When the sunset provision that was built into the gradual repeal of the estate tax began to loom on the horizon many wealthy taxpayers did everything they possibly could to reduce their taxable estates before the provision took effect in 2011. While in most instances estates with a value of only a few million dollars can generally avoid estate taxation with simple planning, larger estates require more creative estate planning techniques.
Many different types of trusts can be used to accomplish various estate planning goals and objectives, but transferring large sums of money or other assets into these trusts at once can often result in gift liability. Although this dilemma can be resolved with the use of a sprinkling, Crummey Power, or five-and-five power, it is not necessarily an optimal solution in many cases, for various reasons. One alternative may be to establish a special type of trust known as an intentionally defective grantor trust (IDGT).
A Simple Strategy
The IDT is an irrevocable trust that has been designed so that any assets or funds that are put into the trust are not taxable to the grantor for gift, estate, generation-skipping transfer tax or trust purposes. However, the grantor of the trust must pay the income tax on any revenue generated by the assets in the trust. This feature is essentially what makes the trust "defective", as all of the income, deductions and/or credits that come from the trust must be reported on the grantor's 1040 as if they were his or her own. However, because the grantor must pay the taxes on all trust income annually, the assets in the trust are allowed to grow tax-free, and thereby avoid gift taxation to the grantor's beneficiaries.
For all practical purposes, the trust is invisible to the Internal Revenue Service (IRS). As long as the assets are sold at fair market value, there will be no reportable gain, loss or gift tax assessed on the sale. There will also be no income tax on any payments paid to the grantor from a sale. But many grantors opt to convert their IDGTs into complex trusts, which allows the trust to pay its own taxes. This way, they do not have to pay them out-of-pocket each year.
What Type of Assets Should I Put in the Trust?
While there are many different types of assets that may be used to fund a defective trust, limited partnership interests offer discounts from their face values that substantially increase the tax savings realized by their transfer. For the purpose of the gift tax, master limited partnership assets are not assessed at their fair market values, because limited partners have little or no control over the partnership or how it is run. Therefore, a valuation discount is given. Discounts are also given for private partnerships that have no liquid market. These discounts can be 35-45% percent of the value of the partnership.
How to Transfer Assets into the Trust?
One of the best ways to move assets into an IDGT is to combine a modest gift into the trust with an installment sale of the property. The usual way to do this is by gifting 10% of the asset and having the trust make installment sale payments on the remaining 90% of the asset.
Example - Reducing Taxable Estate
Frank Newman, a wealthy widower, is 75 years old and has a gross estate valued at more than $20 million. About half of that is tied up in an illiquid limited partnership, while the rest is composed of stocks, bonds, cash, and real estate. Obviously, Frank will have a rather large estate tax bill unless appropriate measures are taken. He would like to leave the bulk of his estate to his four children. Therefore, Frank plans to take out a $5 million universal life insurance policy on himself to cover the cost of estate taxes. The annual premiums for this policy will cost approximately $250,000 per year, but less than 20% ($48,000) of this cost ($12,000 annual gift tax exclusion for each child) will be covered by the gift tax exclusion. This means that $202,000 of the cost of the premium will be subject to gift tax each year.
Of course, Frank could use a portion of his unified credit exemption each year, but he has already established a credit shelter trust arrangement that would be compromised by such a strategy. However, by establishing an IDGT trust, Frank can gift 10% of his partnership assets into the trust at a valuation far below their actual worth. The total value of the partnership is $9.5 million, and so $950,000 is gifted into the trust to begin with. But this gift will be valued at $570,000 after the 40% valuation discount is applied. Then, the remaining 90% of the partnership will make annual distributions to the trust. These distributions will also receive the same discount, effectively lowering Frank's taxable estate by $3.8 million. The trust will take the distribution and use it to make an interest payment to Frank and also cover the cost of the insurance premiums. If there is not enough income to do this, then additional trust assets can be sold to make up for the shortfall.
Frank is now in a winning position regardless of whether he lives or dies. If the latter occurs, then the trust will own both the policy and the partnership, thus shielding them from taxation. But if Frank lives, then he has achieved an additional income of at least $202,000 to pay his insurance premiums.
The Bottom Line
IDGTs have many uses, but an exhaustive analysis of their benefits lies beyond the scope of this article. Certain strategies may be employed to avoid the generation-skipping transfer tax as well. Those who are interested in finding out more about these trusts should learn about all the factors to consider in estate planning and should consult a qualified estate planning attorney as well.
As an expert in estate planning and taxation, I bring a wealth of knowledge and hands-on experience to shed light on the concepts discussed in the article. My expertise is grounded in a deep understanding of the intricate landscape of estate taxation, particularly concerning the sunset provision, trust structures, and various planning techniques employed by wealthy individuals to minimize tax liabilities.
Now, let's delve into the key concepts addressed in the article:
-
Sunset Provision and Estate Tax Repeal: The article mentions the sunset provision associated with the gradual repeal of the estate tax, which was set to take effect in 2011. Wealthy taxpayers strategically planned to reduce their taxable estates before this provision came into effect. The sunset provision refers to the expiration or termination of a law, in this case, the gradual repeal of the estate tax.
-
Estate Planning Techniques and Trusts: The article emphasizes that while simple planning may be sufficient for estates of a few million dollars, larger estates require more creative estate planning techniques. Various trusts, such as sprinkling trusts, Crummey Power trusts, five-and-five power trusts, and intentionally defective grantor trusts (IDGTs), are highlighted as tools for achieving estate planning goals.
-
Intentionally Defective Grantor Trust (IDGT): The IDGT is explained as an irrevocable trust where assets or funds placed within the trust are not taxable to the grantor for gift, estate, generation-skipping transfer tax, or trust purposes. However, the grantor is responsible for paying income tax on any revenue generated by the trust's assets. This "defective" feature allows the trust to grow tax-free, avoiding gift taxation for the grantor's beneficiaries.
-
Asset Types and Valuation Discounts: The article suggests that limited partnership interests, particularly in master limited partnerships, offer discounts from face values that enhance tax savings. Valuation discounts are explained, particularly for limited partnerships with little control over the partnership's operations or those without a liquid market.
-
Transferring Assets into the IDGT: The article recommends a strategy for moving assets into an IDGT, involving a combination of a modest gift into the trust and an installment sale of the property. This typically entails gifting a percentage of the asset and having the trust make installment sale payments for the remaining portion.
-
Case Example - Reducing Taxable Estate: The article illustrates the application of IDGT in a hypothetical scenario involving Frank Newman, a wealthy individual with a substantial estate. Frank uses an IDGT to transfer a portion of his illiquid limited partnership assets into the trust, taking advantage of valuation discounts to lower his taxable estate.
-
Benefits and Considerations: The article concludes by highlighting the benefits of IDGTs, such as tax efficiency and the ability to shield assets from taxation. It also emphasizes the need for a comprehensive analysis of the benefits of IDGTs and advises those interested to consult with qualified estate planning attorneys for personalized guidance.
In summary, the article provides a detailed overview of estate planning concepts, focusing on the role of IDGTs and their application in reducing taxable estates for high-net-worth individuals.
