The Intentional Defective Irrevocable Trust (IDIT)/Dynasty Trust

The Intentionally Defective Irrevocable Trust (“IDIT Trust”) or Dynasty Trust is an estate freeze technique that allows taxpayers to remove appreciating assets from their taxable estates at a low gift-tax cost, while providing liquidity at death to pay taxes and other estate costs.The great difficulty with placing any quantity of assets into trust is the federal gift tax. Modest gifts can be covered with gift tax annual exclusions and unified credits; however, once these protections have been exhausted, the affluent are forced to pay gift tax on such transfers at a marginal rate that can equal 55%, or even 60%.

By selling the assets (instead of making gifts) to a particular type of trust-an IDIT or Dynasty-in exchange for a promissory note, this gift tax cost can be reduced dramatically or eliminated altogether. Life insurance is used to repay the note at the seller’s death, or to recover the cost of repayment if the note was repaid during the seller’s life, to fund estate taxes, and for other estate liquidity needs.

This strategy offers the following planning advantages:

  1. It allows an income tax-free sale of property (reflecting appropriate valuation discounts) to an irrevocable trust.
  2. It provides that only the note is included in the seller-grantor’s estate; all post-sale appreciation is immediately excluded from the seller-grantor’s estate.
  3. It offers an ideal wealth transfer mechanism for multi-generational planning.
  4. It combines the transfer tax leverage of several estate planning tools into a dynamic new technique.

Either individual or survivorship insurance can be used with the IDIT Trust technique. Survivorship insurance can be less costly than individual life insurance, and that is often a consideration. The insurance can be either split-dollar or ledger (non-split-dollar), depending on trust cash flows.

Overview of the IDIT Trust Strategy

High-net worth individuals often own assets that are appreciating in value. Good estate planning generally dictates that these assets be eliminated from estate taxation because as time passes, the assets will create tremendous estate tax before they can be passed to children, grandchildren, or other beneficiaries. Also, these assets often generate considerable income that the owner cannot or does not want to give up currently. Further, the gift tax cost of giving those assets away may be prohibitively expensive.

The IDIT Trust offers an excellent solution to these problems. An individual first makes a “seed money” gift to an IDIT Trust, which is an irrevocable trust for the benefit of the grantor’s family. The individual then sells appreciating assets (reflecting any applicable valuation discounts) to the trust in return for a promissory note that pays interest only to the seller-grantor, with a balloon principal payment due at the end of the note’s term.

Assuming the seller-grantor dies during the term of the promissory note, only the value of the note will be included in his estate. Therefore, the value of the assets sold to the trust is capped in the seller-grantor’s estate at the value of the note, and all subsequent appreciation passes to the trust free of estate and gift tax. Because the assets sold to the trust are “frozen” in value in the seller-grantor’s estate, the IDIT Trust is called an estate “freeze” technique. In addition, because the trust is a grantor trust-a “defective” trust for income tax purposes – the IRS’s current position is that no capital gain is recognized from the sale, and the seller-grantor’s basis carries over to the trust. Furthermore, interest is not taxable to the seller nor deductible by the trust. Therefore, although the IDIT Trust is “defective” for income tax purposes, it is “effective” for transfer tax purposes.

Almost any kind of property can be sold to the IDIT Trust; however, it should have the potential for future appreciation. After the property is transferred to the trust in exchange for the promissory note, the IDIT Trust purchases life insurance on the seller-grantor’s life. (An IDIT Trust is also an excellent life insurance purchasing vehicle, independent of its value as an estate freezing technique.) Assuming that income-producing assets are transferred to the trust, funds are now available in the trust to purchase life insurance. The amount of life insurance that can be purchased is thus limited by the trust’s cash flows and underwriting limitations, and not by the face amount of the note.

On the death of the seller-grantor, the IDIT Trust applies the insurance proceeds that it receives to pay the note, assuming it was not paid off during the seller-grantor’s life. (If the note were repaid during the seller-grantor’s life, the insurance proceeds can be used to recover the cost of the earlier repayment, which depleted trust assets.) The seller-grantor’s estate then uses the cash that it receives from the IDIT Trust to pay estate taxes and fund other estate liquidity needs.

