Using an Intentionally Defective Grantor Trust (IDGT)
Introduction
Several wealth transfer strategies are available to provide high net worth individuals with the ability to shift their wealth to younger generations with little or no gift tax. Among the most commonly used are the grantor retained annuity trust (GRAT), the charitable lead trust (CL T), and the intentionally defective grantor trust (IDGT). But only the IDGT stands out as viable wealth transfer strategy for most real estate owners. In general real estate owners Jack sufficient net cash flow to support the liquidity necessary to make annual annuity payments required with a GRAT; and the implementation of the CRT generally requires a steady stream of cash flow from the operation of the business to be philanthropically transferred to a charity, which generally is not desired in most family business situations. On the other hand, the utilization of an IDGT provides an extremely effective and tax-efficient tool to accomplish this goal. This article examines the applications and benefits of incorporating the IDGT into a real estate owner’s succession and wealth transfer plan.
Intentionally Defective Grantor Trust (IOGT)
Using an Intentional Defective Grantor Trust (IDGT), a real estate owner, as the grantor, makes a gift of LLC entity member interests to an irrevocable trust for the benefit of the real estate owner’s children and grandchildren utilizing up to the maximum gift and generation skipping transfer (GST) tax exemption available at the time of the transfer. In 2015, the current gift and GST tax exemptions are $5.43M. The transferred LLC member interests are structured so that their fair market value reflects the business entity valuation discounts.
The unique characteristics of the JDGT, combined with discounted valued LLC entity interests, produce significant transfer tax savings for high net worth real estate owners who wish to transfer their appreciating interests to the younger generations with little or no gift, estate, or GST tax consequences.
The IDGT unique characteristics include:
- An irrevocable trust with “grantor” trust status (labeled an IDGT) that allows nontaxable transactions between the grantor and the IDGT;
- The requirement in IRS code that the grantor remains obligated to pay the income tax liability of the IDGT on any taxable income earned from the real estate LLC member interests and other assets transferred to the IDGT; and
- Valuation discounts attributable to the nonvoting LLC member interests when transferred by gift and/or sale to the IDGT. As described below, the grantor creates nonvoting interests in the LLC to incorporate the discounting power into this real estate succession and wealth transfer technique.
Taxation of the Intentionally Defective Grantor Trust
The IDGT (also referred to as the “trust”) is an irrevocable grantor trust that treats the grantor as the owner of the trust for income tax purposes, but not for estate, gift, and GST tax purposes. The IDGT technique takes advantage of the inherent inconsistencies between the income tax laws and the estate, gift, and GST tax laws.
For income tax purposes only, the trust is treated as nonexistent if the grantor holds certain administrative powers contained in the trust’s provisions that statutorily cause the trust to be treated as a “grantor” trust. However, for estate, gift, and GST tax purposes, transfers to the trust in the form of gifts or sales are treated as completed transactions between the grantor and the trust. Therefore, the assets owned by the trust are not treated as part of the grantor’s gross estate for estate tax purposes.
NOTE: The phrase “Intentionally Defective Grantor Trust” is actually a misnomer because the trust is a very “effective” grantor trust. However, this commonly used phrase is meant to convey the fact that when the grantor transfers assets into the IOGT, for income tax purposes, it is “defective” for transferring or shifting the income tax liability to the trust. The trust doesn’t pay income tax on income earned by trust assets. The grantor remains the taxpayer and retains the income tax liability on the income earned by trust assets. But for estate and gift tax purposes it is “effective” in transferring the assets out of the grantor’s estate.
Income Tax Retention Benefits
The grantor trust status causes all transactions between the grantor and the IDGT to be free from any income tax consequences. This is true because the grantor is the taxpayer for himself and for the trust. From an income tax standpoint, one cannot be taxed on transactions with himself. Accordingly, the grantor’s sale of business interests to the trust is ignored for income tax purposes. Any capital gain that might otherwise have occurred on this transaction if the sale was between the grantor and a third party remains unrecognized. When an asset is transferred to the trust the basis of the asset is also transferred, so that the IDGT now owns the transferred asset with the exact same basis the asset had prior to the transfer. In addition, when there is a sale of the asset in exchange for a promissory note, the interest payments on the note, paid by the trustee of the IDGT to the grantor, have no income tax consequence to the grantor or to the trust. It is simply a cash flow occurrence. So long as the trust remains a “grantor” trust until the note is paid off, the grantor will never receive any income tax recognition on the sale.
