Special report on estate planning for farmers: Part 6 of 7

In a special report prepared in conjunction with a presentation at the University of Iowa College of Law's 2011 Spring Tax Institute, David Repp takes in in-depth look at estate planning considerations for farmers and other landowners.  Part 6 of 7, below, explains an estate planning technique for individuals with a high net worth in excess of the federal estate tax exemption – a sale to an intentionally defective grantor trust. Sales to Intentionally Defective Grantor Trusts A sale to an IDGT is an estate tax planning technique for individuals with high a net worth in excess of the federal estate tax exemption amount.  Generally, the taxpayer will create an irrevocable grantor trust and make a contribution to it.  The contribution will constitute a gift, but the corpus of the trust will be excluded from the grantor's estate for federal estate tax purposes.  However, the grantor trust is considered to be 'owned' by the grantor for income tax purposes.  This creates a disparity in treatment between estate tax and income tax (the trust is excluded for estate tax purposes, but included for income tax purposes). The trustee then uses the contributed proceeds to 'purchase' assets belonging to the grantor that are expected to appreciate substantially in value.  The trustee gives an installment note to the grantor paying principal and interest or interest only during the term of the loan.  The loan is amortized using future gifts to the IDGT or income from the contributed property.  At the death of the grantor, only the value of the installment note is included in the grantor's estate for estate tax purposes.  Any income tax paid by the grantor on the income of the trust is essentially a tax free gift to the trust beneficiaries.  Rev. Rul. 2004-64. Implementation Steps

1. The grantor creates an irrevocable trust for the benefit of his descendants.

2. The grantor 'seeds' the trust with assets equal to at least 10% of the value of the assets to be sold to the trust.

3. The grantor allocates generation skipping transfer (GST) tax exemption to the trust to cover the amount of the seed money gift (if the IDGT is a dynasty trust).

4. The grantor sells assets to the trust that are expected to increase rapidly in value and takes back an installment note.

5. The interest rate on the note is set at the lowest rate allowed under the tax law.

6. If the total return on the assets sold to the trust exceeds the interest rate on the note, assets are transferred tax-free to the trust beneficiaries.

7. The transfer tax benefits of the sale are enhanced by making the trust a grantor trust for income tax purposes.

8. As a result of grantor trust status, the grantor: (a) recognizes no gain or loss on the sale (Rev. Rul 85-13);  (b) is not taxed on the interest payment received from the trust (Rev. Rul. 85-13); (c) recognizes no capital gain if payments are made in-kind (Rev. Rul. 85-13); (d) can make additional tax-free transfers to the remainder beneficiaries by paying the tax due on the trust income (Rev. Rul. 2004-64); and (e) makes the trust an eligible S corporation shareholder.

9. If the trust is properly structured, none of the assets are included in the grantor's gross estate at death.

Additional Benefits If the grantor has an existing irrevocable life insurance trust, such trust will likely be a grantor trust and will qualify as an IDGT.  The death benefits of the life insurance policy can be used to pay the installment obligation upon death. If the grantor owns a majority interest in a corporation, limited partnership or limited liability company, the IDGT can be an excellent vehicle to purchase a non-controlling block from the grantor and qualify for a minority and marketability discount.  The remaining block retained by the grantor would also so qualify at death. A benefit to an IDGT over a GRAT is the IDGT is allowed to use the lower short term or mid term interest rate versus the higher § 7520 rate required of the GRAT.  Another benefit is that the grantor to the IDGT does not have to outlive the IDGT transaction as is required of the GRAT.  The downside to the IDGT is that there is not as strong of an established statutory or regulatory framework as there is for a GRAT.

The material in this blog is not intended, nor should it be construed or relied upon, as legal advice. Please consult with an attorney if specific legal information is needed.