The major risk involved in using this estate planning strategy is that, because it is relatively new, there is little direct legal authority for its use. However, all estate planning strategies have some risk, and the IDIT Trust is well within the list of respectable, accepted techniques.

When to Use This Strategy

The IDIT Trust planning strategy should be considered for individuals who have highly appreciating assets that they want to pass on to their beneficiaries, but that, because of that appreciating character, will create a large increase in the value of their estates subject to transfer tax. It is also a useful planning technique when a multi-generational “Dynasty” trust is indicated (discussed below). Many professional advisors think that an IDIT Trust is superior to a GRAT (Grantor Retained Annuity Trust), and that it may be better than, or serve as a complement to, a QPRT (Qualified Personal Residence Trust).

In addition to being an outstanding estate “freezing” technique, the IDIT Trust can serve as the wealth replacement trust when a charitable remainder trust (CRT) is implemented. The insurance and other assets in the IDIT Trust that pass to the family replace the assets that the estate owner transfers to the CRT.

The IDIT Trust can also be a very cost-efficient vehicle for purchasing life insurance to pay estate taxes, in addition to any insurance proceeds made available from repayment of the promissory note at death (or from the cost recovery funding of the earlier repayment of the note during life). If the trust holds income-producing assets (such as S corporation stock, partnership interests, and real estate), it can use the income to pay annual economic benefit (“P.S. 58/38”) costs in a split-dollar insurance plan, or full premiums when split-dollar is not used. Using trust cash flows to pay premiums eliminates the need for subsequent gifts by the estate owner for this purpose. Furthermore, trust cash flows are enhanced because the grantor, not the trust, pays the income taxes on trust income under the grantor trust rules.

In the context of a buy-sell arrangement, for example, in a family-owned corporation, the IDIT Trust can serve as the purchasing entity, instead of the child or children active in the business. This has three distinct advantages over a typical buy-sell arrangement:

  1. The purchase price is fixed at the time of sale, rather than at the time of the selling parent’s death, and the life-insurance funding costs less because the insurance does not have to fund an escalating purchase price.
  2. The problem of successively running the purchased stock through the children’s taxable estates is avoided since the trust, not an individual child, purchases the stock, and the trust is designed to avoid taxation in the children’s estates (and the generation-skipping transfer tax (GSTT) at a child’s death).
  3. Children not active in the business can share in the estate as beneficiaries, if desired (solving the “estate equalization” problem), while control can be in the hands of the active children as trustees of the IDIT Trust.

For the estate owner who wants to keep control of the business during his life (and most estate owners seem to fall in this category), the property sold to the trust can be an interest that is not entitled to vote. Examples include nonvoting stock in a C or S corporation, or a nonvoting interest in a limited liability company or family limited partnership.

A particularly favorable application of this technique involves a corporation (or other entity) that ultimately plans to sell out to a competitor or go public. If the value of the stock sold to the IDIT Trust can be valued as a closely held corporate interest (with appropriate minority interest and lack of marketability discounts, including a discount for the corporation’s built-in capital gains tax allowed by the recent Davis decision), the value of the stock in the trust will be much greater when the subsequent sale or public offering takes place. In this instance, all of the “instant growth” can avoid transfer taxation via the use of an IDIT Trust. In short, the IDIT Trust technique is an extremely flexible estate planning strategy that can be used to generate substantial tax savings in several estate and business-continuity planning situations.

Example
The following example illustrates the advantages of the IDIT Trust technique compared to other estate planning techniques. (These comparable techniques are all non-charitable and the client may also employ charitable giving techniques as part of a wealth transfer plan.)

