Authored by Mark Lobb
Advanced estate planning was under attack last year as certain versions of the Build Back Better Act would have substantially curtailed the use of irrevocable grantor trusts. Fortunately, the legislation did not go forward. If you have not implemented advanced estate planning into your wealth structure or if you have not updated your structure lately, you should do so in 2022.
Irrevocable Grantor Trusts not only provide all of the estate planning tools necessary for avoidance of probate, orderly transition of assets, legacy planning, estate tax elimination, etc., but also, these trusts are some of the best asset protection tools available.
When working with irrevocable grantor trusts you will be exposed to a wide variety of acronym identifiers. There are many different acronyms which refer to the same form of trust. This article will discuss two types of irrevocable grantor trusts: (1) Grantor Defective Trusts; and (2) Beneficiary Defective Trusts. Acronym references to these two types of trusts include the following:
Grantor Defective Trusts
“GDOT” or “grantor deemed owned trust”
“IDGT” or “intentionally defective grantor trust”
“GDIT” or “grantor defective inheritance trust”
“GDIT” or grantor defective irrevocable trust”
Beneficiary Defective Trusts
“BDOT” or “beneficiary deemed owned trust”
“IDBT” or “intentionally defective beneficiary trust”
“BDIT” or “beneficiary defective inheritance trust”
“BDIT” or “beneficiary defective irrevocable trust”
You will also hear of an “IDIT” or “intentionally defective irrevocable trust.” An IDIT is either a grantor deemed owned trust or a beneficiary deemed owned trust. When referencing both beneficiary and grantor trusts generally in this article, the acronym IDIT will be employed.
The Benefits of an IDIT
As referenced above, an IDIT has many benefits. The foremost reasons for incorporating an IDIT into a wealth structure include the following:
Elimination of Estate Tax: One of the primary benefits of an IDIT is focused on the elimination of estate tax. Currently, the gross value of an estate which is over $12,060,000 for an individual and $24,120,000 for a married couple is taxed at 40%. The benchmarks for estate tax exclusion (estate tax exemptions) will be substantially reduced on January 1, 2026, to approximately $6,600,000 for an individual and $13,200,000 for a married couple.
There are two main paths an IDIT eliminates estate tax. First, a settlor can take cash or assets and fund them into an IDIT for the benefit of heirs. If a settlor proceeds down this path, a gift tax return will need to be filed for gifts in excess of the annual exclusion amount, currently at $16,000. If a settlor does not gift into the trust more than the current estate tax exemptions identified in the above paragraph, no tax will need to be paid. The gift tax and estate tax exemptions are currently unified. Once the gift is completed, the increase in the value of the assets in the trust will appreciate outside of the estate of the settlor of the trust, thus excluding the appreciation from the estate of the settlor.
The second path is to sell assets to the IDIT. Often the sale transaction is structured as an installment sale. This method of getting assets into the IDIT, as opposed to gifting, is employed when the settlor is not the owner of the assets to be housed in the trust, but rather a beneficiary of the trust. This sale transaction is a very effective way to eliminate estate tax if it is properly engineered. Ideal assets for this transaction are assets which will appreciate in value over time. For instance, if real property is the target asset to go into the trust, the real property can be capitalized into a partnership with partnership interests being sold to the trust. The value of the interests in the partnership can be discounted in some instances up to 30% which means the value of the asset to be taxed at death is decreased with no gift exemption having to be declared on a return. Furthermore, the value of the real estate inside of the partnership will increase in value outside of the estate of the transferring party. Ultimately, the transferring party will have a promissory note or payments from the trust which will pull assets back into the transferring party’s estate, but that note or those payments are up to 30% less than the value of the property transferred and the appreciation in value is safe from estate tax calculations.
It should be noted, the IDIT is a grantor trust to the beneficiary-seller for federal income tax purposes. Gain on the sale transaction does not generate any taxable income.
Why Is the Trust Defective?
The trust is defective for tax purposes. This means that the taxes incurred at the trust level are either passed to the settlor if the trust is a grantor defective trust or the beneficiary if the trust is a beneficiary defective trust. This is done to minimize the tax bill. Although the top marginal rate for trusts is the same as the top marginal rate for individuals at the federal level, the top marginal rate for trusts is realized once taxable income reaches $13,450, whereas the top marginal rate for an individual is not realized until taxable income reaches $539,900 for single filers and above $647,850 for married couples filing jointly. So, making the trust defective for tax purposes is tax efficient.
Asset Protection. The IDIT provides a significant asset protection. If the IDIT is structured properly, the assets held by the trust cannot be accessed by creditors of the settlor or beneficiaries. Thus, if the settlor or beneficiaries end up with a judgment against them or in bankruptcy, the assets are shielded and not subject to liquidation by creditors. Also, a divorcing non-beneficiary individual is not entitled to assets held by the trust for the benefit of their spouse.
Control and Access. A beneficiary who sells assets to the trust can serve as an investment trustee of the trust and a manager of the partnership holding the assets to be housed in the trust. The beneficiary can also receive discretionary income or principal distributions from the trust. Such distributions are not taxable to the beneficiary.
IDITs are complex but the benefits are substantial. If you have not considered advanced planning, now is the time to do it and IDITs should be a part of the conversation.