Planning options with intentionally defective irrevocable trusts.

A relatively new estate planning vehicle involves the use of an intentionally defective irrevocable trust (IDIT). This type of trust is a grantor trust only for income tax purposes; if properly used, it can produce effective estate planning results. The technique resembles that of a grantor retained annuity trust (GRAT), but has several distinct advantages. The taxpayer creates an irrevocable trust with beneficiaries that ultimately would receive his assets on death. However, the grantor retains certain powers that cause the trust to be "defective" for income tax purposes. As a grantor-type trust under Sec. 691, all income generated in the trust is taxed to the grantor.

After the trust is established, an essential first step is to transfer assets (i.e., "seed" the trust) via a taxable gift to the trust. One should transfer at least 10% of the property's value that will subsequently be sold to the trust, making the trust economically legitimate. The taxpayer then sells appreciating assets (marketable securities, closely held business interests, etc.) to the trust in exchange for a promissory note (bearing interest at the applicable Federal rate (AFR)). Because the sale is between the taxpayer and the grantor trust, it is disregarded for income tax purposes; thus, no gain or loss is recognized (Rev. Rul. 85-13). In addition, the grantor is not taxed on the interest portion of the installment note payments he receives; nor will the trust deduct the interest payments made to the grantor (the taxpayer). However, as noted, all income generated by the trust's assets will be currently reported by the grantor. The assets sold to the trust are removed from the grantor's estate on execution of the sale transaction; the trust now holds title to the assets. This effectively freezes the value of the assets in the grantor's estate to the promissory note's face-value. The trust's beneficiaries will benefit from all future appreciation. In addition, because the grantor pays tax on the income generated in the trust, his estate will be further reduced by the tax payments. The end result is removal of highly appreciating assets from the grantor's estate with no gift tax payable other than on the initial seeding of the trust.

A comparison of the advantages of using this technique versus the use of a GRAT clearly illustrates that an installment sale to the defective trust (known as an ISDT) is a preferable estate-planning vehicle in many situations. First, while there is no gift on the sale transaction, there is always some gift tax due on the set up of a GRAT. On a grantor's premature death, the GRAT can cause all assets (including post-transfer growth) to be brought back into the taxable estate; with the ISDT, only the unpaid principal on the note is included in the estate. A GRAT requires a fixed schedule of annuity payments to the grantor, while the ISDT offers more flexibility in structuring the installment note payments. GNAT annuity payments require interest at 120% of the AFR (Sec. 7520); the ISDT installment note bears minimum interest at just 100% of the AFR, resulting in more property passing to beneficiaries. Finally, the generation-skipping transfer tax exemption can be allocated on the sale date with an ISDT, while this cannot be done with a GNAT until the end of the term (because of the estate tax inclusion period). One potential disadvantage to the use of an ISDT is that, because it is such a relatively new technique, it has not been fully tested or ruled on. However, if done properly, it should have effective results.

One option is to combine the ISDT with another popular estate planning vehicle--the family limited partnership (FLP). The discounts available with these partnerships for minority interests and lack of marketability can further enhance the benefits of using an ISDT, with the ability to move even more property out of a taxpayer's estate. Initially, the taxpayer creates a partnership with general partnership units and limited partnership units; these units are owned by the taxpayer or his spouse or both. The taxpayer then contributes assets (such as marketable securities, closely held business interests, etc.) to the partnership. There are no transfer tax consequences to this step of the transaction. The taxpayer keeps the general partnership interest (usually a small percentage) to retain control. The limited partnership units (or some portion thereof) are then sold to the IDIT, again in exchange for a promissory note. All of the estate planning benefits of a sale to a IDIT are achieved, with one additional result. Because the assets are sold to the trust in the form of limited partnership units, the discounts described earlier reduce the fair market value of the property transferred. Thus, the lower selling price means a smaller installment note, which means lower payments to the seller. Ultimately, more property has been transferred gift tax-free out of the taxpayer's estate.

One further option that would increase the estate planning benefits would be to use a self-canceling installment note (SCIN) with the sale. A SCIN is a standard installment note, but terminates on the seller's death. The outstanding obligation is not included in the estate (as opposed to a traditional installment sale, in which payments would continue). There is a small price to pay for this additional benefit. To avoid a gift when the sale takes place, payments via the SCIN must be increased to compensate the seller for the possibility that he might not realize all payments. If the seller lives through the note's full term, the amount payable to him and the increase in his estate are greater than if a standard installment note were used; this premium is calculated using table 80CNSMT in Notice 89-60. The increase in the payments under this calculation can be reduced by shortening the term. With the use of a SCIN in other situations, there is some uncertainty as to the proper treatment of unreported gain at the seller's death. However, this is a moot point for a SCIN used in a sale to an IDIT, because no gain or loss is recognized, as explained earlier.

The sale of assets to an IDIT should be considered as an alternative in the wide array of estate planning ideas. As illustrated, it could be a preferable option in many situations. And, coupled with the use of a FLP or a SCIN or both, the estate tax savings and other benefits could be substantial.

FROM ROBERT R. BROWN, CPA, MT, COHEN & COMPANY, CPAs, YOUNGSTOWN, OH