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trust and Estate Planning
S H O U L D Y O U T A K E A D V A N T A G E O F A “T A X B U R N ” ?
Intentionally “defective” grantor trusts can be effective wealth transfer tools
Raymond C. Odom
National Director of
Wealth Transfer Services
Garrett Ndiege
Buchanan, CFP
Vice President,
Senior Financial
Consultant
Would the potential
wealth transfer
benefits you and your
beneficiaries gain with
an IDGT outweigh
increased tax liability
down the road?
Often, wealth owners want to make a gift but delay the use or consumption of that gift by the
beneficiary. Gifting to an irrevocable trust naming the beneficiary is a common way of deferring
and protecting a gift. As a wealth owner you can increase the wealth transferred to beneficiaries
through a trust by designing the trust so that you (rather than the trust) pay the tax on the trust’s
income. In effect, you, as wealth owner, pay taxes on income attributable to assets held in trust for
the benefit of your beneficiaries. This tactic creates a gift of taxes that is not treated as a taxable gift.
In addition to increasing the amount of wealth transferred to the beneficiary, paying taxes
attributable to trust assets is sometimes regarded by estate planning professionals as an advantageous
tax reduction strategy. Since paying income taxes consumes a portion of your estate that may be
subject to estate tax, planners refer to this strategy as a “tax burn.” Unfortunately, on occasion, this
intentionally designed “tax burn” can diminish the donor’s future cash flow in unanticipated and
unacceptable ways. Below we will discuss the delicate balance between a good thing and too much
of a good thing.
WHY DID PLANNERS PREVIOUSLY AVOID CREATING GRANTOR TRUSTS?
Thirty years ago a top bracket taxpayer with $20,000 of corporate bond income would have paid
about $10,000 of income tax. If that taxpayer could transfer the bond into a taxable trust, the same
$20,000 of interest would generate only $2,629 of tax – a 74% tax savings by just using a taxable
trust to hold the bond income. A wealthy individual who could afford to transfer taxable investment
assets into a trust could save enormous amounts of income tax.
Congress was aware of this tax savings opportunity for wealthy individuals. Their response
was to create a complex set of tax rules that made the creator of the trust (the grantor) taxable
on the income inside the trust as if the trust did not exist. In effect, the IRS ignored the trust. This
“non-taxable” trust is known as a grantor trust. A grantor trust exists as a legal owner of assets
(for property law purposes) but does not exist as a separate taxpayer for income tax purposes. All
taxable transactions inside the trust are treated as if the grantor executed the transaction without
the existence of a trust. Planners used to work very hard to avoid the grantor trust rules so that
investment income would be taxed at the lower tax brackets of the trust, instead of the higher
brackets of the grantor.
WHY DO PLANNERS NOW REGARD GRANTOR TRUSTS AS A HELPFUL
WEALTH TRANSFER TOOL FOR CERTAIN WEALTH OWNERS?
In order to severely limit the ability of taxpayers to use trusts to save income taxes, Congress
substantially increased trust tax rates in 1986 and 1991. Congress did this by simply compressing
the tax brackets for trusts so that in 2014 all but $12,150 of trust income is taxed at the highest
marginal rate. Now there is only about $1,642 of income tax savings for using a trust. The costs
to top bracket taxpayers to establish and maintain a trust as a separate taxpayer are generally
much greater than the $1,642 of potential tax savings. Congress, therefore, has essentially ended
the tax advantage of shifting income to a trust.
However, a 2004 IRS ruling (Revenue Ruling 2004-64) revived the use of grantor trusts by
estate planners. The IRS ruled that when the rules of a grantor trust require the grantor to pay
taxes on trust income that will eventually go to trust beneficiaries, the tax payment is not a gift to
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the beneficiaries. This ruling allows grantors to pay the income tax on gifted assets by gifting to an irrevocable
grantor trust for the beneficiaries. This result is so helpful for wealth transfer purposes that estate planners
decided it would make sense to “intentionally” create trusts that triggered the grantor trust tax rules. Estate
planners called this type of trust an intentionally defective grantor trust (IDGT) because it intentionally inserts
trust provisions that were originally designed to be a tax detriment. Of course, for the affluent individual with
a taxable estate and a desire to maximize gifts to beneficiaries, there is nothing defective about intentionally
creating a grantor gift trust.
WHY WOULD I WANT TO CREATE AN
INTENTIONALLY DEFECTIVE GRANTOR TRUST?