Additionally, since the grantor, not the IDGT, is treated as the taxpayer for “income” tax purposes, the grantor continues to be obligated to pay the income tax attributable to the earnings of the trust’s assets. At the same time, the grantor also continues to receive all the income tax attributions, such as deductions, credits, depreciation, etc., just as if the assets were still owned by the grantor. Again, the IRS treats the grantor as the “owner” of the assets held in the I DGT for income tax purposes. Therefore, the grantor’s personal funds, not the trust’s, must be used to pay the income tax on the IDGT’s income. As a result, the IDGT’s assets will not be depleted for the income taxes attributable to the earnings on trust assets. This “retention” of the grantor’s income tax obligation rather than its shifting to that of the trust’s allows, in effect, an indirect gift in the amount of the income tax payment, from the grantor to the beneficiaries of the trust that completely escapes gift and GST tax, while at the same time reducing the grantor’s overall gross estate at death.
For example, if A, the grantor, sells some or all of an LLC’s nonvoting member interests to an IDGT in exchange for an installment note, the IDGT becomes a new member in the LLC. When A the controlling voting member subsequently makes a taxable distribution to the LLC members, the IDGT will receive its pro rata cash distributions, but A will remain obligated to pay the income tax on the distributions attributed to the LLC nonvoting member interests A transferred to the IDGT In turn, the IDGT may transfer all or a portion of its cash distribution back to A as a payment on interest and/or principle of the installment note, thereby decreasing the amount owed on the note. A, in turn, will utilize the payment received from the IDGT (which become A’s personal funds) to satisfy A’s income tax liability, thus decreasing A’s gross estate. In effect, you may accomplish both the reduction on the installment note and the reduction of A’s overall gross estate with just one distribution to the LLC members.
Finally, taxable transactions between the trust and third parties result in the grantor’s incurring individual income tax liability, not the trust Accordingly, if low basis assets which the grantor gifted or sold to the trust are thereafter sold by the trust to a third party, the grantor must pay the capital gains tax on the sale, thus allowing the entire amount of the sales proceeds to remain in the IDGT for the benefit of the trust’s beneficiaries.
Valuation Discounts
If the grantor is holding assets, such as appreciating real estate owned in an LLC, the use of marketability and minority discounts of the LLC nonvoting or minority interests should be incorporated into the strategy to obtain optimal benefits from transfers to an IDGT
To incorporate the discounting power into this wealth transfer technique and retain control, the grantor first should create nonvoting interests in the LLC. Amending the Operating Agreement of an existing LLC or creating a new one, so that the entity has voting and nonvoting member interests will accomplish this. Generally, for wealth transfer estate planning purposes, the equity arrangement is created with 1 % voting and 99% nonvoting member interests.
Estate Freeze Installment Sale
The estate freezing benefit involves the grantor’s sale of nonvoting member interests in an LLC, which owns appreciating real estate and other assets, to an IDGT in exchange for an installment note for a term of years. As stated above, this is generally referred to as the “Installment Sale to an IDGT Technique.” (See the example “A” above).
To avoid an unintended gift element on the transaction, and to set the value of the transferred asset, the sales price must be equal to the LLC’s nonvoting member interest’s fair market value, which is determined by an appraisal performed by a professional business valuation firm. After the sale is effectuated, the grantor of the IDGT no longer owns nonvoting LLC interests. As the purchaser of the nonvoting LLC interests, the I DGT owns the asset. The grantor received in return an installment note with a face amount equal to the sales price. As a result, the grantor’s estate, to the extent of the LLC Interests transferred, is “frozen” at the amount of the note plus interest. All future appreciation of the assets held in the LLC in excess of the interest rate passes to the beneficiaries of the IDGT free of estate, gift and applicable GST taxes.
Real Estate Wealth Transfer Plan
So we can see that this real estate wealth transfer planning technique involves the grantor’s sale of the nonvoting LLC member interests to the IDGT in exchange for the installment note. The grantor, after making an initial gift (up to the existing $5.43M exemption amount) of nonvoting interests to the IDGT, then sells all or a portion of the grantor’s remaining nonvoting interests to IDGT. The fair market value of the nonvoting interests will be discounted to reflect their lack of marketability and minority interest (also called lack of control) aspects. The grantor will keep the voting interest in the LLC in order to retain control. By selling the discounted nonvoting interests to the IDGT, a larger value of the underlying real estate value can be transferred to the trust per dollar of “discounted” nonvoting interests. In other words, although the value of each nonvoting interest has been discounted for purposes of the gift and sale, the inherent underlying proportionate economic value of the real estate equity held in nonvoting interests has not been reduced in value. Accordingly, more appreciating asset value is transferred to younger generations with little or no gift and GST tax.
Gift and GST Tax Implications of the Sale
In order to avoid a taxable gift on the sale of the nonvoting interests to the trust, the sale price must be at the fair market value and the promissory note must bear an interest rate equal to or greater than the applicable federal rate (AFR) at the time of the transfer. If the sales price is found to be lower that the true fair market value upon a successful challenge by the IRS, then a “bargain sale” will be deemed to have occurred and the spread between the two values (i.e., initial sales price and IRS proven value) would be subject to federal gift tax and possibly GST tax.
