An intentionally defective grantor trust (“IDGT”) can be beneficial for transferring wealth and reducing estate taxes. With a transfer of assets to an IDGT, the settlor effectively removes those assets from the settlor’s estate while retaining the income tax liability for the income generated by those assets. By including certain powers in the trust (known as “grantor powers”) the settlor is treated as the owner of the trust assets for income tax purposes and the trust’s income is taxed to the grantor as if he or she received the trust income directly (IRC Section 671). The trust is called “intentionally defective” because the settlor relinquishes ownership of the assets for estate tax purposes but remains the owner of the trust for income tax purposes. The primary benefit of the grantor trust status is that the trust assets can continue to appreciate without being depleted by income tax payments, which amounts to an additional transfer of wealth to the trust beneficiaries that is not subject to transfer tax (Rev. Ruling 2004-64).
The following is a discussion of various income tax issues related to transfers of assets to an IDGT:
Will the transfer of encumbered assets result in taxable gain?
The grantor trust status provides an additional benefit when transferors intend to transfer assets to the trust that are encumbered by debt. A transfer of encumbered property could cause realization of a taxable gain if the amount of debt exceeds the transferor’s basis in the asset (IRC 1001). This raises a concern that the transfer of encumbered assets could be a tax event for the settlor. However, due to the grantor status of an IDGT, the settlor remains the owner of the trust assets for income tax purposes, and there will be no realization of gain upon the transfer of encumbered assets.
Can income tax liability be shifted to the trust?
IDGTs can also be drafted to retain the flexibility for the trust to pay its own income tax in the future. To provide such flexibility, and to allow for any future occasion in which the burden to the settlor of paying the income tax outweighs the above benefits, the trust may include terms which allow the grantor trust status to be turned, or “toggled” off. Exercising this “toggle power” shifts the income tax liability from the settlor to the trust itself. Depending on the nature of the grantor powers either the settlor or a trust protector can exercise the toggle power under the trust to relieve the settlor of the grantor powers, and the trust changes status to a non-grantor trust immediately. However, termination of the grantor trust status could be a tax realization event with respect to the original transfer of encumbered assets mentioned above. If the encumbrance is recourse, i.e. the holder of the debt retains the right to pursue the settlor directly, there would be no taxable event to the settlor upon transfer of the assets to the trust or upon the subsequent change in grantor trust status to a non-grantor trust.
Can the settlor be reimbursed for income taxes paid?
Although the settlor cannot shift the income tax liability to the trust without losing grantor trust status, the settlor may be reimbursed by the trust for the income tax paid. Trust terms may be included to allow the trustee to reimburse the settlor for income taxes paid at the trustee’s discretion.
Note the IRS has ruled that if reimbursements are mandatory, or if evidence of agreement or collusion exists between the settlor and the trustee, the settlor has effectively retained the right to use the trust property to discharge the settlor’s own obligation to pay income tax, meaning the full value of the trust assets must be included in the settlor’s estate (IRC 2036). Conversely, when the reimbursement is discretionary rather than mandatory, and there is no discussion of reimbursement between the settlor and the trustee, the assets of the trust are not included in the settlor’s estate as a result of the discretionary tax reimbursement clause.
IDGTs are complex, and must be drafted and implemented carefully. Wendel Rosen trust and estate attorneys can help establish an IDGT that works in tandem with your estate planning goals.