Selling assets to an intentionally defective irrevocable trust (IDIT) can be used to transfer assets to your beneficiaries in a tax-advantaged way.

Selling assets to an IDIT can remove assets, and any growth in value on those assets, from your estate with reduced or minimal gift tax consequences.

Although the term “defective” seems pejorative, it is not. Rather, the word “defective” is used to describe a trust that is ignored for income tax purposes (i.e., you are treated as the owner of the trust’s assets for income tax purposes), but the value of the trust’s assets would be excluded from your gross estate.

There is no direct statutory or regulatory authority authorizing the federal tax consequences of the sale of assets to an IDIT. Instead, the expected tax consequences have been pieced together from a number of different and previously unconnected legal principles, which, when taken together, will more likely than not produce the results described herein. Even still, this technique has been used for decades and has become an integral part of many estate and business succession plans.

The sale to an IDIT technique begins with your creation of an irrevocable trust, the IDIT. The IDIT would usually benefit your family members (including, perhaps, your spouse), although an IDIT can be created for non-family members as well. However, you cannot be a beneficiary of the IDIT.

The IDIT is designed to be a “grantor trust” for federal income tax purposes. There are a number of common ways to cause a trust to be a grantor trust. Two common ways are to retain a power to substitute the assets of the trust for assets having an equivalent value[1], or to grant a non-adverse party the right to add and remove beneficiaries[2] (many grantors restrict the beneficiaries that can be added and removed to charitable organizations). If the income of the trust may be distributed to your spouse, the trust would also be a grantor trust.[3] If a trust that you create is a grantor trust, for federal income tax purposes, you are treated as owning the assets of the trust. This means that income, gain, and loss realized by the trust will taxed to you as if you owned the assets that generated such income.

Next, you would contribute a small amount of cash (or other property) to the IDIT. This transfer to the trust, being a gift, could cause gift tax or consume some of your lifetime exclusion amount from the gift tax. The gift is intended to give the transaction in which you sell assets to the IDIT economic substance. The gift to the IDIT would serve as collateral for the trust’s promissory note given to you in the sale transaction (discussed below) and help to enable the note to be paid. It is also intended to cause the debt owed to you by the IDIT to be respected as debt rather than being treated as a retained equity interest in the trust. If you are treated as having retained an equity interest in the trust, the value of the assets transferred to the trust may be treated as a gift[4] and were you to die while the note was outstanding, or within three years of its satisfaction, the value of the trust could be included in your gross estate and subjected to estate tax[5]. Practitioners believe that a transfer to the IDIT equal in value to 10% of the value of the property that will be sold to the IDIT is the minimum amount necessary to support the sale transaction. Some practitioners suggest a transfer of 15% or even 20% of the value of the property that will be sold to the IDIT.

Having created the IDIT and then made a gift to initially fund the trust, you would then sell assets to the IDIT in return for a promissory note. The note would bear interest (which would be paid by the IDIT to you) at the applicable federal rate (AFR) which is set by the Internal Revenue Service (IRS) monthly. Although the note can be structured in many ways (for example, the note could be self-amortizing, or interest only with a balloon payment at the end of its term), its terms should require interest to be paid to you at least annually. In our experience, notes that are required to pay interest only during their term with a balloon payment at the end, but with no prepayment penalty, offer tremendous flexibility.

The IDIT would obtain the funds necessary to pay interest to you either from your original cash gift or from income earned on the assets owned by the IDIT. If interests in a closely held business were sold to the IDIT, distributions from the business to its owners, one of which would be the IDIT, would provide cash to the IDIT to make payments on the note. Of course, if those sources were not sufficient, the assets owned by the IDIT could be used. Using IDIT assets to make payments on the note can cause extra expense, as each time that equity is used to make a payment, the assets must be valued. If an interest in a closely-held business is used, the business must be valued by a qualified valuation expert. This is one reason that an interest-only note with a balloon payment at the end of its term provides great flexibility. In lean years, distributions from the business need only be made to pay interest, but in good years (or if the business is sold) the business can distribute extra cash which can be used by the trust to prepay principal. At the end of the note’s term any principal balance remaining on the note would be repaid to you in a final payment.

Because the IDIT must repay the original value of the assets sold to the trust plus interest at the AFR, the amount by which those assets appreciate in excess of the AFR at the time of the sale will pass to your beneficiaries at the end of the note’s term without gift or estate tax.

Example 1 illustrates the sale of an asset to an IDIT that is designed to pass appreciation on assets sold to your beneficiaries. Although the IRS changes the AFR every month, for purposes of this example the AFR used is 1.5% (the actual current AFR will likely differ). Also, for purposes of this example, assume the initial gift to the IDIT was $100,000 and that assets having a value of $1,000,000 are sold to the IDIT. Further assume that the assets in the IDIT generate income of 3% per year and capital appreciation of 4% per year (for a total return of 7% per year). Lastly, assume the note is an eight-year self-amortizing note. No valuation discounts are used in this example.

