Despite its odd name, the intentionally defective grantor trust (IDGT) is a powerful estate planning tool that can achieve a wide range of objectives: reducing the size of the grantor’s estate, transferring assets outside the probate process, removing assets from the reach of the grantor’s creditors, and reducing the future tax liability upon transfer or sale of an appreciating asset. The IDGT can be an especially effective device for transferring small business ownership from one generation to another.
To create an IDGT, the grantor first sets up an irrevocable trust funded with cash or other liquid assets in an amount approximately 10 percent of the value of the other assets to be transferred into the trust. Once the IDGT comes into being, the grantor can then sell assets to the trust in exchange for promissory notes, which can either call for interest-only payments with a balloon or amortization of the principal amount of the debt.
Using the IDGT to Transfer Interests in a Closely Held Business
The most common IDGT sales transactions involve transfer of a non-controlling interest in a business owned solely or principally by the grantor, who retains certain rights in the assets transferred – mainly, the right to substitute trust assets or manage them on a non-fiduciary basis. This retention of rights with respect to trust assets is what makes the trust “defective” for income tax purposes. The grantor will need to pay tax on income produced by trust assets, because the IRS will regard the transfer of assets as a sale by the grantor to him or herself.
For estate and gift tax purposes, however, a properly created IDGT will be recognized as valid. Beneficiaries of the trust will take title to the assets free of income, capital gains or estate tax. Because asset values are determined at the time of the grantor’s transfer, subsequent appreciation of assets can be essentially tax-free when the beneficiaries come into title.
Accurate asset valuations are an indispensable part of making an intentionally defective grantor trust work. The installment note taken by the grantor at the time of sale to the trust should be based on current values. When the assets “sold” are interests in an LLC or S corporation, the values can generally be discounted to reflect the non-controlling nature of the interest and the lack of marketability.
Upon the grantor’s death, the grantor’s estate may be liable for tax on any unpaid balance of the installment note at the unappreciated asset value. Transferring an appreciating asset (interest in a closely-held business) in exchange for a non-appreciating asset (the installment note received upon sale) by itself is one of the ways that an IDGT helps families manage estate tax liability for the intergenerational transfer of business interests.
Ridley Park Trusts and Estates Lawyer: Call 610-521-0604
Metro Philadelphia estate planning attorney Gregory J. Spadea has advised many Pennsylvania business owners about their options for protecting asset values while reducing tax liability through the proper use of trust instruments, gift transfers and asset protection strategies. To find out whether the IDGT can help you meet your estate planning objectives, contact Spadea & Associates in Ridley Park. To learn more about the firm and its lawyers’ experience, visit its website at http://spadealawfirm.com.