Helping a client benefit from an intentionally defective grantor trust: These trusts can be advantageous to wealthier clients, but their future use in estate planning is threatened by current legislative proposals.

• Author: Bryniarski, Barbara

An intentionally defective grantor trust (IDGT) is an estate planning technique that may benefit a practitioner's wealthier clients. However, current legislative proposals, if enacted, could nix this tax planning technique as early as 2022. Thus, if a practitioner is considering an IDGT for a client, time is of the essence.

An IDGT is a trust set up by a grantor (i.e., an individual) that is treated as separate from the grantor for federal estate and gift tax purposes but is treated as owned by the grantor for federal income tax purposes. These trusts are referred to as IDGTs because the grantor intentionally includes in the trust agreement a right or power (such as the grantor's ability to switch out and substitute assets for other assets already in the trust) that causes him or her to be treated as the owner of the trust for income tax purposes. The grantor pays income tax on the trust's income, but the appreciation that builds up in the trust's assets is excluded from the grantor's estate.

How these trusts are used

An example of a tax planning scenario where the use of an IDGT would be beneficial is one in which a wealthy individual holds appreciating assets, such as real estate or stock, and wants to shelter the future appreciation of those assets from estate taxes. The individual can sell the appreciating asset to an IDGT at fair market value (FMV) in return for a promissory note that bears interest at the applicable federal rate. The Supreme Court decision in Fidelity-Philadelphia Trust Co. v. Smith, 356 U.S. 274 (1958), sets forth certain criteria that must be met in order to avoid having an asset sold to a grantor trust from being included in a decedent's estate. As relevant to IDGTs, the interest payments on a promissory note from the IDGT to the grantor cannot be tied to the income generated by the asset sold to the trust. Thus, if the asset does not generate sufficient cash flow, grantors typically also gift cash to the IDGT as a cushion to meet the trust's interest payment obligations.

For instance, assume P bought 100,000 shares of XYZ Company, a startup, for $1 per share back in 2010, but the stock is now worth $100 per share and P receives $200,000 each year in dividends. P has an untaxed gain on the stock of $9.9 million, and the assumption is that amount will keep growing. If P sells the stock in October 2021 to an IDGT in exchange for a $10 million 15-year promissory note bearing interest of 3%, and also contributes $1...