Planning in turbulent times: IDITs.

• Author: Lewis, Alev T.
• Position: Intentionally defective irrevocable trusts

Editor's note: If you would like further information about this column, please contact Ms. Lewis at (805) 557-3710 or alev.t.lewis@bankofamerica.com. The author thanks Roger Stinnett, Senior Manager, Ernst & Young LLP, for his assistance.

Intentionally defective irrevocable trusts (IDITs) offer taxpayers an estate-freeze and wealth transfer technique appropriate for these uncertain economic times. They also offer taxpayers an estate planning opportunity, despite the events of September 11, current market instability and recently enacted estate legislation.

What Is an IDIT?

An IDIT is an irrevocable trust that takes advantage of a disparity between the income and estate tax treatments of a trust containing certain powers under Secs. 674 and 675. It is considered a grantor trust for income tax purposes, but it is not includible in a grantor's estate for estate tax purposes. A grantor can sell appreciating assets to an IDIT in exchange for a note, freezing his or her estate and transferring wealth by converting an appreciating asset into a fixed-yield asset (e.g., an interest-bearing note).

How Does It Work?

A grantor initially seeds an IDIT with cash or property that creates a taxable gift. The asset is then sold to the IDIT in exchange for an installment note. Because the IDIT is intentionally made defective to qualify as a grantor trust, the grantor does not recognize gain or loss on a sale of an asset to the IDIT; see Regs. Sec. 1.1001-2(c), Example (5); Rev. Rul. 85-13; and Bernard Madorin, 84 TC 667 (1985).

Similarly, the grantor pays no tax on the interest payments received on the note; however, he or she pays tax on all of the trust's income. If the grantor dies during the note's term, the IRS might argue that the gain should be recognized (Madorin). However, the grantor's estate may be able to defer the gain under the Sec. 453 installment-sale rules, until the note is fully paid off (Sun First Nat'l Bank of Orlando, 607 F2d 1347 (Ct. C1. 1979)).

An IDIT enhances wealth transfer opportunities, because it allows a grantor to discount assets transferred or sold due to lack of marketability or a minority interest, which reduces the assets' fair market value (FMV), the amount of the taxable gift and the promissory note. Further, the grantor can also benefit by using a family limited partnership or dynasty trust (or both) in combination with an IDIT.

Some points about IDITs include:

* Initial cash or property used to seed an IDIT is a...