Intentionally defective? Estate planning with intentionally defective irrevocable trusts.

An intentionally defective irrevocable trust (IDIT) is not a term you normally use when discussing estate planning with your clients; however, it can be a significant estate planning tool. The trust is not literally defective. It's an irrevocable trust designed with enough grantor powers to cause the grantor to be considered the owner for income tax purposes, while preserving the completed gift characteristics for estate tax purposes.

Technically Speaking

An IDIT is a trust that has one or more of the powers described in IRC secs. 671-678, but none of the powers described in IRC secs. 2036-38. Trusts fitting within secs. 671-678 are considered grantor-type of trusts for income tax purposes while trusts containing the powers described in secs. 2036-38 are considered owned by a grantor and included in their estate.

The powers described under each of these code sections are not completely the same. Therefore the planner has the ability, through careful drafting, to have the grantor retain the ownership for income tax purposes but not for estate tax purposes.

Under secs. 671-678, grantor aretreated as trust owners if:

* They retain a reversionary interest in trust corpus or income; has power to control the "beneficial enjoyment" of the income or principal of the trust;

* They retain certain powers of administration without consent of any person in a fiduciary capacity;

* They can revoke the trust at any time or revest the property to themselves;

* They can distribute income to the grantor or the grantor's spouse; and

* Someone other than the grantor will be treated as owner of a portion of the trust if that person has the power to vest the trust's income or corpus in himself.

Secs. 2036-38 generally provide that assets are included in a decedent's estate if the decedent, at death:

* Retained a life estate in the property previously transferred;

* Retained a reversionary interest; or

* Made a revocable transfer of the property.

Planning Opportunities

The primary purpose of an IDIT is to shift income ownership and related tax burden and attributes back to the grantor, while preserving the completed gift characterization for estate and generation-skipping transfer taxes. IDITs are commonly used to:

Shift the Income Tax Bracket--An irrevocable trust is normally taxed on its own income or, if distributed, to the beneficiaries. Creating an IDIT shifts the tax burden back to the grantor, who pays less tax than the trust due to the differences in the income tax brackets.

Consider using an IDIT with irrevocable life insurance trusts or other irrevocable trusts with high-income beneficiaries. IDIT's also work well when the grantor has a large amount of tax-exempt income or loss carryovers.

Increase Cash Flow to Beneficiaries--Because an IDIT is not liable for income taxes, the trust corpus is not reduced by the tax burden, assuming no reimbursement to the grantor. This allows for a larger accumulation for the beneficiaries.

Nonrecognition of Gain--The grantor's sale of property to an IDIT is a nontaxable event. The fact that no gain is recognized results in the transfer of basis to the trust, but keeps the appreciation of the assets sold out of the donor's estate.

Retention of Tax Attributes--The grantor's tax attributes are retained and applicable to the trust income. Thus the grantor's carryovers of passive losses, investment interest and capital losses can be applied to trust income and deductions.

A home mortgage interest deduction is available if the trust holds a mortgage. Also the exclusion on the sale of principal residence would be available if all of the Sec. 121 requirements are met.

Grantor S Corporation Trusts-IDITs can qualify to hold S corporation stock if certain requirements are met. This trust offers more flexibility than a qualified S corporation stock trust (QSST). One drawback is that within two years after the grantor's death the S corp. stock must be distributed.

GRATs, GRUTs and QPRTs also can be used in conjunction with IDIT planning. These devices, as well as the effects of the generation-skipping transfer tax, are very complex issues, and are outside the scope of this article.

Estate Tax Repeal

With the possible repeal of the estate and GST taxes after 2009, the appeal of IDITs may be somewhat diminished; however, the gift tax exemption remains intact at $1 million. Planners should plan with flexibility and not assume that there will be permanent repeal. IDITs are still a beneficial weapon in our estate planning arsenal and should be considered under the appropriate circumstances.

The use and drafting of IDIT provisions into trust documents is complicated and can create unforeseen results if not done carefully. In recommending an IDIT's use, a tax practitioner is well advised to consult a tax attorney familiar with these provisions.

Laura Kauls, CPA, is a partner in the Redondo Beach firm of Kauls & Company, CPAs. You can reach her at [e-mail].

John R. Woodford, CPA, is a partner in the Grass Valley accounting firm of Robertson & Woodford. You can reach him at [e-mail].

Kauls and Woodford are both Ca/CPA Estate Planning Committee members, www.calcpaweb.org/estate.