SC Lawyer, September 2012, #4. Bottling Lightning.

• Author: By G.P. Diminich and Halsey O. Schreier

South Carolina BAR Journal

2012.

SC Lawyer, September 2012, #4.

Bottling Lightning

South Carolina LawyerSeptember 2012Bottling LightningUtilizing the Intentionally Defective Grantor Trust to Turbocharge Estate Tax Planning and Protect Assets from CreditorsBy G.P. Diminich and Halsey O. SchreierThis year's unique federal estate and gift tax environment presents an important tax planning opportunity for the estate planning attorney. Specifically, because the current $5.12 million estate and gift tax exemption is scheduled to dramatically drop to $1 million on January 1, 2013, a substantial number of previously unaffected clients would be subject to estate taxation at death. Therefore, the estate planning practitioner should contemplate advising clients whose net worth exceeds $1 million and who are consequently subject to estate tax liability to consider gifting assets and take advantage of the millions of dollars of lifetime gift tax exemption scheduled to disappear. By employing a specific type of irrevocable trust to accomplish a gifting strategy, clients may additionally protect assets from potential creditors, a significant ancillary benefit for clients with debt or other liability exposure.

Although the name "Intentionally Defective Grantor Trust" (IDGT) may conjure emotions in lawyers of something exotic (at best) or malpractice (at worst), the IDGT has been a tool that many estate planners have used for decades. Traditionally, it has been used as an "estate freeze" vehicle, whereby a grantor transfers assets out of his or her estate and into the IDGT, and thereby passes wealth to beneficiaries without being subject to the estate tax upon the grantor's death. Further, the estate tax benefits are "turbocharged" in that these assets are able to grow income tax free because the IDGT's income is taxed to the grantor. The IDGT, therefore, has the benefit of further reducing the grantor's estate for federal estate tax purposes. If combined with generation-skipping transfer (GST) tax planning, the IDGT's benefits become even more pronounced.

For this tax year in particular, the confluence of a number of independent developments has made the IDGT an attractive vehicle not only to avoid estate tax upon the grantor's death but also to protect the grantor's assets from possible creditors. The IDGT, unlike most other irrevocable trusts, offers both of these protections, giving it a unique advantage in the current favorable estate and gift tax environment and today's generally poor economic climate.

However, absent action by Congress and the President soon (and in an election year, no less), the high exemption amount for federal estate and gift taxes (unified at $5.12 million, the highest it has ever been) will expire by December 31, 2012, and an important planning opportunity could be lost. Further, the President has stated that he will propose legislation substantially reducing the estate and gift exemptions amounts and curtailing the tax benefits of an IDGT, making tax planning in 2012 more advisable. With the languishing economy, these events are so rare that they are the estate planning equivalent of lightning striking. A high net worth client or a client with significant potential creditor concerns should consider bottling the lightning by maximizing the opportunities presented by these unique circumstances and employing the IDGT in 2012 to transfer assets estate and gift tax free and shelter those assets from future creditors.

TABLE 1. ESTATE AND GIFT TAX EXEMPTIONS AND RATES

Year

Estate Tax Exemption/Rate

Gift Tax Exemption/Rate

2009

$3.5 million/45%

$1.0 million/45%

2010

N/A*

$1.0 million/35%

2011

$5 million/35%

$5.0 million/35%

2012

$5.12 million/35%

$5.12 million/35%

2013**

$1.0 million/55%

$1.0 million/55%

2013##

$3.5 million/45%

$1.0 million/45%

*For electing estates ** Scheduled # President's Green Book proposal

wnat is an IDGT?

An IDGT is an irrevocable trust whose assets are excluded from the grantor's estate for estate and gift tax purposes but whose income is attributed to the grantor for income tax purposes. To ensure that the assets of the IDGT are not included in the grantor's estate, the grantor is not included as a beneficiary of the trust. By contrast, in non-grantor irrevocable trusts the trust's income is attributed to the beneficiary(ies) of the trust. The IDGT name derives from the fact that the grantor intentionally includes a "defect" in the trust instrument that violates the rules contained in Sections 671 through 679 of the Internal Revenue Code and causes the income to be taxable to the grantor, thereby eroding the assets held in the grantor's estate. This in turn reduces the grantor's estate taxes.

By virtue of the grantor paying income taxes on the income of the IDGT, the assets held in the IDGT are therefore able to appreciate unreduced by income taxes. In essence, this "turbocharges" the appreciation of the assts held in the IDGT. This increases the value of the assets available for the IDGT beneficiaries, enabling more wealth to be passed to the beneficiaries. Put simply, the payment of income taxes by a grantor is a gift to the IDGT beneficiaries that is not subject to the gift tax.

Further, because the grantor is the owner of the IDGT assets for income tax purposes, the sale of an appreciated asset by a grantor to the IDGT will not trigger gain. Rev. Rul. 85-13, 1985-1 C.B. 184. Accordingly, highly appreciated assets (e.g., real estate, stocks, certain business interests, etc.) may be sold to the IDGT without any adverse income tax consequences. Although beyond the scope of this article, this sale presents further beneficial estate planning opportunities, such as the sale of appreciated assets to the IDGT in exchange for a promissory note.

The eventual estate tax savings upon the death of the grantor can be substantial, as traditionally the highest estate tax rate has been 55 percent. Therefore, an IDGT is commonly utilized to hold assets that are expected to substantially appreciate over the course of the grantor's remaining lifetime.

The estate planner must take great care in drafting an IDGT as it is unlike other irrevocable trusts. An IDGT is most commonly created in one or more of the following ways by various clauses and powers in the trust instrument itself:

1. The grantor, the grantor's spouse or some third party retains the power to reacquire the trust assets (e.g., the grantor retains the right to reacquire property out of the trust in exchange for property of equal value). l.R.C. 675(4)(C) (2006). There is a concern that this power creates a risk of estate inclusion; however, the Internal Revenue Service has ruled in Revenue Ruling 2008-22 that no such inclusion will occur merely because of the retention of a nonfiduciary power to substitute assets of equivalent value, based on the U.S. Tax Court's holding in Jordahl Estate v. Comm'r, 65 T.C. 92 (1975). To avoid this risk, one may grant the power to a party other than the grantor, such as some third party. 2. A "nonadverse party" controls to whom and when trust income and principal is to be distributed, exercisable during the grantor's lifetime, as well as the power to add beneficiaries (e.g., a nonadverse trustee may add beneficiaries of the trust income and/or principal). l.R.C. 674(a) (2006). 3. The grantor...