In previous Lane Reports, we discussed efficient ways to remove assets from your estate for estate tax purposes, but still maintain control and receive benefits from the removed assets. One popular way, as described in the April 1999 Lane Report, is through the use of a family limited partnership ("FLP") where a taxpayer forming a FLP can gift partnership interests to future generations and effectively remove the value of such partnership interests from his or her estate for estate tax purposes
However, not all taxpayers can afford to gift assets and permanently forgo the benefits from such assets. For some taxpayers, in order to remove assets from their estate for estate tax purposes, it is more advantageous to sell rather than to gift.
One efficient method to remove assets from an estate is to transfer the assets to an intentionally defective irrevocable trust ("IDIT"). An IDIT is an irrevocable trust that is "complete" for federal estate tax purposes, but "incomplete" for income tax purposes. The "defect" in an IDIT arises because of the possession by the grantor (the person that creates the trust), the grantor's spouse, or others of certain powers with respect to the trust that cause the grantor to be deemed the trust's owner for income tax purposes. The idea is to include intentionally in the trust those powers that will keep the grantor as the owner of the trust for income tax purposes. The result is that the property transferred is removed from the grantor's gross estate but continues to be treated as owned by the grantor for income tax purposes. Since the grantor is treated as the owner of the trust, the grantor's payment of the income tax due, out of nontrust assets, in subsequent years will further reduce the grantor's potential gross estate.
The power that makes the IDIT a flexible tool for estate plans is the power to substitute assets of equivalent value exercisable in a nonfiduciary capacity. If the grantor has the power to substitute, this will cause the trust to be "defective," and the grantor will be deemed the owner of the trust for income tax purposes. As such, the subsequent substitution of trust assets for other property of equivalent value cannot be considered a sale or exchange of the property for income tax purposes. The ability to substitute assets is perhaps the most advantageous feature of an IDIT. Seldom in estate planning do people have the ability to change their minds after making a gift, without incurring substantial estate tax consequences. However, through the use of an IDIT, the grantor does have this power.
A grantor can either sell or gift assets to IDIT, with both methods accomplishing the goal of removing assets from the grantor's estate. If a grantor gifts assets to an IDIT, the grantor may incur a gift tax if the value of the gift is greater than $10,000 per beneficiary of the IDIT and the value of the assets transferred exceed the grantors unified credit.
In the alternative, the grantor can sell assets to an IDIT in exchange for an installment note, payable over time, bearing an adequate interest rate. An installment sale to an IDIT ("IDIT Sale") is a deferred sale arrangement between an individual and an IDIT that allows an individual to make gift-tax-free transfers of appreciated property and corresponding income to junior generations. An IDIT Sale will not be a gift if the grantor receives full and adequate consideration in exchange for the transferred property. Therefore, the fair market value of the property should equal the fair market value of the installment note, bearing interest at the applicable federal rate. On the grantor's death, only the outstanding balance of the note, if any, would be included in the grantor's estate.
Any individual with a large taxable estate that includes income-producing or rapidly appreciating property should consider an IDIT Sale. Income-producing property is the ideal type of property, because an IDIT can use the property's income to make the payments to the grantor. If the property produces a return in excess of the note's interest rate, the arrangement should yield a positive transfer of wealth. This is true even if the property fails to appreciate over the grantor's lifetime because the IDIT will receive the benefit of the transferred income and only pay interest to the grantor. Nonetheless, the arrangement will remove more wealth from the grantor's estate if the property also appreciates in value. Any appreciation in value accrues to the IDIT and its beneficiaries, since the payments the IDIT must make to the transferor are based upon the sales price set at the time the parties entered into the sale arrangement.
This strategy can be particularly effective when transferring low-basis, highly appreciated assets and, subsequently, late in life, removing the low-basis assets from the IDIT, substituting high-basis assets, effectively removing the newly contributed assets from the estate of the grantor. If the grantor dies owning the low-basis assets that he or she removed from the IDIT, his or her heirs will receive the removed assets subject to a stepped-up basis for income tax purposes.
The following is an example of an effective use of a gift to an IDIT. A grantor forms an IDIT and contributes stock that is worth $600,000 and has a basis of $100,000. Over the next ten years, the IDIT pays income and principal to the IDIT's beneficiaries while the grantor pays income tax on the income generated by the IDIT. After ten years the value of the stock is worth $2,000,000, but its basis is still $100,000. If the grantor dies, the beneficiaries of the IDIT will receive the Grantor's carry-over basis of $100,000. However, the grantor can remove the stock from the IDIT and in its place contribute $2,000,000 in other high-basis assets or cash, effectively removing such assets from his or her estate but bringing the low-basis stock back into his or her estate. For example, the Grantor could substitute securities with a basis of $1,700,000. Upon the grantor's death, he or she will be able to pass the removed stock, now with a stepped-up basis of $2,000,000, to his or her descendants, decreasing the descendants' future capital gains on the sale of the stock by $1,900,000, the difference between the carry-over basis of $100,000 and the stepped-up basis of $2,000,000. Now the $2,000,000 in securities in the IDIT have a basis of $1,700,000, and, if they were sold for $2,000,000, the IDIT will pay income tax on only $300,000 of capital gain.
In the alternative, the grantor could have sold the $600,000 worth of securities for $100,000 down and a note paying $50,000 principal, plus adequate interest for 10 years. In this case there is no gift tax consequence to the transfer because the grantor has received full fair market value for the shares. Assuming the assets in the IDIT earn enough to pay the installment payments on the note, the grantor will continue to have an income stream from the transferred property which also helps defray the grantor's income tax liability on the income of the IDIT. If, after 10 years, the shares are then worth $2,000,000, the grantor can still substitute other securities, as above.
IDITs are not without risk, but have their place where appropriate. Where IDITs are not appropriate, other approaches exist that may accomplish similar results. Obviously, these are complex techniques and legal counsel should be consulted to create a comprehensive estate plan to address the needs and desires of the grantor.
The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.