Using IDITs/IDGTs in Estate Planning
Author: Michael Tulley
While estate planning is not limited to those with significant net worth, it’s especially important for taxpayers whose wealth would result in a taxable estate on death. In general, estate planning is used to help taxpayers quantify their potential estate tax liability, understand sources to fund that liability and identify ways to transfer wealth in a tax-efficient manner.
Intentionally defective irrevocable trusts (IDIT), also called intentionally defective grantor trusts (IDGT), can offer significant estate planning opportunities for taxpayers. In general, an IDIT is an irrevocable trust for which assets will not be subject to estate taxes at the death of the grantor but which is disregarded for income tax purposes. This seemingly conflicting status under the estate tax and income tax rules may allow for estate and income tax reduction and may serve as a vehicle for more sophisticated “estate freeze” techniques, described below.
An irrevocable trust becomes an IDIT by including certain provisions during the trust’s drafting, such as allowing the grantor to substitute trust assets for assets of equal value or borrow trust funds without adequate consideration.
How Does an IDIT Work?
An IDIT works much the same as other irrevocable trusts: A trustee is appointed to manage the trust property, with distributions to beneficiaries determined by the trust document. Unlike other irrevocable trusts, however, the IDIT is not a separate taxpayer for income tax purposes; the trust’s income and expenses are reported directly on the grantor’s income tax return as though the grantor still owned the trust assets.
Why would a grantor want to pay extra taxes? Although trusts have the same marginal rates as individuals, the brackets are highly condensed. In 2015, a married couple reaches the highest federal marginal rate of 39.6 percent at about $465,000 of taxable income. By contrast, a trust reaches this same rate at just more than $12,000. Further, by structuring a trust as an IDIT, the taxpayer may be able to use tax attributes unavailable if the trust was taxed separately. For example, under an IDIT structure, a grantor may offset total capital gains with the trust’s capital losses, which may not be fully usable in a given year if taxed separately at the trust level.
Finally, for taxpayers looking to increase tax-free gifting and overall family wealth, a grantor’s ability to pay taxes on the IDIT’s assets can provide a significant planning opportunity. Under current tax law rules and regulations, if a taxpayer chose to pay the income tax liabilities of his adult children, that tax payment would be considered a taxable gift, possibly using a portion of the taxpayer’s gift and estate tax exemption. However, if a taxpayer establishes an IDIT for his adult children, current laws do not regard tax payment on the IDIT’s income as an additional gift to the trust.
Selling Assets to an IDIT
The fact that an IDIT is disregarded for income tax purposes always allows for more advanced tax planning opportunities, such as the sale of assets by a grantor to an IDIT he or she establishes.
The grantor establishes the IDIT and then sells assets to the trust in exchange for an installment note. The federal applicable rate—which is currently at historically low levels—can be used to calculate interest on the installment note. The IDIT then pays interest payments to the grantor according to the terms of the note. Because the grantor and the IDIT are the same taxpayer for income tax purposes, the grantor does not include the interest in his or her taxable income. It is very important to respect the terms of the transaction; many advisors suggest “seeding” the trust with an initial gift sufficient to generate funds necessary to make timely interest payments.
Carefully choosing what assets to sell to the trust can serve as a significant estate planning opportunity. To get the most advantage from an IDIT, the grantor should sell to the trust those assets that are expected to appreciate in value. As a result, the assets will appreciate outside of the grantor’s estate, which will freeze the assets’ value when they are transferred outside of the estate.
When developing an estate plan, implementing an IDIT may be a good way for grantors to transfer property outside of their estate for estate tax purposes. All property transferred to the trust, along with the income taxes paid by the grantor, will help reduce the grantor’s taxable estate and allow income generated by the trust and the appreciation of trust property to benefit the trust’s beneficiaries as intended.