IDGTs are a very popular way to pass significant additional
wealth to children, grandchildren and other beneficiaries
because the grantor can “pick up the tab” for taxes that would
otherwise be paid by the recipient of the gift. An IDGT is a
strategy chosen to give children and other beneficiaries tax-free
income via an irrevocable gift trust. The wealth is income tax-free
to the beneficiaries because the grantor of the trust pays the tax.
An intentionally defective grantor trust
(IDGT) is an irrevocable trust that has at
least four characteristics:
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WHY WOULD ANYONE WANT TO PAY INCOME TAX
FOR HIS OR HER BENEFICIARIES?
Normally, the goal of financial advisors is to decrease your
income taxes. However, when the goal is to transfer wealth,
your decision to pay the current and future income taxes on
dividends, interest and capital gains for the trust may be
especially desirable in situations like the ones listed below.
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■■
■■
■■
■■
■■
■■
Any transfers of property to the trust are
considered completed gifts for federal
gift tax purposes.
The property in the trust will not be
includable in the taxable estate of the
trust creator (grantor) for federal estate
tax purposes.
Income from the trust will be taxed to
the grantor (even though the grantor
does not receive the income).
The trust is a legal owner but is not
considered a separate tax-paying entity.
You want the assets and income held in the trust to have
compound growth, in essence, income tax free.
You have a large estate and paying income taxes for someone else becomes a way to reduce your taxable estate
without incurring gift tax.
You are in a better position to pay the taxes than the beneficiaries, typically children or grandchildren.
The trust is funded with certain partnership interests that generate losses, and you might want to use the
losses to offset other income.
In certain limited situations, you may be in a lower marginal tax bracket than the trust/beneficiaries,
for example, you have large tax-free investment income, large tax deductions or significantly decreased
taxable income because of a change in employment status
WHAT DOES IT COST THE GRANTOR TO PAY THE TAX OF AN IDGT OVER A LIFETIME?
For most planners the “tax burn” is a great benefit of the IDGT because it reduces the taxable estate of the
grantor. However, the benefits of paying the income tax of the grantor’s beneficiaries must be carefully
quantified to prevent a too much of a good thing scenario. For instance, if you are a 50-year-old grantor funding
a $5,000,000 grantor trust with assets that produced a 6.5% ordinary income annual yield, the annual tax
liability (taxed at the top marginal tax rate plus the full Medicare Net Investment Income surtax) might start
out at a little more than $140,000/year. At age 75, after 25 years of compounded growth, your annual tax liability
could grow from $150,000 to just under $640,000/year. The cumulative income taxes paid over those 25 years
would be $8,306,107.
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Perhaps the best way to look at your real gift cost is by calculating the present value of the future payments
of trust tax liability. In the preceding example, the present value calculation (at a 3% discount rate) comes
to $5,262,116. So the real gift, if you live 25 years and pay all of the income tax (at the assumed rates on the
assumed taxable income) is $10,262,116, not $5,000,000. The estate tax savings of the additional transfer of
$8,306,107 ($5,262,116 in present value terms) could be significant – approximately $3.22 million at 2013 estate
tax rates for an unmarried decedent. However, for some grantors an income tax bill of $684,321 at age 75
might be too big a gift for their cash flow.
The easiest way to avoid too much of a good thing is to give the trustee the right to reimburse you, as the
grantor of the trust, for the taxes you pay for the trust. While this is the most direct solution to the problem,
there are potential risks. The IRS has ruled that a prior agreement by the trustee to reimburse the grantor for
tax payments could potentially make all or a portion of the IDGT taxable as part of your estate. Therefore,
care must be taken to permit tax reimbursement only in limited circumstances that are not predetermined
before the creation of the trust.
Over the years planners have identified ways to create grantor trust powers that can be “turned off ” if the
tax liability becomes too high. The trustee or the trust protector is given the authority to limit or eliminate the
power that causes the IRS to view this trust as “owned” by you.
WHEN SHOULD I CONSIDER SELLING ASSETS TO AN IDGT, A POPULAR STRATEGY?
Since the trust does not exist as a tax entity separate from the grantor, but does exist as a legal owner, you can
sell discounted or appreciating assets to the trust without any income tax consequence. The IRS regards the
sale of assets to the trust as a sale to yourself, so it ignores any capital gain or income from payments on a note.
