Estate Planning Strategy; the Intentionally Defective Grantor Trust, IDGT

The Intentionally Defective Grantor Trust, the IDGT is a tool for business succession.

Many financial planners use the Intentionally Defective Grantor Trust, or IDGT, not only as an estate-planning tool, but also as a succession-planning tool for family businesses.

An IDGT holds the assets outside the grantor's taxable estate. This is not the only strategy that accomplishes both these objectives, but the IDGT is often the most useful strategy for owners who expect their companies to become significantly more valuable.

An IDGT freezes a company's value, at least for federal estate and gift tax purposes, as of the day the shares are sold or given away. This is what the grantor does to initiate the trust.

> The grantor sells or gives business shares to the trust at a discounted price, and
> Then I exchange receives a promissory note from the trust.

This means, in effect, that the grantor trades an appreciating asset (business shares) to the trust for a non-appreciating asset (the note). The grantor has the potential to maintain control of the business even when the trust has bought most or all shares. Upon the death of the grantor, the company's appreciated value passes to his beneficiaries free of federal estate tax, and the estate pays tax on the note's unappreciated value, meaning the unpaid balance.

As of 2006 you can to take advantage of the annual $12,000 gift tax exclusion or $2 million lifetime gift tax exemption (or both), the grantor can transfer some business shares to the trust as a gift, as well as sell shares to the trust.

It is fairly complicated as to how an IDGT works, but there is a simplified explanation of the fundamentals and the advantages and disadvantages.

Definition
An IDGT is an irrevocable trust in which the grantor retains a controlling interest in trust-owned assets. For example, the asset in the trust may be a minority interest in the grantor's family business and he may own controlling interests in the business.

Because of the provision(s) in the trust causes the grantor to be the owner of the trust for income tax purposes, the trust income is taxable to him. This is why it is considered to be an "intentionally defective" grantor trust. For both the estate and gift tax purposes, the grantor has removed the assets from his estate, so they are not subject to estate tax.
There is one exception. A gift made within three years after the death of the grantor will be ignored for estate-tax purposes.

Step-by-Step
First, the grantor should determine how much of the company he can give away or sell. The discounting works best when the grantor gives away or sells non-controlling minority interests, so that will be a major factor in his decision.

The next step is to create the IDGT and fund it. As a rule, the grantor should fund the trust with cash, marketable securities or other assets worth at least 10% of his anticipated sale price. That puts the trust in a reasonable position to issue a promissory note so it can buy the business interest.

The Main Transaction
The grantor may give business shares to the trust, without having to incur the gift tax, up to the annual exclusion amount of $11,000 ($22,000 for a married couple) per trust beneficiary as long as the trust provides the beneficiaries with a current withdrawal right. The grantor may also give amounts in excess of the annual exclusion to the extent both his and his spouse's lifetime exemption amount is available.

Beyond that amount, or if the beneficiaries have no current withdrawal right, the grantor should then sell nonvoting shares to the trust at fair market value in return for a promissory note. He will determine the note's terms, but often they are drafted as interest-only for nine years, with the stated interest equal to the prevailing federal mid-term rate.

He will need to obtain a valuation to establish the company's fair market value, by using a discount based on lack of control, and lack of marketability. The trustee should pay installments punctually and the grantor should not have to forgive the debt, because doing so risks having the IRS treating the sale as a gift. If the grantor properly structures the transaction, business earnings will cover note payments while providing him with enough income to maintain his lifestyle.

Other Tax Benefits
Although the grantor will owe income tax on the earnings of the trust, he will not owe on the installment payments that he will receive (not even on the interest). In addition, he will not have to recognize any capital gains tax on the company's sale to the trust.

Because the grantor sold shares to the trust at fair market value, that portion of the transfer will incur no gift tax. Over the years, the company's strong growth markedly increases the value of the trust. That appreciation takes place inside the trust and not inside the grantor's estate. It will then pass free of estate tax to his beneficiaries when he dies. His estate will then pay estate taxes only on the outstanding value of the promissory note, including the interest remaining n his estate on the date of his death.
In other words, the IDGT essentially allows the trust's grantor to avoid gift tax on his company's growth. This results in incredible savings, especially if he lives a long time and his business grows as much as expected.

Disadvantages
IDGTs do not necessarily fit an estate plan for everyone. In addition to complicated rules of establishment, along with the cost of a business valuation before every transaction, the downside is that if the business does not grow as expected, the interest on the promissory note and other costs could rinse out the savings.

This strategy is not without some risk. The IRS can treat the transferred shares as gifts if it believes that the grantor sold the business shares to the trust for less than fair market value. Or the IRS can try to reject the trust altogether and treat the business as if it were still part of the grantor's taxable estate. Recently, the IRS has implied that it might treat any tax paid on trust income as an additional gift to the trust. Should this IRS strategy prevail, the grantor will have to determine whether to continue to pay the tax on trust income or simply cure the defect and let the trust pay its own tax.

Avoiding Pitfalls

If the grantor should decide that an IDGT is right for his situation, he must make sure his trust document is properly written, the transactions are structured for the greatest tax advantages and his valuator has good credentials and experience.

Succession Strategies

The Intentionally Defective Grantor Trust is one of several strategies for passing a family business onto the next generation. The others include,

> Life insurance. A policy on a person's life could provide enough liquidity to pay estate tax and buy his share of the business. Caution: Life insurance is includable in an estate unless properly structured to avoid inclusion.

> Family Limited Partnerships (FLPs) and Limited Liability Companies (LLCs). FLPs and LLCs allow a person to transfer portions of his business to family members at discounted values, which helps reduce gift tax. In addition, he can maintain control of the business if he is the general partner of an FLP or the manager member of an LLC.

> Annuities. A private annuity allows successors to make payments over a period based on the life expectancy of an individual. Part of each payment received will be considered tax-free return on capital. Even if a person dies sooner than expected, the business will not be included in his estate and accordingly will escape estate tax. Of course, the annuity value is included in the estate to the extent that his heirs have a right to receive something from the annuity.

What strategy will work best for someone? That depends on many factors, including estate size, the company's value relative to the total estate, liquidity available to pay estate tax, family members' involvement in the company and the rate at which it is appreciating.

To determine the best strategy for your family, call TrustMakers for a free 20 minute consultation.