Intentionally Defective Grantor Trust & Family Limited Partnership
Selling the family limited partnership to the IDGT
Understanding the Confusing but useful Intentionally Defective Grantor Trust (IDGT)
IDGTs can be useful in financial planning for those who:
- want to protect their homes from creditors
- want a solution to the problem of selling highly appreciated assets
- want to move assets out of an estate in a gift and estate tax favorable manner
- want to purchase life insurance in an estate plan in a gift and estate tax favorable manner
This article was written because many people wish to learn more about using Intentionally Defective Grantor Trusts.
What is an IDGT (Intentionally Defective Grantor Trust)?
An IDGT is an irrevocable trust typically established for the benefit of the grantor's children and future descendants. An Intentionally Defective Grantor Trust generally benefits the grantor's children during their lifetimes, and is structured to benefit the grantor's children's descendants and future generations after their death.
What does the term "defective" in the IDGT mean?
From an income and estate planning perspective, the IDGT would be purposely structured to be "defective" for income tax purposes, but "effective" for estate tax purposes. Therefore, if there is income in the trust from trust assets, the grantor will receive the tax bill. However, when the grantor dies, the assets of the trust (minus installment payments due if any) will pass estate tax free to the beneficiaries.
Outright Gifts to an IDGT
While Intentionally Defective Grantor Trusts are typically used in conjunction with a sale of assets to the trust (see below), you can simply make an outright gift to an IDGT using the your gift and estate tax exemptions. You can gift assets to an IDGT and the gift works like any gift when using your gift and estate tax exemptions. Again, the unique aspect to an IDGT is that the gift is complete for estate tax purposes but incomplete when it comes to the income taxes.
Selling assets to Defective Trusts
Intentionally Defective Grantor Trusts are typically used when clients are "selling" assets to the trust (vs. just outright gifting to the trust). Why sell assets to a defective trust? There are several reasons. The main one is that a client is looking to transition an asset (many times a family business) in a gift tax free manner while retaining the income to pay income taxes on the trust income and sometimes to provide a retirement income stream for a period of years.
Practice pointer: To ensure that the sale transaction to the IDGT is respected by the IRS, certain attributes of the transaction should be respected. The IDGT must have assets that provide economic substance prior to the sale. The general rule of thumb is that the IDGT should have assets worth at least 10% of the value of those that are being sold to it.
Discount Strategy (The use of an FLP - Family Limited Partnership)
In most cases it will make sense to combine a family limited partnership with an Intentionally Defective Grantor Trust. Clients looking to maximize the economic benefit (paying the least amount of gift or income taxes) of an IDGT should incorporate the use of an FLP. The best way to explain the discounting strategy with an FLP and an IDGT is with an example.
Assume, Dr. Jones, transfers a mixed portfolio of investments (stocks, bonds, and cash) worth $1 million to an family limited partnership. Typical FLP discounts reduce the value of that $1 million to about $650,000. Then Jones creates an IDGT and sells the limited partnership interests (now valued at $650,000) to the IDGT in exchange for an installment note.
If the client sells the family limited partnership interest to the Intentionally Defective Grantor Trust in exchange for future payments, those future payments will be based on the lower value of the FLP interest (vs the actual value of the assets in the FLP), thereby reducing the size of the required installment note payments to the grantor. If the client chose to gift the FLP interest to the IDGT instead of selling the interest, the obvious benefit to incorporating an FLP is the fact that the client only uses $650,000 of his $1,000,000 gift tax exemption.
Because the Intentionally Defective Grantor Trust is not considered a separate taxpayer from the grantor, there is no recognition of capital gains on the sale of the family limited partnership interest to the trust. Also, since the IDGT would be purchasing the stock from the grantor at a market value determined by a qualified appraiser, there would be no gift being made and no gift taxes due on the sale.
The IDGT would issue the grantor an installment note and give the grantor a security interest in the stock. The note would bear interest at the IRS assumed rate (the "federal applicable rate"), and could be structured as a self-amortizing note, a level principal payment note, or an interest-only with balloon payment note. The type of note used will largely depend on the cash flow being generated by the assets being sold to the IDGT. Because the grantor and the IDGT are not considered separate taxpayers for income tax purposes, the grantor will not recognize income when the interest on the note is received.
Benefits of the Intentionally Defective Grantor Trust Transaction
The grantor moved a percentage of his assets out of his estate for estate tax purposes without gift taxes. If the grantor dies before the installment note has paid in full, the remaining payment will be in his estate. However, any appreciation in the assets in the IDGT will pass estate tax free. Additionally, because of the discount of the family limited partnership interest, 35% of the pre-FLP funding value of the assets will pass estate tax free.
If planned correctly, the grantor will be able to pay the income taxes on the IDGT assets out of the installment sale payments being made each year under the terms of the note. The payment of income taxes by the grantor on income of the trust (some of which stays in the trust), is done without gift taxes. While it might not initially seem favorable for the grantor to pay income taxes for the trust, it is a good planning tool due to the fact that paying the taxes benefits the heirs while not incurring gift taxes.
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