In order to freeze the value of assets and remove the assets from in an individual’s personal, taxable estate, an effective strategy is an installment sale to an Intentionally Defective Grantor Trust (“IDGT”)
This technique includes the grantor selling assets to an irrevocable trust in exchange for an installment note. A small “seed” gift is typically also made to the trust to ensure enough equity to support the loan.
The strategy often includes incorporating a family limited partnership (“FLP”) or family limited liability company (“FLLC) that holds the grantor’s assets. The the FLP or FLLC is structured in a way that will result in valuation (by a CPA) receiving a discount. The FLP or FLLC interests provide a greater benefit because the interests will be sold at the discounted valuation. This provides for an automatic reduction in the value of the FLP or FLLC that holds the grantor’s assets. The FLP or FLLC is sold to the IDGT for an installment sale.
The installment note is a ballon note (meaning only interest payments have to be paid annually until the term date of the note) that the IDGT pays the grantor in exchange for grantor’s assets (such the FLP or FLLC described above or other assets) to the IDGT will have an interest rate equal to the long term Applicable Federal Rate (AFR). The AFR is set by the IRS each month. The interest payments received by the grantor can be used for anything the grantor wishes.
Since the trust is structured as an IDGT, there are no income tax consequences resulting from the sale. The interest payments on the installment note are not taxable income to the grantor, and the payment of taxes on the trust’s income provides an additional gift that is tax free to the beneficiaries.
To the extent that the assets sold to the IDGT produce income or appreciate in value, it will be for benefit of the beneficiaries of the IDGT. Another benefit of this planning technique is that the assets held by the irrevocable IDGT are protected from creditor claims including divorcing spousal claims.
If properly structured, it is also possible to engage in income tax planning such as swapping high basis assets with trust assets having a low basis, at a later date. By including the low basis assets, rather than the high basis assets in the grantor’s estate, such low basis assets will receive a step-up in basis at the grantor’s death.
Unlike a transfer to a Grantor Retained Annuity Trust (“GRAT”), Generation Skipping Tax (“GST”) exemption can be allocated to the IDGT at the time of the initial transfer, so that the trust assets will be able to be passed from generation to generation free of wealth transfer taxes. This means the Intentionally Defective Grantor Trust can be designed to by a Dynasty Trust that will last in perpetuity.
Finally, one of the greatest advantages of the installment sale to an IDGT is that it removes assets from the grantor’s personal, taxable estate while also preserving the grantor’s ability to use the grantor’s exemption amount to be able to pass assets free from the estate tax.