A 55-year-old grantor has assets of $16.5 million available to commit to the plan. The grantor establishes the IDIT Trust and makes a seed-money gift of $1 million to it (paying gift tax of $500,000). He then sells $15 million of business assets, with a discounted value of $10 million (based on a qualified appraisal), to the trust in exchange for a $10 million promissory note. The note pays interest only, at the applicable federal rate (AFR), over its term of 15 years, with a balloon payment of the entire principal due at that time. (If the grantor survives the term of the note, it is contemplated that the note will be renewed so that it will remain outstanding at the grantor’s death.) Using the cash flow generated by the seed money gift and the business assets, the trust buys a $10 million life insurance policy on the grantor’s life, in this instance on a split-dollar basis. The beginning asset base in the IDIT Trust, therefore, consists of the $15 million of business assets ($10 million discounted value), the $1 million in seed money, and the $10 million life insurance policy.

At the grantor’s death in 24 years (his normal life expectancy), the total asset base has grown to more than $60 million, plus the $10 million in life insurance. This includes the grantor’s taxable estate reflecting interest received over 15 years plus the balloon payment, net of estate taxes. Therefore, after taxes are deducted, the IDIT Trust technique provides over $70 million to the grantor’s heirs, more than any of the other comparative estate planning techniques.

When Not to Use This Strategy

Although the IDIT Trust can be a valuable estate planning technique, it will not provide the desired effect in all circumstances. First and foremost, for the technique to work, the assets sold to an IDIT Trust must be reasonably expected to appreciate (in terms of both income and capital growth) at more than the AFR, which is the measure used to compute the interest rate on the promissory note. Otherwise, neither an IDIT Trust nor any other estate freezing technique makes sense.

Second, although the IDIT Trust does generate an interest income stream back to the seller-grantor, those persons who will likely need all of the income from their assets for a prolonged period should consider alternative methods of planning. The interest payments from the IDIT Trust are generally less than the actual income stream from the assets. The interest income stream may also end at some point, if the note is paid off during the seller-grantor’s lifetime. If the interest income stream does end, the seller-grantor either must be able to replace the lost income, or have no need for that income.

Third, life insurance is an integral part of the IDIT Trust design, and individuals who are extremely elderly or not in good health-and so are subject to higher premiums for coverage-should be careful to avoid having the full premiums paid from the trust. Although the cost of life insurance increases with age or ill health, much of the negative impact of higher premiums on an IDIT Trust can be mitigated by using a split-dollar life insurance plan between the trust and another entity or individual.

Fourth, if there is a risk that the assets sold to the IDIT Trust will not generate enough income to make the interest payments to the seller-grantor, this strategy may not be as effective. If insufficient income is being generated, the trustee of the IDIT Trust will have to return some of the trust assets to the seller-grantor to satisfy the promissory note’s interest payment requirement. Assuming these assets are appreciating, the technique will still be advantageous, but not as advantageous as if there were sufficient income to pay interest. The reason is that not all of the appreciating trust assets will be required to be returned to the seller-grantor in lieu of interest payments, and thus some value will remain in the trust. (Paying interest “in kind” is called a “leaky” freeze.)

Specifics of the Strategy

To put the IDIT Trust strategy to work, an individual first makes a “seed money” gift to the trust, as noted above. Many practitioners think that this gift should be at least 10% of the (discounted) sales price of the property that will be sold to the trust. After making the gift, the grantor sells appreciating assets to the trust in return for a promissory note, which pays interest back to the seller-grantor at the AFR, with a balloon principal payment due at the end of the term of the note. Only the note will be included in the seller-grantor’s estate, and all post-sale appreciation will be immediately excludable from the estate.

As stated previously, because the trust is a grantor trust, the current IRS position is that no capital gain is recognized from the sale, and the seller-grantor’s basis carries over to the trust. Furthermore, interest on the note is not taxable to the seller-grantor, nor deductible by the trust.

