Intentionally Defective Grantor Trusts
How would you like to pay taxes on income that you never receive, earned from property that you do not own? Most people wouldn't. But some wealthy people are willing to do so. Why? Ironically, to save on taxes. Tax laws are complex, and as such, the tax code is often inconsistent, allowing opportunities to save on taxes by taking advantage of the inconsistencies, or what some people would call taking advantage of tax loopholes. One such opportunity is the intentionally defective grantor trust (IDGT), where an irrevocable trust with the right structure can be treated as a grantor trust, under IRC §§671-678, for income tax purposes, but which is not includable in the estate of the grantor, under IRC §§2036-2038, when he dies. The trust is defective in the sense that it does not have all the qualities of an irrevocable trust nor does it have all the qualities of a grantor trust. These 2 types of trust should be mutually exclusive, but because of defects in the tax code, an IDGT can be treated as a grantor trust with respect to income, but as a irrevocable trust that is not includable in the grantor's estate.
To pass IRS scrutiny, the trust document should specifically state that the trust should be treated as a grantor trust for income tax purposes, but as an irrevocable trust for estate tax purposes, and that all provisions of the trust document should be construed to these 2 objectives. This allows a grantor to pay income taxes on the income generated by the trust while allowing the trust assets to accumulate for the beneficiaries. The payment of income taxes is not treated as a gift, so it reduces the grantor’s estate even more.
Because the IDGT is irrevocable, the grantor no longer owns the property transferred to the trust, so it is not includable in his estate. However, by retaining certain powers, sometimes called defective powers, the IDGT will still be treated as a grantor trust for income tax purposes. Some of these defective powers include retaining a nonfiduciary power to substitute trust assets [IRC §675(4)(C)]; authorizing an independent trustee to sanction loans to the grantor for inadequate consideration or security; and retaining a reversionary interest in the trust assets that exceeds 5% of the trust property. To ensure that the IDGT is not includable in the grantor’s estate, IDGT provisions will generally include that:
- the grantor has no right to reimbursement for income taxes paid on trust income
- the trust assets cannot be used to pay any legal obligation or debt of the grantor; and
- the trustee will determine and certify that any asset substitution will not alter the benefits to beneficiaries
Failing to satisfy these requirements will cause the trust assets to be includable in the grantor’s estate, subject to estate tax and, possibly, other gratuitous transfer taxes.
It is desirable to have the trust income taxed to the grantor instead of the trust because trust income is taxed at a much higher rate at much lower income levels. For instance, for 2019, the top tax rate of 37% applies to any income earned by the trust over $12,750. By comparison, the 37% tax rate only applies to income above $510,300 for single individuals or $612,350 for a married grantor filing jointly. The IDGT is most suitable for taxpayers whose wealth exceeds the estate exemption amount, which in 2019, was $11,400,000 or double that amount for married couples.
An IDGT also has other advantages that it shares with irrevocable trusts, including possible asset protection against creditors and avoidance of any disputes into how the property should be distributed, since the beneficiaries of an irrevocable trust cannot be changed. Of course, that could also be a disadvantage.
A drawback of the IDGT is that there is no stepped-up basis for the property when the grantor dies. Nonetheless, significant tax savings can be achieved.
Example: How an IDGT Saves on Taxes
You have a business worth $1 million that you expect to appreciate significantly. You have enough unified credit left to exempt $200,000 of income, which is what you transfer to the IDGT. You sell your business to the trust for $1 million. The trust gives you the $200,000 that you gifted to it and gives you a promissory note for the rest, payable over 10 years at the IRS stipulated long-term interest rate. You pay all income taxes for the business while you are still alive, so the business grows rapidly. After 10 years, the business is worth $20 million. Unfortunately, you die. Your beneficiaries receive the entire business free of both gift and estate taxes. Even if your tax basis in the business is 0, which is the carryover basis for your beneficiaries, if they sell the business immediately after receiving it, they will be in the top tax bracket, so they will owe a long-term capital gain of 20% and a 3.8% Medicare surcharge, yielding a total tax of $4,760,000. On the other hand, if you maintained ownership of the business, then the $20 million business would be includable in your estate, subject to a 40% tax, yielding a total tax of $8 million. Hence, the total tax savings is $3,240,000. Not exactly chump change! (Of course, there are other ways to save on estate taxes, such as grantor-retained interest trusts, but that is another topic.)
Another way that an IDGT can save on taxes is by substituting assets in the trust with a high tax basis for property with a low tax basis. Being able to exchange trust assets for other assets by the grantor is 1 of the "defective powers" that makes the IDGT intentionally defective. Of course, the trust document must allow this. However, to pass muster with the IRS, any substitutions under IRC §675(4)(C) should be accompanied by a written certification by the grantor that the substituted property equals the value of the replaced trust assets and, and if the asset does not have a readily ascertainable market value, then this certification should be accompanied by appraisals by licensed appraisers. If the grantor is suffering a loss on an asset, such as stocks, and the grantor dies, then the tax basis of the stocks is stepped down, forever removing the possibility of using those losses to offset capital gains from other property. By substituting the high tax basis property in the trust for the property with losses held by the grantor, then the highly-appreciated property will receive a step up in basis when the grantor dies, and the property with losses can be used by the trust beneficiaries to offset other income.
Because the irrevocable trust is a separate taxable entity, it should file tax returns, including Form 1041, U. S. Income Tax Return for Estates and Trusts, every year, even when the income is below the reporting threshold, to establish that the trust truly is an independent entity. The grantor will also have to file tax returns to report the income earned by the trust and to pay taxes on that income. Gift tax returns may also have to be filed if the amount transferred to the trust in any tax year exceeds the gift tax annual exclusion per beneficiary of the trust. The IDGT should not be reported on the estate tax return when the grantor dies; otherwise, it will be considered part of the estate. Additional state and local forms may also have to be filed.
Note, however, that most estates large enough to benefit from an IDGT will likely be audited, and since IDGTs take advantage of tax loopholes to lower taxes, it will certainly be scrutinized by the IRS.