Using Intentionally Defective Grantor Trusts to Gift Closely Held Business Interests

An Intentionally Defective Grant Trust (“IDGT”) is a tool for use in transferring an appreciated asset to family members as a current gift early in the appreciation of the asset as opposed to having the transfer at death after much appreciation has occurred. The result is that use of the tool leverages the transfer so that its value for tax purposes is lower than it would be at death. An IDGT is labeled as “defective” because it contains a purposeful flaw where the individual continues to pay income taxes, as income tax laws do not recognize that assets have been transferred away from the individual.

The effectiveness of the IDGT as an estate freeze is achieved by having a completed transfer of income and remainder interests to a trust by gift for gift tax purposes which would be lower in value for federal estate tax purposes than if the transfer were by will at the death of the donor. This is in contrast to and not to be confused with another estate freezing device using a trust, the Grantor Annuity Trust (“GRAT”) where the freeze is achieved by having the gift of the remainder interest have no value at the time of the gift transfer because the present value of the annuity equals the present value of the transfer.

With an IDGT, the idea is to use the basic exclusion, currently $10,000,000, indexed for inflation, up to twice that with spousal portability. There is also the annual gift exclusion, currently $15,000, if not used elsewhere, also twice that if a spouse joins in the gift, to cover the gift tax on the transfer. Of course, to the extent the basic exclusion is used, it reduces the basic exclusion, and portability, for estate tax purposes.

Generally, because of the earlier and steeper increases in tax brackets applicable to trust income as opposed to those applicable to an individual’s income, there is a tax advantage in having a trust defective for federal tax purposes. An IDGT is disregarded for federal tax purposes pursuant to § 674 et. seq. of the Internal Revenue Code (“IRC”), so that capital gains and ordinary income associated with the transferred asset for federal tax purposes are taxed to the grantor. This is so, even if the capital gains are retained by the trust and ordinary income, interest, and dividends go to trust beneficiaries (persons other than the grantor).

Normally, when a tax freezing tool is employed, a donor must give up control powers of the asset transferred to achieve a completed gift for gift tax purposes. IRC § 2511. With an IDGT, however, certain powers, although they make the trust defective for federal income tax purposes, do not make a gift to a trust incomplete according to Treas. Reg. 25.2511-2. For example, powers which can remain with the grantor without disturbing the completeness of the gift are: 1) designating the grantor’s spouse as trustee with authority to add beneficiaries, 2) retaining the nonfiduciary power to substitute trust assets, 3) authorizing an independent trustee to make loans to grantor without adequate security, and 4) authorizing use of a trust to pay life insurance premiums on grantor or grantor’s spouse’s life.

Assets of a grantor which are increasing in value when transferred by a grantor to an IDGT have the basis of the grantor when sold by the trust. IRC § 1015(b). By using the power to substitute grantor property with higher basis, but less anticipated appreciation this drawback could be avoided. Beginning in 2019, the ability to substitute property without federal income tax consequences was restricted to real property. In the case of substitution between a grantor and an IDGT, however, this does not matter because, as indicated above, transactions between a grantor trust and its grantor are disregarded for federal tax purposes.

As with GRATs and other estate freeze techniques reducing or eliminating federal estate tax, using an IDGT runs the risk of scrutiny by the IRS to see if it is an “abusive tax scheme.” See IRS Notice 97-24. The usual sanction for such a scheme, however, is directing the income to the person who actually earned it. This would be the grantor. So, an IDGT should not be an abusive scheme subject to redirection of taxable income, however, there are potential penalties to consider.

If the assets transferred to the trust are the assets of a business and the transfer attempts to change self-employment income or wages, normally subject to FICA and FUTA, into trust distributions, the IRS may allege the trust is a sham and not allow the disregarding of transactions for tax purposes. See IRS Appeals Technical Guidance Settlement Guidelines, Issue: Domestic Abusive Trust Schemes, 2005 WL7980392 (2005). Although trusts are normally disqualified as Subchapter S corporation shareholders, there is an exception in IRC § 1361(c)(2)(A) for a grantor trust owned by a US citizen. Notwithstanding the exception, care must be taken with S corporation stock where income for personal services is often alleged to be being distributed to shareholders as distribution of what should be considered wages.

There is also what is called the Anticipatory Assignment of Income doctrine, another way for the IRS to combat abusive tax schemes according to the above cited IRS Guidelines. This doctrine would apply if the asset transferred generated personal service income. Dividends and interest would not be the kind of income reached by the doctrine, however.

Another concern of the IRS are “tax shelters” which have a purpose of avoiding federal income tax. Since the grantor is not seeking to avoid income tax but wants to purposely be responsible for paying it with an IDGT, such a trust should not meet the definition of tax shelter. Nevertheless, when developing an IDGT, care should be taken that transfer valuations are as required by the IRS—preferably, as set by a national stock exchange or a qualified appraiser. It would also be wise to have a legitimate asset protection purpose, such as potential tort liability, for transferring title to the assets besides an estate tax saving purpose.

An IDGT is a legitimate way to transfer an appreciating asset such as stock in a closely held business to children. If the income from the asset is important to the grantor during his or her life, however, it is not that attractive. Also, if other income of the grantor is not available to pay the additional taxes on the income going to the trust beneficiary or beneficiaries, it is not the right estate planning technique. Finally, even though there are protections against assertions that it is an abusive tax scheme or a tax shelter, a grantor must be prepared for an IDGT to attract the attention of the IRS to it and to all other tax arrangements of the grantor. Using an IDGT for small business stock could, in itself, be considered a red flag.