Although the seed-money gift is subject to gift tax, the assets sold are not, as their sale to the trust is assumed to be a bona fide sale for adequate and full consideration. Gift tax annual exclusions and unified credit can be used to exempt at least a portion of the seed money gift from gift taxes, although it may inadvisable to use annual exclusions for the one-time gift contemplated by the IDIT Trust technique. Assuming annual exclusions are used elsewhere, the IDIT Trust does not have to contain “Crummey” withdrawal powers, avoiding their complexities and uncertainties.

In addition, the $1 million generation-skipping transfer tax (GSTT) exemption can be used to exempt the trust from generation-skipping transfer tax for gifts up to this amount. Again, the GSTT exemption need be allocated only against the seed-money gift. This allows the trust to be multi-generational (a “Dynasty” trust).

Gift-splitting is also allowed. This means that married couples can apply both spouses’ applicable gift tax annual exclusions (if used), unified credits, and GSTT exemptions to the gift, effectively doubling the amount of the tax-free gift.

The property sold to the IDIT Trust can be almost any kind of property, including S corporation, C corporation, or publicly traded stock, a partnership or limited liability company interest, and real estate. A key characteristic of the property is that it should have the potential for future appreciation, in excess of the note interest, which will be frozen out of the seller-grantor’s estate.

The IDIT Trust then purchases individual life insurance on the seller-grantor’s life (or survivorship insurance on the lives of the seller-grantor and spouse). Further transfer tax “leverage” can be achieved by using a split-dollar life insurance plan. However, the insurance can also be ledger (or non-split-dollar), depending on trust cash flows.

At the seller-grantor’s death, only the note (plus any accumulated interest) will be included in his estate, and all post-sale property appreciation will be excluded from the estate. In addition, the seller-grantor’s payment of income taxes on the IDIT Trust income (which is permissible without being subject to gift tax because the trust is a grantor trust) further reduces his estate.

The IDIT Trust then applies the insurance proceeds that it receives to repay the note, if it is not paid off during the seller-grantor’s life. (If the note is paid off during the seller-grantor’s life, the insurance proceeds can be used to replace, or “cost recover,” the trust assets expended to repay the note, plus perhaps cost of money or appreciation forgone on those assets.) Using the insurance proceeds allows the trust to pay off the note without having to sell assets to generate the necessary cash. This is an important factor, because the trust assets are typically low-basis-resulting from the carryover of the seller-grantor’s basis to the trust-and will have appreciated substantially in value. Thus, the insurance not only funds payment of the note, but it also avoids triggering taxation of the built-in gains had the trust assets been sold to pay the note. Any additional insurance proceeds can be injected into the estate in the usual way, by the trust purchasing assets from the estate or making loans to it. The estate then uses the cash that it receives from the IDIT Trust to pay estate taxes and to fund other estate liquidity needs.

In addition, payment of the note can be deferred until the death of the seller-grantor’s surviving spouse, if desired. This allows for funding the note payment with less costly survivorship life insurance, either split-dollar or ledger. Furthermore, the note is an excellent asset to transfer to a marital trust for the benefit of the surviving spouse because it provides the surviving spouse with a lifetime income, without appreciating in his estate.

Although life insurance is central to the IDIT Trust technique, some of the same estate planning advantages can be achieved through the use of an uninsured IDIT Trust. The author feels, however, that combining either individual or survivorship life insurance with this technique maximizes the transfer tax leverage.

Income Tax Considerations During the Life of the Seller-Grantor

The IDIT Trust is a “grantor” trust under the Internal Revenue Code. A grantor trust is one in which certain powers exist that cause all of the income of the trust to be taxable to the seller-grantor, rather than to the trust itself. It is therefore possible for a seller-grantor to be taxed on income, including capital gain income, that he never receives.

While it is usually not the best idea to be taxed on income that one does not receive, there are estate and gift tax advantages to this result. When the seller-grantor pays the income tax on trust income, he is effectively making a gift of the tax paid to the trust beneficiaries, and lowering his own taxable estate, without suffering any gift or estate tax penalty.