For this reason, it is essential that a professional appraisal from a qualified business valuation company be obtained to support the sales price of the nonvoting interests. This appraisal would then be available to counter any dispute from the IRS that the values used in the transaction were incorrect.
Additionally, the initial gift of nonvoting interests in conjunction with the sale by the grantor of additional nonvoting LLC interests to the trust should be disclosed on a gift (and generation skipping transfer) tax return. It is important to file the gift tax return because this starts the statute of limitations, plus, a timely filed tax return will preclude a reassessment of the tax after the statute has run. In addition, a copy of the professional business valuation must be attached to the return. The usual statute of limitations on the gift/GST tax return is three years. However, if the actual value of a gift is ultimately determined to be in excess of 25 percent of the total gifts stated on the tax return, the usual three-year period is extended to six years.
Economic Considerations
In general, the length of the note and the payment terms of the note are a function of the anticipated appreciation of the purchased assets and the life expectancy of the grantor. The IDGT should initially be capitalized with adequate collateral to provide substance to the transaction. A general rule to follow is for the initial gift to the IDGT to be at least 10% of the value of nonvoting business interests being sold by the grantor to the trust. The reason for this is to avoid having an over leveraged sale.
For example, after the grantor makes a gift of $5.34M nonvoting LLC member interests to the IDGT, he desires to employ the Installment Sale to an IDGT technique. The maximum value of the grantor’s remaining nonvoting LLC nonvoting interests and/or other assets that may be sold to the trust would be $54,300,000. Therefore, the note the grantor receives from the IDGT in exchange for the sale will be approximately 110% collateralized. This 10% “seeding” rule is generally acceptable to the IRS.
The note should have the following:
- Commercially reasonable terms.
- Not be a “demand note.”
- Bear interest at the Applicable Federal Rate compounded semi-annually with an annual interest only payment requirements.
- Contain a “no prepayment penalty” provision.
- Contain a “late payment” provision.
Satisfying the Note
As a practical matter, there are several methods of satisfying the note which include the following:
- The trust can borrow from another source to satisfy the note.
- All or a portion of the purchased trust assets can be returned to the seller in satisfaction of the note.
- The remainder of the note can be discharged in the form of a gift.
- The trust can be sold by the trustee to a third party and the proceeds, equal to the unpaid balance of the note, can be distributed to the grantor.
- The note may be renegotiated at the end of the term.
Only items 3 and 4 have tax consequences to the grantor. With respect to the third method of satisfying the note, if the note is discharged, then the trust’s grantor status will preclude the recognition of a capital loss by the grantor and will also preclude the discharge of indebtedness income by the trust. In addition, the discharge will be deemed a taxable gift from the grantor to the beneficiary of the trust. With respect to the fourth method, if the assets are sold to a third party the grantor status of the trust will cause the gain to be taxed to the grantor.
Termination of Grantor Trust Status
Following the term of the note and after the note is paid off; the “grantor” status of the IDGT may be relinquished so that any continuing income tax liability of the trust will no longer be the obligation of the grantor. This is accomplished when the grantor relinquishes all statutory administrative powers to the IDGT which were originally included in the trust document to achieve grantor trust status under the income tax rules. However, by continuing the grantor status the assets held in the trusts will continue to grow undiminished by the income tax, the grantor’s estate will continued to be reduced in the amount of this income tax liability, and thus continually reducing the grantor’s ultimate estate tax obligation.
If the grantor status of the IDGT should intentionally or unintentionally be terminated before the note is paid off, the associated gain with the sale will no longer be sheltered. The sale is ignored only so long as the grantor trust status continues. The gain, however, should be limited to only that portion of the note remaining and not the whole amount of the original note face value. In order to mitigate this risk, prepayment of the note is always permitted provided there is sufficient time to act before the death of the grantor.
In Conclusion
The intentionally defective grantor trust is a time-tested and tax-efficient wealth transfer technique to use as part of an effective real estate succession and wealth transfer strategy. Its primary benefits are that LLC interests which own real estate and other assets can be transferred by gift and sale to an irrevocable trust for the benefit of the client’s younger generations and any subsequent appreciation of these assets are removed from the grantor’s taxable estate. The grantor continues to pay all income taxes on income of the assets in the IDGT resulting in continued tax-free benefits to the younger generation beneficiaries. Finally, with the transfer of non-voting LLC interests, the grantor can leverage the tax-free transfers through the application of valuation discounts while maintaining control of the of the LLC by retaining the voting interest.
