What is a Sale to an IDIT?
Selling assets to an intentionally defective irrevocable trust (IDIT) is a transaction that can allow you to transfer to your beneficiaries, with little or no gift and estate tax (and without using your lifetime applicable exclusion amount dollar for dollar with the amount sold), that portion of the after-transfer appreciation on the value of the assets sold to the trust in excess of an assumed growth rate announced monthly by the Internal Revenue Service (IRS), known as the applicable federal rate (AFR).
This technique is sometimes referred to as a transfer tax “freeze” strategy, because by excluding the growth in the value of the transferred assets from your gross estate which would otherwise be subject to estate tax, you have “frozen” the value of those assets included in your gross estate at their current transferred value.
Why Should I Do This Now?
Interest rates are historically low in mid-2020, which makes a sale to an IDIT a particularly tax-efficient way to transfer wealth. For such a transaction to be successful, the assets in the IDIT must produce a total return greater than the AFR.
How Does It Work?
First, you would create a grantor trust, the IDIT, to benefit individuals of your choice (typically family members, but you cannot be a beneficiary). The IDIT is “effective” for gift and estate tax purposes because it excludes the assets in the IDIT from your gross estate, but “defective” for income tax purposes because you are treated as the owning the trust’s assets for income tax purposes.
After creating the trust, you would make a gift to the IDIT of assets equal in value to at least 10% of the value of the property you plan to sell to the IDIT.
This gives the sale transaction substance and prevents you from having a retained equity interest in the IDIT, which could cause its value to be included in your gross estate if you died before the sale transaction is completed.
Next, you would sell assets to the IDIT in exchange for a promissory note. The note would pay you interest each year calculated by multiplying the outstanding principal value of the note by the AFR in effect when the note was issued. After the note is paid off, whatever assets remain in the IDIT benefit your beneficiaries. If the actual total return earned by the IDIT’s assets while the note is outstanding exceeds the AFR, such excess will pass to (or continue in trust for) your beneficiaries, free from gift tax.
Because the IDIT is a grantor trust for federal income tax purposes, and you will be treated as owning the assets in the trust for federal income tax purposes, the income of the trust will be included on your personal income tax return. However, this status allows you to sell assets to the IDIT without incurring a capital gain. Also, your payment of the income tax attributable to the IDIT’s assets is like an additional gift to the trust’s beneficiaries with no gift tax consequences to you (no tax, no use of the annual exclusion from gift tax, and no use of your lifetime applicable exclusion amount).
The IDIT can also save estate taxes over many generations. You can allocate your exemption from the generation-skipping transfer tax (GSTT) to the original gift to the IDIT, making the entire trust and the appreciation thereon exempt from the GSTT. The sale transaction, not being a gift, would not require an additional allocation of GSTT exemption. Accordingly, the appreciation that remains in the trust after the sale transaction is complete can be wholly exempt from the GSTT. As long as assets remain in a trust that is wholly exempt from the GSTT, they may be able to avoid future estate taxes.
What are the Downsides?
You must pay the income tax on the income earned by the assets in the IDIT, even though you don’t own them. This could be especially burdensome if the IDIT owns interests in a pass-through entity, such as a partnership, limited liability company taxed as a partnership, or corporation taxed under Subchapter S of the Internal Revenue Code.
Depending upon the structure of the transaction, if the IRS determines that the value of the assets sold to the IDIT is less than the face value of the IDIT’s note, the IRS would attempt to treat the difference between the value of the note and the value of the assets as a gift, potentially subject to gift tax (or causing you to use some of your lifetime exclusion amount).
This is a real possibility if a hard to value asset, such as an interest in a closely held business, is sold to the IDIT.
Although, recently, taxpayers have been able to reduce this valuation risk by using formula transfers, such as selling a specific dollar amount of an asset rather than a percentage interest in the asset.
Should I Do This?
If you have assets that are appreciating and would like to “freeze” the growth on some of your estate, or if you would like to transfer wealth to your beneficiaries (including those many generations in the future), leveraging your exemptions from the estate/gift tax and the GSTT, a sale of assets to an IDIT may be right for you.