Example
Trust income is $100 and the resulting income tax is $40. If the grantor pays this $40 tax, in effect he has made a gift of the $40 to the trust beneficiaries (the trust income remains at $100) and reduced his estate by the same amount. The result is that the seller-grantor’s estate is reduced by the amount of income taxes paid on trust income, but the seller-grantor is not treated as having made a gift of these amounts.

Why are the seller-grantor’s income tax payments not taxable as gifts? Because the seller-grantor is merely complying with the terms of the income tax law, i.e., he is not paying tax on income taxable to the trust or its beneficiaries, but satisfying his own legal tax obligation. The IRS purportedly does not like this result. However, most tax professionals agree that despite IRS reluctance to accept this concept, the law is clear that no gift is made when the grantor pays income tax on grantor trust income.

In the context of the IDIT Trust technique, grantor trust status is crucial because of the current IRS position that no gain is recognized by a grantor who sells property to a grantor trust. The rationale for this position is that the seller-grantor is in effect selling to himself, which is not a taxable event. While the IDIT Trust is “defective” for income tax purposes, it is “effective” for estate tax purposes, with the result that all post-sale appreciation in the value of the property sold to the trust is excluded from the seller’s estate. It is these features that make the IDIT Trust work so effectively.

The grantor-trust nature of the IDIT Trust also offers another potential advantage. The trust can be drafted to allow the seller-grantor to “buy back” the assets held in trust at any time, although the seller should have no legal right to repurchase these assets because that could result in adverse estate tax consequences.

Example
A seller-grantor would like to make a sale or gift of income-producing real estate to the trust, but would like the opportunity, prior to the expiration of the trust’s term, to buy the property back at its then-fair market value. When the buy-back occurs, even if the purchase price is in excess of the trust’s basis in the property, there is no taxable gain recognized.

The reason for nonrecognition of gain is that under the grantor trust rules, the seller-grantor is considered to be buying back the property back from himself. As in the sale to the trust, one does not have to pay income taxes when buying something from (or selling something to) oneself. Thus, a seller-grantor can sell or give property to a grantor trust for a period of time and buy it back (at current fair market value) with no income tax consequence.

An advantage of such a buy-back is that the repurchased property will receive a step-up in basis at the seller-grantor’s death because it will be included in his estate. However, once the assets are back in the seller-grantor’s estate, they will continue to appreciate and add to that estate for estate tax purposes. This creates a “leaky” freeze, and wholly or partially defeats the purpose of the IDIT Trust transaction in the first place.

Income Tax Considerations at the Death of the Seller-Grantor

One of the inherent risks in using an IDIT Trust is that the seller-grantor may die during the term of the promissory note. In fact, the estate freeze effect will be maximized if the note is outstanding at death and the seller is not repaid during his or her lifetime.
If death occurs while the note is outstanding, an argument can be made when the trust subsequently pays the balloon principal payment to the seller-grantor’s estate that this payment creates income in respect of a decedent (IRD). The result is that the payment is both income and estate taxable, with an offsetting deduction for the estate tax against the income tax. There are also respectable arguments that this payment is not IRD.

Even if IRD, the amount in question is confined to the face amount of the promissory note, and all of the post-sale appreciation escapes taxation in the seller-grantor’s estate. Moreover, the trust may receive a step-up in basis for the assets purchased, and the insurance proceeds received by the estate on payment of the note can also be applied to pay any income tax generated, as well as the estate tax on the note. This is another advantage of using life insurance with the IDIT Trust technique.

Trustees

To avoid estate tax problems, the seller-grantor should not serve as a trustee of an IDIT Trust, nor should he have the right to appoint and remove trustees. In a properly drafted IDIT Trust, anyone other than the grantor can act as trustee, as long as he is not a minor or otherwise legally incapacitated. This includes the grantor’s child or children, or spouse (assuming the spouse is not also a grantor of the trust). In order for a seller-grantor to preserve control of a business entity, he should transfer a nonvoting interest in the entity to the trust, rather than act as trustee.

