Practical analysis for investment professionals
22 June 2012

Intentionally Defective Grantor Trusts: Popular Strategy in the Crosshairs

This may seem like an odd time to bring up President Obama’s proposed budget for 2013, released last February, but a recent blog post on Nerd’s Eye View reminded me that there are only a few months to go before a popular trust strategy — the sale of an asset to an intentionally defective grantor trust, or IDGT — may be eliminated.

What has made this technique so appealing to estate-planning attorneys and financial advisers is that the grantor — the person who sets up the trust — pays income tax on trust earnings. In effect, this is an annual tax-free gift to the trust. At the same time, the assets are removed from the grantor’s estate, thus lowering the value of the estate and saving the heirs estate taxes.  And when the grantor sells a low basis asset (such as an interest in a family business) to the grantor trust, there is no income tax event.

Typically, this is how it works: the grantor creates a trust and then lends it money to buy an asset he expects will appreciate significantly. In return for lending the trust money, the grantor receives interest payments for a set number of years. The lower the interest rate, the less the trust must repay the grantor — and the more the heirs stand to benefit. (See “Unusual Trusts Gain Appeal in Unusual Time” in the Wall Street Journal.)

While the sale to an IDGT can be complicated and costly to set up, it remains popular. But its days may be numbered: The 2013 budget proposal includes a provision to include grantor assets in the grantor’s estate.

With this in mind, here are some resources that help explain the technique, what may change, and what advisers should considering doing now.

What makes this trust “intentionally defective” is that “the estate planner intentionally creates a trust that allows for the severing of the estate tax link without severing the income tax link with the grantor,” according to Rob Clarfeld, founder and CEO of Clarfeld Wealth Strategists & Financial Confidantes, a wealth management firm. (For more, see Clarfeld’s very thorough, informative Forbes article “Estate and Gift Tax Considerations for 2012: IDGTs — And you Must Act Now!”) Jesse Drucker, a reporter at Businessweekexplained the mechanics and appeal of this strategy, using an example in which the technique could help avoid a $50 million federal estate tax bill.

But as Eileen Reichenberg Sherr pointed out in “Budget Proposal Includes Change to Treatment of Intentionally Defective Trustsin the Journal of Accountancy, under the president’s plan “the assets in these trusts would be included in the estate of the grantor at death.”

The key elements of the president’s proposal are below. You can find the details on page 83 of the Green Book (PDF):

To the extent that the income tax rules treat a grantor of a trust as an owner of the trust, the proposal would:

(1) include the assets of that trust in the gross estate of that grantor for estate tax purposes,

(2) subject to gift tax any distribution from the trust to one or more beneficiaries during the grantor’s life, and

(3) subject to gift tax the remaining trust assets at any time during the grantor’s life if the grantor ceases to be treated as an owner of the trust for income tax purposes.

So what are the planning implications? Michael Kitces, author of the Nerd’s Eye View blog, explains:

The good news is that the proposed rules stipulate that they would only apply to new trusts created on/after any enactment date, so trusts that have already been created should be safe — although the proposal does suggest that new contributions to pre-enactment trusts made after the effective date may be subject under the new rules. The proposal also indicates that the new rules will not apply to any form of trust otherwise explicitly allowed under the tax code, including qualified personal residence trusts (QPRTs) and grantor-retained annuity trusts (GRATs) (although a separate Green Book proposal would alter GRATs to require a minimum 10-year term).

In addition to having future-trusts-only applicability, it’s notable that the proposed new rules are at this time only proposed. Not everything in the President’s budget proposals is always enacted into law, and indeed at this time it’s not even clear that the President will still be the President for all of the government’s 2013 fiscal year.

Nonetheless, the fact that a shutdown of the IDGT has been proposed at all suggests some risk that the days may be numbered for the strategy, given the current fiscal outlook and the Treasury’s estimate that the new rules could raise $910 million of tax revenue over the next decade (not to mention the fact that the strategy is typically only used amongst ultra high net worth clients, who are being targeted by many more-restrictive tax proposals in the current environment). And given the complexity of the IDGT strategy and the time it often takes to establish the trust, gift to it, and structure and complete the sale of assets to the trust, clients who are considering an IDGT sale strategy in the coming years may wish to get started sooner rather than later, just in case.

For a refresher on the significant tax provisions that are set to expire at the end of the year (unless Congress acts) and how to plan, take a look at “Before the Door Closes” from U.S. Trust, my April post “Five Tax-Savvy Wealth Transfer Strategies,” and “U.S. Income Taxes: What 2013 Might Bring and What You Need to Do About It Now,” an article by Robert N. Gordon in the April issue of the CFA Institute Private Wealth Management newsletter.

*Correction: Due to an editing error, an early version of this article mistakenly stated that the grantor pays no income tax on trust earnings. This article was updated on 10 October 2012.

About the Author(s)
Lauren Foster

Lauren Foster was a content director on the professional learning team at CFA Institute and host of the Take 15 Podcast. She is the former managing editor of Enterprising Investor and co-lead of CFA Institute’s Women in Investment Management initiative. Lauren spent nearly a decade on staff at the Financial Times as a reporter and editor based in the New York bureau, followed by freelance writing for Barron’s and the FT. Lauren holds a BA in political science from the University of Cape Town, and an MS in journalism from Columbia University.

3 thoughts on “Intentionally Defective Grantor Trusts: Popular Strategy in the Crosshairs”

  1. Steve says:

    Please double-check your research on your assertion that the “grantor pays no income tax on trust earnings.” I believe the idea of an IDGT is that the grantor DOES pay the tax, but it is left out of his estate. You say as much in your reference to the proposed legislation change, which effectively ties an owner for income tax purposes to ownership for estate tax purposes.

    Steve Mogdis
    Law Office of Kevin Adams, PLLC
    Livonia, MI

    1. Lauren Foster says:

      Steve, thank you for pointing out the error. We have updated the post accordingly.

  2. Steve says:

    **his or her estate

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