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Using Intentionally Defective Grantor Trusts (IDGTs) To Create The Family Bank

By Roccy M. DeFrancesco, JD, CWPP™, CAPP™ - Email Editor

Date : 26-June-2007

There are many advisors running around out there calling themselves “advanced” estate planners. The truth of the matter is that there are very few advisors nationwide that actually know “advanced” planning. That was one reason I created the three different certification courses I offer: Certified Wealth Preservation Planner, Certified Asset Protection Planner, and Master Mortgage Broker.

It is impossible to call yourself an “advanced” planner if you do not have a working knowledge of how to use Intentionally Defective Grantor Trusts (IDGTs). IDGTs have many different uses, but for this newsletter, I wanted to discuss how to use an IDGT to create the “family bank.”

Typical Estate Planning

Most high net-worth clients who have put off doing proper estate planning end up having their advisors tell them, at some point in their lives, that they must set up an Irrevocable Life Insurance Trust (ILIT) so the death benefit of a life insurance policy owned by the trust will pay estate tax-free and be used to pay for the inevitable estate taxes that will be due.

While it is easy for an advisor to tell a high net-worth client to gift $150,000 in premiums to an ILIT, most clients are upset when they hear that they must pay gift tax on some of the premium gifted to the ILIT (or use their limited lifetime gift tax exemption).

Explaining IDGTs

I am not going to explain in this newsletter exactly how an IDGTs works to discount assets and then sell them to an IDGT. For such an explanation, you should purchase the Advanced Estate Planning Education Module from the CWPP™ course, which can be purchased through assetprotectionproducts.com by clicking here.

Better Planning

An IDGT provides an excellent way to acquire significant amounts of life insurance without having to worry about taxable gifts on the premium payments. This makes the IDGT a terrific tool since the ability to discount the value of the property sold to the IDGT, combined with an interest-only installment payment, should provide the IDGT with sufficient tax-free cash flow to allow the funding for significant amounts of life insurance.

Because I do not have the 5-7 pages needed to more fully explain how IDGTs are set up, and why they work from a tax perspective, it’s difficult to explain this topic.

Having said that, I think by reading over a somewhat simple example, you can get the feeling of whether an IDGT might be a tool that you will want to obtain more information on for possible incorporation into your estate plan.

Example:

Marty and Sylvia, ages 68 and 67, have an estate valued at $18 million and would like to acquire a $4.5 million second-to-die survivorship life insurance policy for the benefit of their only child, Matt.

Due to medical issues, however, the premium for the policy will be $150,000 per year. While there is plenty of cash flow available to pay the premium, Marty and Sylvia are concerned over the gift taxes that would be imposed on the premium payments if they were to gift $150,000 a year to an irrevocable life insurance trust (ILIT).

Among the assets owned by Marty and Sylvia are real estate investments valued at $7 million, generating income of 6% or $420,000 per year.

Marty and Sylvia contribute their real estate interests to a newly formed family limited partnership (FLP) and receive a 1% general partnership interest and 99% limited partnership interests. Working with an appraiser, a 35% valuation discount is applied to the partnership interest.

Marty and Sylvia create an IDGT and sell their limited partnership interest to the trust in exchange for an interest only note.

Gross Value of Property: $7,000,000
Discounted Value: $4,550,000
Term of Payment: interest only 15 years
Income on Property: 6%
Property Growth: 5%

Why would Marty and Sylvia want to transfer their assets to an FLP, discount them and sell them to an IDGT for a 15-year installment note?

The simple answer is that because of the discount (35%) on the FLP interest, the installment note which will be paid to the clients is based not on the $7,000,000 of income producing real estate in the FLP, but instead is based on the discounted value of $4,550,000. This is the key to the transaction.

Because the installment note is based on a $4.5 million asset instead of a $7 million dollar asset, there will be significant surplus cash flow which stays in the trust. That surplus income can be used to pay life insurance premiums in a completely gift-tax free manner where the death benefit will remain out of the estate.

Let's see how this arrangement can help fund the life insurance premiums without imposing gift taxes.

Year	Installment Note Based On	Trust Income	Interest On Note	Life Insurance Premiums	Excess Cash Flow	Value Of Property
1	$4,550,000	$420,000	$266,175	$150,000	$3,825	$7,140,000
5	4,550,000	454,621	266,175	150,000	38,446	7,728,566
10	4,550,000	501,939	266,175	150,000	85,764	8,532,961
15	4,550,000	554,181	266,175	150,000	138,006	9,421,078

This planning has allowed $4,871,078 (which is derived by subtracting the installment note from the property value in year 15) in value to be shifted to Matt, free of all taxes while creating a death benefit of $4.5 million that will also be received totally tax free. It has also allowed Marty and Sylvia to make substantial tax-free gifts to the trust in the form of income taxes paid on the trust income.

The $266,175 of interest paid to them annually for 15 years is not taxable, but the $420,000 of income created inside the IDGT is taxable annually to Marty and Sylvia as grantors. Taxes on $420,000 at the 40% rate are $168,000 and typically, a portion of the installment note payment of $266,175 is used to pay that tax.

If the grantor is still alive in 15 years when the note becomes due, there are a few options. The note could be re-done, or it could pay the $4.5 million due. Upon redoing the note, it could also be structured to start to pay down principal.

The Family Bank

Once Marty and Sylvia die, a large death benefit will pass income and estate tax free to the trust for the benefit of the heirs (children/grandchildren). When a child or grandchild needs let’s say a loan for a new house, a loan to start up a new business, a partner in a new business, etc. they can look to the IDGT as their friendly lending source or business partner. In the lending situation, the average loan for a residential or commercial loan may range from 7-12%. The IDGT, in a commercially reasonable manner, may have a range from 4-9%.

Then when the 2nd generation is getting up there in age, the IDGT will buy more life insurance on their lives in a gift tax free manner so as to perpetuate the life of the trust for future generations. This is what the mega wealthy use as part of nearly ever estate plan.

Conclusion

While I know the above quick example is not going to make readers an expert in IDGTs, I hope you can get a feel for the basics of how to use an IDGT to move assets our of an estate and into an irrevocable trust where life insurance can be purchased in a gift-tax free manner while also moving other assets out of the estate at a discount.

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