Protection from Creditors

Assets that are sold or given to an IDIT Trust have been irrevocably parted with; even though a seller-grantor owns the trust’s promissory note, he no longer owns the assets transferred. If, after the sale or gift is made, the seller-grantor has creditor problems, the assets that he sold or gave to the trust cannot, absent fraud, be taken by creditors. However, creditors can reach the note itself.

With respect to the beneficiaries of an IDIT Trust, generally, so long as the assets remain in trust, the beneficiaries have creditor protection (assuming an adequate spendthrift provision in the trust document). However, income or principal that is actually paid out of the trust to the beneficiaries is subject to the claims of their creditors.

GSTT Considerations

The IDIT Trust is an excellent candidate for use of the GSTT exemption. The law allows a seller-grantor to immediately allocate, to the seed money gift only, his $1 million GSTT exemption ($2 million for spouses who gift-split). All of the assets subsequently sold to the trust are not subject to the GSTT because they are the product of a bona fide sale for adequate and full consideration. Thus, the entire trust can be exempted from the GSTT at the outset, assuming sufficient GSTT exemptions to allocate to the seed money gift. This characteristic of the IDIT Trust is what makes it so suited to multigenerational, Dynasty trust planning.

Planning Risks and Detriments

An estate tax risk occurs in using an IDIT Trust if the seller-grantor dies during the term of the promissory note. The IRS could argue that the sale of the property to the trust was in effect the retention of an income interest in the property transferred to the trust. This argument, if successful, would result in inclusion of the trust property (not just the note) in the seller-grantor’s estate at his death. It could also result in a taxable gift at the time of the sale.

A proposed solution to this problem is to ensure that (1) payment of the note interest is not in any way tied to or dependent on trust income (the appreciating trust assets themselves can be used to pay interest in kind, if necessary); and (2) the seed money gift is substantial in relation to the sales price, generally at least 10% of the sales price. These steps should rebut the argument that the seller is relying only on the property sold for his interest income payments and therefore has retained an income interest in that property. Of course, the trust’s promissory note should be bona fide, and interest should be paid at the AFR in accordance with the terms of the note. In addition, a qualified appraiser should value the property to be sold so that the purchase price equals the property’s fair market value.

As stated above, the trust’s payment of the balloon principal payment to the seller-grantor’s estate at his death may be both income and estate taxable as IRD. However, even if it is IRD, the insurance proceeds received by the seller’s estate in payment of the note can be applied to these taxes.

A further danger is that the assets held in the IDIT Trust may not produce sufficient income to support the interest payments. If this occurs, the interest can be paid in kind from the appreciating trust assets themselves. This is not as effective an estate freeze as having trust income adequate to pay interest. Any assets that are returned to the seller-grantor immediately begin to appreciate in his estate, again inflating the estate tax value. However, as long as the assets remaining in the trust are appreciating in value, payment of interest in kind will not exhaust trust assets. Even such a partial or leaky freeze will save some estate taxes.

Yet another problem can occur if the IDIT Trust produces income in excess of the required interest payment amount, and the seller-grantor reports this phantom income on his income tax return. While this result is good from an estate planning perspective-the trust beneficiaries will get more assets and the seller-grantor’s estate will be reduced at no gift tax cost-it may present an obstacle to some clients. There are measures for dealing with this issue if the grantor does not want to pay the income tax on trust income.

Those who are older or not in good health should carefully consider whether to use this strategy because life insurance is an integral part of this plan, and the cost of life insurance increases with age or ill health. However, much of the negative impact of higher premiums on the IDIT Trust technique can be mitigated through the use of a split-dollar life insurance plan.

Conclusion

While the IDIT Trust estate planning technique, like other planning strategies, is not effective for all situations, it should be seriously considered by individuals with highly appreciating assets that they want to pass on to their beneficiaries without incurring large gift or estate tax liabilities. By using insurance, the IDIT Trust technique also provides the trust with funds to repay the note (or to recover the cost of repayment) and the grantor’s estate with liquidity to pay taxes and other estate costs that arise at the grantor’s death.