USING INTENTIONALLY DEFECTIVE GRANTOR TRUSTS (IDGTS) IN ESTATE PLANNING

By Alfred J. LaRosa, CPA, Eisner & Lubin

A major incentive for making lifetime gifts is the ability to avoid including future appreciation of, and income from, the transferred property in the donor's estate. After the transfer, the donee (recipient of the gift) is generally responsible for paying taxes on the income and appreciation attributable to the transferred property. It may be possible, however, to structure the gift so that the donor, rather than the donee, is responsible for paying the income taxes. Why would the donor want to pay taxes on income from property he or she no longer owns? Because by relieving the donee of this responsibility, the donor in effect makes an additional gift, free of any gift tax. We can accomplish this by using an intentionally defective grantor trust (IDGT) as the recipient of the transfer.

A transfer to a properly structured IDGT is considered a completed transfer for estate and gift tax purposes, but incomplete for income tax purposes. Therefore, an IDGT would not be included in the donor's estate upon his or her death, yet it would be considered a grantor trust for income tax purposes. As a grantor trust, the donor is taxed currently on the trust income. By paying the income taxes attributable to the income earned by the trust, the donor in effect is making additional transfers to the trust beneficiaries without being subject to gift tax. This can result in substantial savings.

One of the main concerns in establishing an IDGT is ensuring that the trust is not included in the grantor's estate. Proper draftsmanship is important so that the transfer does not run afoul of the estate tax inclusion rules on prior transfers (IRC Secs. 2036-2038). The trust must, at the same time, fall under the grantor trust income tax rules (IRC Secs. 671­679). Therefore, the grantor needs to retain enough control for grantor trust status, but not enough to cause the trust assets to be included in the grantor's estate. There are various ways that the drafter of the trust instrument can accomplish this.

Another concern may be the lack of assurance that the IRS will not treat the income taxes paid by the grantor as a taxable gift. Although there is not much guidance in this area, many practitioners feel that since the income taxes are the obligation of the grantor under IRC Sec. 671, no gift tax will be imposed. By satisfying his own liability to pay taxes, the grantor should not be treated as making taxable gifts to those who have no legal obligation to pay such taxes.

Consider the following example:

Mr. and Mrs. Jones are considering using each of their $600,000 lifetime gift and estate tax exemptions currently. It was suggested that separate inter vivos credit shelter trusts be created with each spouse's $600,000 exemption equivalent amount. The trustee(s) of each trust will be given broad discretionary powers to distribute or "sprinkle" income and principal among a group of individuals which will include the grantor's spouse, the Jones' two children, the children's spouses, and the Jones' four grandchildren. Because the grantor's spouse is eligible to receive distributions of income or principal at the discretion of the trustee(s), these trusts will be considered grantor trusts, provided the trustee(s) is not an adverse party under IRC Sec. 677(a). Although it would not be advantageous from an estate planning point of view to make distributions to the spouse, a grantor generally would feel more comfortable about making larger transfers to an IDGT knowing that the spouse is entitled to income or principal distributions.

The trusts will be structured so that additional contributions will be made with the intention that such additional transfers will qualify for the $10,000 annual gift tax exclusion. This may be accomplished by installing "Crummey" powers, giving each beneficiary the right to withdraw up to $10,000 within a limited time period after such additions are made to the trusts. (Note: There are some uncertainties and inconsistencies concerning the income tax and estate and gift tax consequences to a beneficiary who permits his or her Crummey power to lapse. Although this is beyond the scope of this discussion, it is important to consider the implications of lapsed powers when structuring such a plan.) Therefore, by giving the two children, their spouses, and the four grandchildren Crummey powers, Mr. and Mrs. Jones can make combined annual gifts of $160,000 per year ($10,000 x 8 beneficiaries x 2 donors) without incurring any gift tax.

At the beginning of year 1, the trusts will be funded with a total of $1,360,000 ($680,000 per trust). On January 1 of each subsequent year, the Joneses will make additional contributions of $160,000 to the trusts ($80,000 per trust).

The trusts are expected to generate 8% annually before the effective income tax rate of 45% (Federal, state, and city). The results after 10 years of using IDGTs (Case 1) versus having the trusts bear the income taxes (Case 2) is shown in the accompanying Exhibit.

The fact that $141,000 ($1,032,000­ $891,000) more in income taxes is being paid by the trusts in Case 1 is not of much relevance since the trusts' pre-tax income in Case 1 is $315,000 higher.

The real savings result from the fact that in Case 1 there is a total of $1,205,000 more in the IDGTs at the end of 10 years without any additional gift or estate taxes being incurred.

If the IDGTs are not used (Case 2) and the donors would like to net the same results by transferring an additional $1,205,000 at the end of the 10-year term, it would cost approximately $663,000 in gift taxes (assuming a 55% rate). If instead

of transferring the additional funds during their lifetime, the donors make the transfer upon their deaths, it would cost approximately $1,473,000 in estate taxes (assuming a 55% rate) to net a transfer of $1,205,000. This results from the fact that the estate tax computation is tax inclusive, while the gift tax computation is tax exclusive.

The above results are based only on a 10-year term. Imagine the results that can be accomplished over a longer time period. The possibility of using assets other than cash in funding the trusts should also be considered. For example, using limited partnership interests or stock of a closely-held corporation might be a good choice, since substantial discounts could be considered in arriving at the fair market value of the gifts to reflect minority holdings and/or the lack of marketability of such holdings.

The concept behind IDGTs has existed for some time now. As a result of the harsh fiduciary income tax rates imposed by RRA '93, however, the restrictions and complexities imposed by Chapter 14, and the high estate and gift tax rates, more attention should be given to the use of IDGTs as possible gifting vehicles. *

Case 1 Case 2

Results from Tables Below IDGTs No IDGTs

Initial funding (Year 1):

Combined lifetime exemptions $1,200,000

Annual gift 160,000 $1,360,000 $1,360,000

Annual gifts ($160,000 x 9 years) 1,440,000 1,440,000

Trust income for 10 years

(compounded annually @ 8%) 2,294,000 1,980,000*

Less: Income taxes paid by

trusts (» 45%) -0- (891,000)

Remaining principal balance

of trusts $5,094,000 $3,889,000

Income taxes paid by donors (» 45%) $1,032,000 $ -0-

*Earnings are less because payment of taxes has reduced the amount available to produce earnings.

Editors:
Marco Svagna, CPA
Lopez Edwards Frank & Co., LLP

Edward A. Slott, CPA
E. Slott & Company

Contributing Editors:
Richard H. Sonet, CPA
Zeitlin Sonet Hoff & Company

James B. McEvoy
Chemical Banking Corporation

Lawrence M. Lipoff, CEBS, CPA
Lipoff and Company, CPA, PC

Frank G. Colella, LLM, CPA

Jerome Landau, JD, CPA

OCTOBER 1995 / THE CPA JOURNAL