The name Intentionally Defective Grantor Trust (IDGT) is really just referring to the income tax defective nature of an Irrevocable Gifting Trust. It can be drafted for greater than the annual gift exclusion amount or for sales made to the trust. It allows the Grantor of the trust to pay the income taxes on the trust assets while still allowing the transferred assets to grow unencumbered by income taxes and free from estate taxes.
This is accomplished by making the trust a “Grantor” Trust. This power can even be toggled on and off by a Trust Protector. Different than the Trustee or Successor Trustee, a Trust Protector is an individual or entity not related to the person creating the trust that is given certain special powers. If the Grantor includes a Trust Protector in the trust document, the Trust Protector can turn Grantor Trust powers on or off. However, toggling more than once in a calendar year is not recommended. The Trust Protector should be a party not related or subordinate to the Grantor.
Why might we want to do this? It’s possible that the Grantor may initially want to burn other assets of his or her estate by paying the income taxes on the assets in the trust for the beneficiaries without reducing the value of those assets. However, there may come a time when the Grantor no longer wants or needs to burn or spend down his or her estate and then would prefer that the Trust Protector toggle this power off and allow the trust to pay its own income taxes.
Benefits of an IDGT
IDGTs are commonly used for transferring by gift closely held business interests to spouses, children or grandchildren. The gift to the trust is usually for a discounted value for estate and gift tax purposes because of the lack of marketability or possibly lack of control. Sales to the trust for a note at a special lower intra-family (AFR) interest rate can also be made. If properly drafted, the assets in the IDGT can continue to grow free from implication of future estate taxes.
Establishing the Trust
The trust is established as an irrevocable trust. Gifts and/or sales of assets can be made to the trust. Careful planning around the estate and gift tax is a must. The trust can also be utilized to “freeze” the value of the assets transferred to the trust for estate inclusion purposes.
For example, for a highly appreciating asset, the value at the date of transfer is the value to compute for estate and gift tax. This value can be further enhanced or “squeezed” through the use of valuation discounting with a qualified appraisal.
As of the date of this writing (2022), the IRS allows (with a formal valuation report) for the ability to value an asset for less than fair market value when certain marketability restrictions are present.
Lastly, an IDGT strategy can allow the Grantor to “burn” his or her “taxable” side of the estate by allowing for the payment of the IDGT income taxes without that payment being considered a gift to the IDGT trust beneficiaries. This is the trifecta of benefits—the “freeze,” the “squeeze” and the “burn”—which is a very powerful combination in the right circumstances.
Who Should Use an IDGT?
You should consider an IDGT if you have a taxable estate and you have a business, real estate, or securities that you’d like to pass to your children or grandchildren, and you’d like to reduce the amount of estate tax due on your estate. You should also consider this strategy if you like the idea of protecting your children and grandchildren from creditors, predators, divorcing spouses and bankruptcy.
Sam and Sally Smith have an LLC that owns several investments, such as a stock portfolio and real estate with a fair market value of roughly $20,000,000. The LLC operates as a business and is closely held by just Sam and Sally.
Sam and Sally have been married for 30 years, and they have two adult children together. Their daughter Marie is married and has one child. Although they like Marie’s husband, they do have concerns about the longevity of her relationship with her husband.
Their son just graduated from college and is looking for a career job. They think he’s on the right track for long-term success in life, but they still have some concerns about his ability to effectively manage money.
Because Sam and Sally’s estate that includes all of their other assets is above their combined $24,120,000 (2022) estate tax exemption, they are looking for one or more strategies to reduce or eliminate estate tax liability that their children will inherit if they do nothing. Their estate planning attorney recommends they set up an IDGT and transfer some membership interests from their LLC to that new trust. She cautions them that the trust is irrevocable but that a Trust Protector can be named in the document to make certain types of changes that could be necessary in the future for unforeseen circumstances and flexibility.
Their attorney advises them that they could maintain control over the LLC as the Managers of the LLC even if they chose to give away or sell 99% of the LLC to the IDGT. If they decide to do a note sale of some of the LLC to the IDGT, their attorney cautions them to seed the IDGT with a gift of at least 10% of the value of the LLC they intend to sell to the IDGT as a safe harbor to make sure the transaction has economic substance. You wouldn’t lend money to someone who had no assets, so the same concept holds true here.
Sam and Sally are also concerned about their children having direct access to the money inside the LLC right now if something should happen to them, but they would like to put them in control when they get older. Additionally, they have concerns about divorcing spouses and creditor protection since their son wants to go into business for himself.
They decide to proceed with the IDGT. Their attorney also informs them that the IRS currently allows them to discount the value of a gift or note sale to the IDGT typically for an amount less than the fair market value of the assets inside the LLC, due to a lack of marketability. However, this requires a competent business appraiser to create a special report as to the value and what the discounts are. If the valuation is ever later challenged by the IRS, they will want to be able to support the valuation discount as a reasonable discount.
Let’s say Sam and Sally decide to transfer 75% of the $20 million LLC interest to the IDGT by note sale. Sam and Sally would want to make a gift of seed money to the IDGT first. Then they would get a valuation report done on the LLC. In this case, we could estimate the discount to be somewhere between 20% to 40%. Let’s use 30% in this example.
Estate Squeeze with Valuation Discounting
At a discount of 30%, Sam and Sally’s initial fair market value of $15 million on 75% of the LLC for the note sale is actually only going to be a note for $10.5 million. The note can be structured for many years—let’s say nine years, with a balloon payment at the end—and the AFR rate for intra-family loans is fairly low (as of March 2022 –2%). As a result, the IDGT could pay just the interest back to them annually for the note.
This is a technique that is called “squeezing” the estate size for estate valuation purposes. The LLC’s value is squeezed with the discounted valuation appraisal.
Freezing of the Value of the Estate
So far, Sam and Sally have effectively removed $4.5 million from their estate with this part of the strategy alone. But it gets even better. We have also frozen the value of the assets that are transferred to the IDGT. This means that the 75% interest in the LLC continues to grow inside the IDGT without implication of the estate tax (outside their estate). All future appreciation is captured in the IDGT. This is referred to as the estate “freeze.”
The Estate Burn
Another huge advantage of the IDGT is that Sam and Sally can continue to pay the income taxes on the 75% of the LLC that they transferred to the IDGT without that payment of income taxes being considered a gift to their children. This allows them to further “burn” the taxable side of their estate with money they would have used to pay the income taxes anyhow had the assets remained just in the LLC and all in their name.
Sam and Sally also love that the IDGT protects their children from creditors, bankruptcy, lawsuits, and divorcing spouses. In addition, they like that they can assign an age at which their children can control their shares as Trustees if they wish and the assets can cascade to future grandchildren when their children pass.
To meet with one of our experienced attorneys to develop an advanced strategy for your family to protect them from future estate taxes and legal threats to their inheritance, call our office at (760) 448-2220.