Intentionally defective grantor trusts.

• Author: Welker, Curt J.

Sophisticated estate tax planners have long used the seemingly oddly named intentionally defective grantor trust (IDGT) as an effective tool. The IDGT can freeze the value of an asset for estate planning purposes, while effectively transferring funds out of the estate free of gift taxes. The IRS, with one caveat, recently reaffirmed this planning technique, in Rev. Rul. 2004-64.

How IDGTs Work

Example: Individual G creates an irrevocable inter vivos trust as the grantor, using an unrelated third-party trustee. He then sells to the trust an asset which is likely to appreciate, in return for an installment note (usually with a balloon payment), bearing an interest rate at the applicable Federal rate (AFR). The trust beneficiaries are G's heirs. To make certain that the asset's fair market value is reflected by the installment note, G has the asset appraised. This ensures that the transfer is not treated as a gift under Sec. 2512(b).

By intentionally retaining a minor power (discussed below), G triggers the Sec. 671 grantor trust rules, causing the trust's net income to be taxed to G (in the same way as a revocable living trust). Some of the more commonly retained minor powers that trigger these rules include G'S rights under Sec. 675(4) to substitute property of equal value for the property originally transferred, and to borrow from the trust without adequate security under Sec. 675(2).

Although the 'trust is disregarded for income tax purposes (i.e., all income from the trust asset is reported by G directly on his individual return, and the gain on the sale, as well as the interest income/expense on the installment note, is completely disregarded), the transfer is respected for estate tax purposes (i.e., the asset is no longer in G's estate); for such purposes, G owns an installment note.

Because G must report the asset's income, he must pay the related income tax. Thus, while the asset's future appreciation and any income received from it grow shielded from estate tax, G continues to pay the income tax on the earnings accruing to the beneficiaries. By paying an expense which is economically that of the beneficiaries, the IDGT in effect allows G to make additional gifts without paying gift tax or using his annual exclusion. As a result, an asset with annual taxable income (as well as potential future appreciation)...