.

If structured properly, the IDGT will receive the gross income generated from the trust's income-producing assets, which will accrue to the benefits of the trust's beneficiaries. The trust also allows the grantor the opportunity to remove future appreciation from the grantor's estate while maintaining control over the assets.

Defective Powers

The most common powers that are retained by the grantor and thus make the trust defective for income tax purposes include:

1. Designating the grantor's spouse as a trustee and granting such trustee authority to add beneficiaries (Sec. 674(a));

2. Retaining the nonfiduciary power to reacquire or substitute trust assets (Sec. 675(4)(C));

3. Authorizing an independent trustee to make loans to the grantor without adequate security (Sec. 675(2)); and

4. Authorizing use of trust income to pay premiums for life insurance on the grantor's or the grantor's spouse's life under Sec. 677(a)(3).

Mechanics of an IDGT

The transfer of assets to an IDGT may be via either a completed gift or a fair market value (FMV) sale or installment sale, both of which are disregarded for income tax purposes. The disregarded installment sale is generally used for leverage with the goal of shifting income and appreciation in excess of a favorable interest rate to the IDGT. Such a shift would occur only if total returns exceed the interest on the installment note.

Also, the installment sale technique would be beneficial where the contemplated transfer exceeds the current gift tax exemption...