Intentionally defective irrevocable trusts; estate planning for insecure times.

In tumultuous economic times, intentionally defective irrevocable trusts (IDITs) offer taxpayers a powerful triple play: an estate-freeze and wealth-transfer technique, as well as an estate planning opportunity--despite terrorism, the market's vagaries and recent estate tax legislation. CPAs should become familiar with IDITs to help eligible clients preserve wealth.

WHAT IS AN IDIT?

An IDIT is an irrevocable trust; it takes advantage of a disparity between the income and estate tax treatments offered certain trusts under IRC sections 674 and 675. Because an IDIT is deemed a grantor trust for income tax purposes, the trust grantor reports the trust's income annually; however, the trust assets are not includable in the grantor's estate for estate tax purposes. A grantor can sell appreciating assets to an IDIT in exchange for a note, "freezing" the value of his or her estate and transferring wealth by converting an appreciating asset into a fixed-yield asset (for example, an interest-bearing note).

HOW DOES IT WORK?

A grantor "seeds" an IDIT with cash or property that creates a taxable gift. He or she then sells an asset to the IDIT for an installment note. Under regulations section 1.1001-2(c), example 5 (see also revenue ruling 85-13 and Madorin, 84 TC 667 (1985)), the grantor does not recognize gain or loss on a sale of an asset to the IDIT. Similarly, the grantor pays no tax on the interest payments received on the note, but pays tax on all of the trust's income. If the grantor dies during the note's term, the IRS might argue that under Madorin the gain should be recognized. However, the grantor's estate may be able to defer the gain under the section 453 installment-sale rules, until the note is fully paid off (see Sun First Nat'l Bank of Orlando, 607 F2d 1347 (Ct. Cl. 1979)).

With an IDIT, a grantor can discount assets transferred or sold due to lack of marketability or a minority interest, reducing their fair market value, the taxable gift and the promissory note. Grantors should carefully choose the assets to be sold to maximize the wealth-transfer opportunity.

PLANNING STRATEGIES

Despite the anticipated steady decline in estate tax rates, the estate tax will return in 2011. Even though high-net-worth taxpayers hope for permanent tax repeal, this seems unlikely. The uncertainty of repeal, coupled with the turbulent times, however, make an IDIT a viable estate planning tool. For example, a grantor can benefit from low asset valuations and interest rates. He or she needs a smaller amount of seed money, thus reducing gift tax. Because low interest rates cap annual interest payments on a promissory note, the grantor can manage cash flow better until the note matures.

CONCLUSION

A thorough consideration of all the possibilities makes an IDIT an appealing estate planning tool and can give taxpayers experiencing difficult economic times realistic expectations of the results to be achieved. With IDITs, CPAs can help clients weather the economic storm.

For more information, see the column, Personal Financial Planning, by Alev Lewis, in the January 2003 issue of The Tax Adviser.

--Lesli S. Laffie, editor The Tax Adviser

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