IDGT: Intentionally Defective Grantor Trusts
January 2009
Here's a great technique for
transferring wealth in an advantageous and unique way: gifting an asset's
appreciation while keeping its income. An intentionally defective grantor trust
(IDGT) is an irrevocable trust designed for the benefit of your children and
future descendants.
How Does a Defective Trust Work?
Typically, the trust maker sets up an irrevocable trust. The trust is drafted so
that the trust maker retains enough control to cause it to be "defective"
because trust maker continues to be responsible for paying the income tax, but
the trust remains effective enough that it transfers the asset avoiding estate
and gift tax. The trust maker sells the asset to the trust in exchange for a
promissory note. Interest on the note is paid at the Applicable Federal Rate (AFR).
The result is that the sale of the appreciated asset "freezes" its value for
estate tax purposes and avoids negative gift tax consequences.
For example: Mom and Dad create an IDGT into which they wish to transfer
$500,000 worth of stock. They can either gift the stock or sell it. If they sell
it to the IDGT, they need to convey enough cash into the trust to cover its down
payment to them. They enter into an agreement for a monthly amount. The interest
rate on the promissory note must at least equal the Applicable Federal Rate (AFR).
The logic is that the stock will appreciate at a greater rate than the AFR, so
that they kids benefit from the appreciation but Mom and Dad's value is the
$500,000 note they traded for the stock.
What Are the Advantages?
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An "estate tax freeze" of the appreciating asset.
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No gift tax conveyance while shifting future appreciation estate tax free.
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If the trust maker dies, only the value of the note is included in his estate.
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Creditor protection for the asset inside the trust.
The ultimate goal is that assets sold to the IDGT will be completed gifts for
your children and will not be subject to estate taxes. Since you are receiving
the income, the trust allows the transfer without a negative gift tax
consequence.
Transfer Assets at Fair Market Value
It's important to note that if the IRS believes you sold assets to an IDGT for
less than fair market value, it can treat them as gifts or reject the trust
altogether and treat the assets as if they were still part of your taxable
estate. To avoid this, assets should he sold to an IDGT at fair market value,
and the promissory note's interest rate should at least equal the Applicable
Federal Rate (AFR).
Through careful design and a rigorous attention to detail, an IDGT can be a
powerful way to reduce estate tax liability while benefitting your family.
Adapted from the Daily Plan-It newsletter. Hoopes,
Adams & Alexander, PLC, is a Chandler, Arizona, law firm offering services to
Phoenix-area clients in the areas of estate planning, entity formation,
commercial and real estate transactions, and civil litigation. |
