November 18, 2013
Using the Internal Revenue Service Rules and Regulations to Achieve Estate Tax Savings
By Louis Viscuso, Manager, Tax & Business
The use of trusts known as Intentionally Defective Grantor Trusts (IDGT) may provide the opportunity for estate tax savings by using the IRS rules and regulations in your favor. In this instance, the term defective does not mean that it does not work or it is substandard like a defective toy or defective product. This type of trust is specifically drafted to be an irrevocable trust for gift and estate purposes. The carefully drafted document includes certain selected provisions under the Internal Revenue Service Code 671 to 677 that cause the trust to be a grantor type trust for income tax purposes. For example, a provision to allow the substitution of property by the grantor can cause the trust to be considered a grantor type trust. A gift to this type of trust is considered completed and reportable for gift tax purposes. The provision or the intentional defect results in income earned from the gift being taxable to the grantor.
At first glance this may not be considered a great bargain to the donor. However, if the donor’s intention is to reduce the taxable estate over a period of years, the requirement to pay the income tax on the earnings of the grantor trust reduces the donor’s estate. Revenue Ruling 2004-64 further reinforced the benefit by stating the grantor’s payment of the income taxes that was not distributed to the grantor is not a taxable gift. Also, the current trust income tax rate thresholds are substantially lower resulting in higher taxes on accumulated trust income. For taxable years beginning in 2013, a trust’s highest tax rate on ordinary income is 39.6% when exceeding $11,950 of taxable income. During 2013, a single taxpayer reaches the 39.6% rate on the excess of $400,000 taxable income. Avoiding the compressed brackets result in tax savings.
If the value of the property contributed to the IDGT trust is below the available applicable lifetime exclusion amount there is no gift tax due. The lifetime gift tax exclusion for 2013 is $5,250,000.
Another opportunity to achieve estate tax savings is when the grantor can sell appreciating property to the IDGT. Under IRS Revenue Ruling 85-13, the sale is considered a nonevent and is not recognized for income tax purposes. The interest earned and interest paid is disregarded for income tax purposes. Capital Gain is not recognized and the trust takes the grantor’s basis in the assets. By coupling the sale with a promissory note the seller can fix the value of the property at the time of the sale. The remaining value of the promissory note at the time of death is includible in the grantor’s estate. The benefit is that the property sold the IDGT is allowed to continue to appreciate outside of the grantor’s taxable estate and the value to the estate is in effect frozen at the time of the sale.
When using the IDGT, there are many technical issues in drafting and complying with the law. Due care is required to make sure you are within the guidelines of IRS rules and regulations. Also, not all property is ideal for this type of trust. Closely held business interests that generate cash flow are the favored property for this type of transaction. Whereas, marketable securities contributed to the trust may not achieve the desired result.
The fans of the estate tax are not fond of this estate planning technique and routinely plot to restrict or to eliminate their use. But in the meantime, with proper consultation with a skilled estate and trust attorney and coordination with your Marcum tax professional you may want to consider the use of Intentionally Defective Grantor Trust to achieve tax savings and maximize the transfer of property to your heirs.