What You Should Know About Sales to Intentionally Defective Grantor Trusts
1. What is an Intentionally Defective Grantor Trust?
An Intentionally Defective Grantor Trust is an irrevocable trust that may be excluded from the taxable estate of the person who established the trust (“grantor”), but designed in a manner to have the grantor treated as the owner of the trust for income tax purposes. Thus, the grantor pays income tax on behalf of the trust. The trust and the trust beneficiaries do not.
The irrevocable trust is called defective because it takes advantage of differences in the tax rules for determining when the grantor is the owner for income tax purposes from the tax rules for determining when a trust is included in the grantor’s estate for estate tax purposes. The irrevocable trust is not defective in a literal sense, but rather distinct from a standard irrevocable trust where the grantor would not be responsible for paying its income tax.
The Intentionally Defective Grantor Trust is used to permit tax-free transactions of appreciated property between the grantor and the irrevocable trust.
2. Why sell property to an Intentionally Defective Grantor Trust?
Imagine a married couple with a successful family business. Assuming they want to transfer the business to the children someday, they have three options:
3. How does the Intentionally Defective Grantor Trust pay for the stock?
In order to make the technique work, the trust must actually purchase the stock from the parents. The payments could be made by installment plan subject to a promissory balloon note with interest equal to the applicable AFR interest rate issued by the IRS. Provided the business produces enough income to pay the interest and the business grows at a rate higher than the AFR rate, then the plan benefits both parents and children. Another option is for the business to obtain a bank loan that could be used to pay the parents in full.
4. When does an Intentionally Defective Grantor Trust not make sense?
If the transferred property is not projected to increase in value at a rate equal to or greater than the applicable AFR interest rate, then the sale to an Intentionally Defective Grantor Trust is a poor technique. The reason is that, upon sale, the parents receive either full payment or a promissory note equal to the value of the stock. In the event of their deaths, the value of the payment they received (plus appreciation) or the promissory note would be included in their taxable estate for estate tax purposes. They would have achieved no estate tax savings.
Even the avoidance of capital gains tax would be offset by the fact that the trust now holds the stock subject to the same income tax basis as before. A subsequent sale will trigger capital gains tax based on the parents’ original basis. The stock will not receive a step-up in basis when the parents die because they no longer own it.
Using this same logic, a sale to an Intentionally Defective Grantor Trust is a poor technique when the grantor is elderly or in poor health. If the grantor dies before the sale to the trust is complete, the grantor’s final income tax return must include the entire amount of capital gain that was not yet realized when the property was transferred.
5. Does the IRS actually approve this?
Yes, the IRS has consistently ruled in favor of this planning technique. It is important, however, for the trust to be solvent before it enters into a purchase contract to buy the stock. Otherwise the trust may be considered a “sham” by the IRS with no economic substance. Making the trust solvent is usually accomplished by gifting a small portion – perhaps 10% – of the stock to the trust before selling the rest.
About the Author
Thomas J. Bouman provides legal counsel in the areas of estate planning, estate settlement, and asset protection. He brings a highly systematic approach to the practice of law, which is critically important when wading through the complex, and often bizarre, legal requirements associated with estate and trust law. Mr. Bouman is author of the Arizona Estate Administration Answer Book and a prominent member of Wealth Counsel, LLC, the nation’s premiere organization of estate planning attorneys.
An Intentionally Defective Grantor Trust is an irrevocable trust that may be excluded from the taxable estate of the person who established the trust (“grantor”), but designed in a manner to have the grantor treated as the owner of the trust for income tax purposes. Thus, the grantor pays income tax on behalf of the trust. The trust and the trust beneficiaries do not.
The irrevocable trust is called defective because it takes advantage of differences in the tax rules for determining when the grantor is the owner for income tax purposes from the tax rules for determining when a trust is included in the grantor’s estate for estate tax purposes. The irrevocable trust is not defective in a literal sense, but rather distinct from a standard irrevocable trust where the grantor would not be responsible for paying its income tax.
The Intentionally Defective Grantor Trust is used to permit tax-free transactions of appreciated property between the grantor and the irrevocable trust.
2. Why sell property to an Intentionally Defective Grantor Trust?
Imagine a married couple with a successful family business. Assuming they want to transfer the business to the children someday, they have three options:
- Hold the Stock until Death. The parents could pass the stock to their children as part of their estate plan. The problem is that the stock will be includable in their estate for estate tax purposes, and may trigger a large tax bill.
- Gift the Stock prior to Death. The parents could gift the stock to their children, perhaps upon retirement. The problem is that the gift will be subject to gift tax, and will likely reduce or eliminate the parents’ applicable estate tax exemption.
- Sell the Stock outright to the Children. The parents could sell the stock to their children, assuming the children are able to secure a large enough loan to purchase the stock. The problem is that the sale will likely result in a large capital gains tax to the parents.
3. How does the Intentionally Defective Grantor Trust pay for the stock?
In order to make the technique work, the trust must actually purchase the stock from the parents. The payments could be made by installment plan subject to a promissory balloon note with interest equal to the applicable AFR interest rate issued by the IRS. Provided the business produces enough income to pay the interest and the business grows at a rate higher than the AFR rate, then the plan benefits both parents and children. Another option is for the business to obtain a bank loan that could be used to pay the parents in full.
4. When does an Intentionally Defective Grantor Trust not make sense?
If the transferred property is not projected to increase in value at a rate equal to or greater than the applicable AFR interest rate, then the sale to an Intentionally Defective Grantor Trust is a poor technique. The reason is that, upon sale, the parents receive either full payment or a promissory note equal to the value of the stock. In the event of their deaths, the value of the payment they received (plus appreciation) or the promissory note would be included in their taxable estate for estate tax purposes. They would have achieved no estate tax savings.
Even the avoidance of capital gains tax would be offset by the fact that the trust now holds the stock subject to the same income tax basis as before. A subsequent sale will trigger capital gains tax based on the parents’ original basis. The stock will not receive a step-up in basis when the parents die because they no longer own it.
Using this same logic, a sale to an Intentionally Defective Grantor Trust is a poor technique when the grantor is elderly or in poor health. If the grantor dies before the sale to the trust is complete, the grantor’s final income tax return must include the entire amount of capital gain that was not yet realized when the property was transferred.
5. Does the IRS actually approve this?
Yes, the IRS has consistently ruled in favor of this planning technique. It is important, however, for the trust to be solvent before it enters into a purchase contract to buy the stock. Otherwise the trust may be considered a “sham” by the IRS with no economic substance. Making the trust solvent is usually accomplished by gifting a small portion – perhaps 10% – of the stock to the trust before selling the rest.
About the Author
Thomas J. Bouman provides legal counsel in the areas of estate planning, estate settlement, and asset protection. He brings a highly systematic approach to the practice of law, which is critically important when wading through the complex, and often bizarre, legal requirements associated with estate and trust law. Mr. Bouman is author of the Arizona Estate Administration Answer Book and a prominent member of Wealth Counsel, LLC, the nation’s premiere organization of estate planning attorneys.