Grantors often use IDGTs to sell portions of their closely held businesses or concentrated stock positions to
the trust using very favorable low interest loans. In this technique, the discounted or appreciating asset is sold
to the trust, so there is no gift or gift tax. If the asset sold increases at a faster rate than the interest on the sales
note, there is a non-taxable transfer of wealth to the trust.
Planners often compare the results of the “installment note sale to an IDGT” to a zeroed-out gift to a
grantor retained annuity trust (GRAT) in order to determine which technique leaves more wealth to the trust
beneficiaries. The installment sale is sometimes used by planners because the note’s interest rate is generally
lower than the Internal Revenue Code Section 7520 rate used to determine the dollar amount of annuities that
must be repaid to the grantor of a GRAT. Sometimes GRATs are favored because of greater simplicity and previous
IRS approval (see also the comments on the Greenbook treatment of installment sales to IDGTs below).
THE GREENBOOK
The President of the United States is charged with administration of the government’s revenue laws
including the tax law. Each year when the President releases his budget for the following year, the
Treasury Department releases a document called the General Explanations of the Administration’s
Revenue Proposals for Congress, also known as “the Greenbook.” While the suggestions within the
Greenbook are often ignored by Congress, it does give a snapshot of the IRS’ attitude towards
current tax “loopholes” and benefits.
In the 2013 Greenbook proposing changes for 2014, the administration suggests that grantor trusts
be treated consistently for income tax and estate tax purposes. One potential effect of this “consistent”
treatment is that estate tax would apply to all the post-sale gains of assets sold to an IDGT. If
Congress decided to implement this idea through legislation, it would eliminate the estate tax benefit of
an installment note sale to IDGTs discussed previously. However, the good news is that the administration
did not propose legislation that would make a gift of the tax payments from the grantor to an IDGT.
This means that the popularity of IDGTs to enhance gifts should continue.
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WHAT ARE THE POTENTIAL DANGERS AND COMPLICATIONS OF USING AN IDGT?
In general, a gift to an IDGT puts the gifted assets outside the reach and use by the grantor except for tax reimbursements that
are not previously agreed upon. The gifted trust assets do not get a new basis when they are transferred to the IDGT so the
sale of the assets could cause a significant capital gain. This creates the potential danger that the grantor will not have enough
cash liquidity to pay the capital gains tax. This problem can be minimized by careful drafting and accurate tax projections.
Another complication pointed out by some commentators is that the IRS may treat the death of the grantor as a sale of
the IDGT assets. If the IRS is successful in arguing that your death generates a taxable gain in the IDGT, your estate would
owe additional income tax.
In conclusion, the popularity of IDGTs will continue as long as wealth owners desire to maximize the economic benefit
of wealth transfers and the IRS does not change its position that paying the taxes of an IDGT is not a gift. However, savvy
grantors of IDGTs will always want to quantify the present and future cost and benefit of paying the IDGT’s tax. The “tax
burn” of an IDGT will decrease the estate of the grantor, but in the extreme circumstance, the “tax burn” could create too
large a bite out of the grantor’s cash flow.
Higher top marginal income tax rates and longer life spans can create the rare situation where the grantor’s continued
annual payment of IDGT income tax could hamper his or her lifestyle. For wealth owners with individual estates under
$5.4 million, quantifying the future tax burn may be important. For those wealth owners that will have reduced income in
future years a controlled “tax burn” may be essential to prevent the prospect of decreased death taxes from turning into the
problem of curtailed cash flow.
FOR MORE INFORMATION
As a leader in trust and estate services, Northern Trust can help provide guidance
about intentionally defective grantor trusts. To learn more, contact your
Northern Trust relationship manager or visit northerntrust.com.
Additionally, Legacy: Conversations About Wealth Transfer was created
to help individuals and families engage in meaningful dialogue about their
wealth – and key considerations for defining one’s legacy – both during their
lifetimes and for generations to come. Visit northerntrust.com/legacy to
download the e-book or request a complimentary copy.
IRS CIRCULAR 230 NOTICE: To the extent that this communication or any attachment concerns tax matters, it is not
intended to be used, and cannot be used by a taxpayer, for the purpose of avoiding any penalties that may be imposed
by law. For more information about this notice, see http://www.northerntrust.com/circular230.
LEGAL, INVESTMENT AND TAX NOTICE: This information is not intended to be and should not be treated as legal
advice, investment advice or tax advice. Readers, including professionals, should under no circumstances rely upon this
information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel.
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