Example 1

Year Beginning Principal Income of Trust Payment on Note Ending Principal
1 $1,100,000 $77,000 $133,584 $1,043,416
2 $1,043,416 $73,039 $133,584 $982,871
3 $982,871 $68,801 $133,584 $918,088
4 $918,088 $64,266 $133,584 $848,770
5 $848,770 $59,414 $133,584 $774,600
6 $774,600 $54,222 $133,584 $695,238
7 $695,238 $48,667 $133,584 $610,321
8 $610,321 $42,722 $133,584 $519,459

In Example 1, after the note is repaid, more than $500,000 remains in the IDIT for the benefit of your beneficiaries. Your gift to the IDIT was $100,000. By using an IDIT, in this case, you would be able to transfer over $400,000 for the benefit of the beneficiaries of the IDIT without a gift tax (and without using additional lifetime gift exclusion amount).

Example 2 uses the same facts as Example 1, except that the transaction uses a note in which only interest must paid to you annually with the entire principal sum being repaid in year 8.

Example 2

Year Beginning Principal Income of Trust Payment on Note Ending Principal
1 $1,100,000 $77,000 $15,000 $1,162,000
2 $1,162,000 $81,340 $15,000 $1,228,340
3 $1,228,340 $85,984 $15,000 $1,299,324
4 $1,299,324 $90,953 $15,000 $1,375,276
5 $1,375,276 $96,269 $15,000 $1,456,546
6 $1,456,546 $101,958 $15,000 $1,543,504
7 $1,543,504 $108,045 $15,000 $1,636,549
8 $1,636,549 $114,558 $1,015,000 $736,108

In Example 2, after the note is repaid, more than $700,000 remains in the IDIT for the benefit of your beneficiaries. Your gift to the IDIT was $100,000. By using an IDIT, in this case, you would be able to transfer over $600,000 for the benefit of the beneficiaries of the IDIT without a gift tax (and without using additional lifetime gift exclusion amount). The benefit of leaving appreciating assets in the IDIT is clearly illustrated when Example 2 is contrasted with Example 1.

Because the IDIT is a grantor trust, you would pay the income tax attributable to the IDIT’s income. If using a note that pays interest only, you may only receive interest from the IDIT each year. Therefore, it is likely that you would have to use other assets to pay income tax attributable to the income from the property owned by the IDIT. Once the note is satisfied, your payments from the IDIT would stop, and unless the trust ceased to be a grantor trust, your responsibility to pay those taxes would continue with no receipts from the IDIT.

This is an important consideration if 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 is owned by the IDIT. In that case, the share of the entity’s income that passes through to its owners would pass through to the IDIT. Because the IDIT is a grantor trust to you the pass through income would be included on your personal tax return. Thus, when selling a pass through entity to an IDIT you should take into consideration your ability to pay income tax attributable to a part of the entity that you no longer own. You should consult your personal tax advisor to determine how such a strategy would apply in your particular circumstances.

Nevertheless, for the IDIT sale to work correctly, at least during the term of the note, the IDIT should be a grantor trust. Because you are treated as the owner of the assets of the IDIT, when you sell assets to the trust, receive interest payments and receive repayments of principal, there will be no federal income tax.[6]

Additionally, 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[7]There is some gift tax audit risk when selling assets to an IDIT. You should discuss these risks with your personal tax advisors.

For example, 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 difference between the value of the note and the value of the assets would be a gift, potentially subject to gift tax (or to the use of some lifetime gift 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 valuations, such as selling a specific dollar amount of an asset rather than a percentage interest in the asset.[8]

Selling assets to an IDIT is a good way to move assets from your estate at a reduced gift tax cost, particularly when the asset that is sold to the IDIT is expected to rapidly appreciate in value or has sufficient cash flow to pay off the entire note within its term. Additionally, the IDIT may be a good choice when moving closely-held business interests or other hard to value assets, because the note can be structured so that only interest is paid during the term of the note and any principal distribution to repay the principal value of the note, which would require the property in the IDIT to be valued by a valuation expert each year, is made in one payment at the end.

Finally, selling assets to an IDIT allows you to leverage your exemption from the generation-skipping transfer tax (GSTT). To make the trust fully exempt from the GSTT your exemption from that tax need only be allocated to the original gift to the IDIT.

The sale of assets to the GSTT is not a gift, so exemption from the GSTT need not be allocated. Accordingly, all of the appreciation on the assets in the IDIT, after repayment of the note, will be fully exempt from the GSTT.

As with any wealth transfer strategy, you should consult your personal attorney or other tax advisors to determine if that strategy is appropriate for your circumstances.

For more information, please contact your PNC advisor. If you are not a PNC client, please call 844-749-2854.