With the Bush tax cuts set to expire, the healthcare mandate upheld by the Supreme Court, and new budget and tax proposals from both sides of the political aisle, there is currently uncertainty in all aspects of tax, financial and business planning. In 2011 and 2012 there has been significant planning ability with regards to estate taxes and wealth transfers, but the advantageous gift and estate tax exclusions are set to expire, with other popular planning strategies on the chopping block as well.
For tax year 2012, individuals have the ability to gift up to $5.12 million ($10.24 million for married couples). One of the key tools used by advisors has been the Intentionally Defective Grantor Trust (IDGT). There are revisions to the rules of IDGTs in President Obama’s proposed budget for 2013 in which the elimination of the sale of assets to an IDGT technique. The good news? These proposed changes would only apply to new trusts created on/after any enactment date. Trust that have already been created should be safe, though new contributions to pre-enactment trusts made after the effective date may be subject to the new rules.
What is an IDGT?
Under a grantor trust, one or more donors are treated as owning all or a portion of a trust for federal income tax purposes. The assets transferred into the trust can be excluded from the donor’s estate, if treated as a completed gift. The trust is named “defective” since you are “severing the estate tax link without severing the income tax link with the donor.” This means that the assets will not be part of the donor’s estate, but the donor will be individually liable for any income tax due on the income generated by the trust.
Why is an IDGT useful?
On a basic level the advantage of an IDGT is the growth of the assets unreduced by income taxes while reducing the assets held in the donor’s estate, but many other planning opportunities exist within the realm of the IDGT rules. The main one is the sale of assets for a promissory note, which is on some lawmaker’s agendas to alter or stop all together. Some key elements for a grantor to be treated as an owner of a trust for income tax purposes include:
- The ability to add beneficiaries to the trust agreement after inception, without the consent or approval of an adverse party.
- The ability to appoint trust income and principal during the grantor’s lifetime without the consent or approval of an adverse party.
- The power to substitute or require assets in a non-fiduciary capacity by exchanging assets of equivalent value.
- The power to borrow from all or part of a trust without adequate interest or security.
- The power to use trust income to make premium payments on an insurance policy on the life of the grantor or grantor’s spouse without consent of an adverse party.
How to effect an “estate tax freeze” through sale of assets for a promissory note:
Appreciating assets can be sold to a grantor trust in exchange for a promissory note. The note will be set at the applicable federal interest rate (AFR), the logic being that the asset will appreciate at a greater rate than the interest on the note. This has many advantages, such as an estate tax freeze in the value of an appreciating asset, no gift tax on the transfer, if the donor dies only the value of the note is included in their estate, and creditor protection for the assets inside the trust.
For example: John creates an IDGT, in which he wishes to transfer $250,000 Apple Common Stock. John has the option of gifting the stock to the trust and eating into his gift and estate tax exclusion, or he can sell the stock to the trust in exchange for a promissory note. John believes the stock will be appreciate significantly, so he sells the stock to the trust in exchange for a promissory note set at the current AFR. Since John is receiving the income, the trust allows the transfer without a negative gift tax consequence, and the asset will appreciate inside the trust without any income tax liability.
Proposed budget changes and why to act now:
President Obama’s budget proposal includes changes to the sale rules where the assets in the trust will be included in the gross estate of the donor, subject to gift tax distribution from the trust to one or more beneficiaries during the grantor’s life and subject to gift tax remaining trust assets at any time during the grantor’s life if the grantor ceases to be treated as an owner of the trust for income tax purposes.
Transfers of assets using the promissory note will still be available through the end of the year, but estate planners and their clients must act now to insure they meet the deadline. The last half of 2012 is a critical time to firm up your estate plan, and take advantage of not only these beneficial IDGT rules, but the $5.12 million gift/estate tax exemption. If lawmakers do not take action before January 1, 2013 the gift and estate tax exclusion is set to go down to $1 million and a the top estate tax rate will increase from 35% to 55%.
Sheehan & Company, CPA, PC.