Tax-Efficient Wealth Transfer

When the sunset provision that was built into the gradual repeal of the estate tax began to loom on the horizon many wealthy taxpayers did everything they possibly could to reduce their taxable estates before the provision took effect in 2011. While in most instances estates with a value of only a few million dollars can generally avoid estate taxation with simple planning, larger estates require more creative estate planning techniques.

Many different types of trusts can be used to accomplish various estate planning goals and objectives, but transferring large sums of money or other assets into these trusts at once can often result in gift liability. Although this dilemma can be resolved with the use of a sprinkling, Crummey Power, or five-and-five power, it is not necessarily an optimal solution in many cases, for various reasons. One alternative may be to establish a special type of trust known as an intentionally defective grantor trust (IDGT).

The IDT is an irrevocable trust that has been designed so that any assets or funds that are put into the trust are not taxable to the grantor for gift, estate, generation-skipping transfer tax or trust purposes. However, the grantor of the trust must pay the income tax on any revenue generated by the assets in the trust. This feature is essentially what makes the trust "defective", as all of the income, deductions and/or credits that come from the trust must be reported on the grantor's 1040 as if they were his or her own. However, because the grantor must pay the taxes on all trust income annually, the assets in the trust are allowed to grow tax-free, and thereby avoid gift taxation to the grantor's beneficiaries.

For all practical purposes, the trust is invisible to the Internal Revenue Service (IRS). As long as the assets are sold at fair market value, there will be no reportable gain, loss or gift tax assessed on the sale. There will also be no income tax on any payments paid to the grantor from a sale. But many grantors opt to convert their IDGTs into complex trusts, which allows the trust to pay its own taxes. This way, they do not have to pay them out-of-pocket each year.

While there are many different types of assets that may be used to fund a defective trust, limited partnership interests offer discounts from their face values that substantially increase the tax savings realized by their transfer. For the purpose of the gift tax, master limited partnership assets are not assessed at their fair market values, because limited partners have little or no control over the partnership or how it is run. Therefore, a valuation discount is given. Discounts are also given for private partnerships that have no liquid market. These discounts can be 35-45% percent of the value of the partnership.

One of the best ways to move assets into an IDGT is to combine a modest gift into the trust with an installment sale of the property. The usual way to do this is by gifting 10% of the asset and having the trust make installment sale payments on the remaining 90% of the asset.

Example - Reducing Taxable Estate

Frank Newman, a wealthy widower, is 75 years old and has a gross estate valued at more than $20 million. About half of that is tied up in an illiquid limited partnership, while the rest is composed of stocks, bonds, cash, and real estate. Obviously, Frank will have a rather large estate tax bill unless appropriate measures are taken. He would like to leave the bulk of his estate to his four children. Therefore, Frank plans to take out a $5 million universal life insurance policy on himself to cover the cost of estate taxes. The annual premiums for this policy will cost approximately $250,000 per year, but less than 20% ($48,000) of this cost ($12,000 annual gift tax exclusion for each child) will be covered by the gift tax exclusion. This means that $202,000 of the cost of the premium will be subject to gift tax each year.

Of course, Frank could use a portion of his unified credit exemption each year, but he has already established a credit shelter trust arrangement that would be compromised by such a strategy. However, by establishing an IDGT trust, Frank can gift 10% of his partnership assets into the trust at a valuation far below their actual worth. The total value of the partnership is $9.5 million, and so $950,000 is gifted into the trust to begin with. But this gift will be valued at $570,000 after the 40% valuation discount is applied. Then, the remaining 90% of the partnership will make annual distributions to the trust. These distributions will also receive the same discount, effectively lowering Frank's taxable estate by $3.8 million. The trust will take the distribution and use it to make an interest payment to Frank and also cover the cost of the insurance premiums. If there is not enough income to do this, then additional trust assets can be sold to make up for the shortfall.

Frank is now in a winning position regardless of whether he lives or dies. If the latter occurs, then the trust will own both the policy and the partnership, thus shielding them from taxation. But if Frank lives, then he has achieved an additional income of at least $202,000 to pay his insurance premiums.

IDGTs have many uses, but an exhaustive analysis of their benefits lies beyond the scope of this article. Certain strategies may be employed to avoid the generation-skipping transfer tax as well. Those who are interested in finding out more about these trusts should learn about all the factors to consider in estate planning and should consult a qualified estate planning attorney as well.