As the country continues to struggle with its fiscal woes, Congress and the White House are increasingly proposing tax law changes intended to cut down on perceived "abuses" and "tax loopholes" - especially those used by the wealthy. The latest, in the President's Fiscal Year 2013 budget, is a proposal to change to the estate tax laws, requiring any grantor trust to be included in the estate of the grantor (or pay gift taxes if the grantor trust assets are distributed before the grantor's death). The proposal would kill the popular Intentionally Defective Grantor Trust (IDGT) estate planning strategy, which works specifically by relying on the fact that a trust can be a grantor trust for income tax purposes even while being excluded from the grantor's estate for estate tax purposes - after all, if the grantor trust is automatically included in the grantor's estate, there's no longer any value to make gifts or sales of property to an IDGT. While the rules are only proposed at this point - and would only apply to trusts created in the future, after the enactment date of any legislation - the fact that the change was proposed at all suggests that the days of IDGT planning strategies may be numbered. 

The inspiration for today's blog post was a discussion by charitable planning attorney Jerry McCoy in a recent article from Leimberg Information Services, about whether a recent revenue proposal in the President's budget could be a threat to grantor Charitable Lead Trusts. Yet in reviewing the details from the so-called Treasury Green Book (which provides a more detailed explanation of the administration's budget proposals), I realized that the issue has a far greater risk than threatening "just" grantor CLTs - the new proposal threatens to eliminate the popular Intentionally Defective Grantor Trust (IDGT) strategy entirely!

What Is An IDGT?

For those who aren't familiar, the basic idea of an Intentionally Defective Grantor Trust is to create a trust whose property is treated as the grantor's assets for income tax purposes, but not for estate tax purposes. The name "intentionally defective" is meant to describe that the trust is "defective" in that while the assets are outside of the grantor's estate for estate tax purposes, the trust "fails" to be excluded for income tax purposes and instead is treated as a grantor trust.

This can be accomplished because the powers that a grantor retains that cause estate tax inclusion under IRC sections 2036 or 2038 are not exactly the same as the powers that a grantor can retain to cause a trust to be a grantor trust for income tax purposes under IRC Sections 673 to 677. Most commonly, the trust is drafted to either give the grantor the power to substitute assets of equal value into the trust (triggering grantor trust status under IRC Section 675(4)), or the power to borrow from the trust without adequate security or interest (triggering grantor trust status under IRC Section 675(2)); neither provision would cause inclusion of the trust assets in the grantor's estate for estate tax purposes.

Given a proactive decision to include such powers that trigger grantor trust treatment without triggering estate tax inclusion, the reality is that making an IDGT is a planning strategy, not a 'defective' drafting mistake. The basic approach of the strategy is that once the IDGT is created, the grantor contributes property to the trust, which will from that point forward be outside of the grantor's estate - thereby "freezing" the value for gift and estate tax purposes at the value reported at the time property is gifted to the trust. All future appreciation occurs inside the trust, which is outside of the grantor's estate. In addition, since being affirmed in Revenue Ruling 2004-64, the income tax consequences that occur inside the trust can be paid by the grantor's personal assets outside the trust (since it will be the grantor's tax liability due to grantor trust status) without triggered further gift taxes or estate inclusion. This essentially allows the trust property to grow "tax free" outside of the grantor's estate because the trust's income tax consequences are paid by the grantor (with the additional benefit of further reducing the grantor's estate!).

In practice, the value of the IDGT strategy is often leveraged even further, thanks to Revenue Ruling 85-13, which stipulates that a sale of property from a grantor to his/her grantor trust is not treated as a taxable sale for income tax purposes. Consequently, a grantor can use funds inside of an IDGT to finance the payment of an even larger purchase of property, to remove even more appreciating assets from the estate.

For example, a grantor might gift $2,000,000 to an IDGT (using a portion of the individuals' lifetime gift tax exemption amount), and then use the money to finance the installment note payments (or sometimes a self-cancelling installment note) to purchase a $10,000,000 share of closely held business (by the time the $2,000,000 of cash is used up making installment note payments, the business should have distributed enough income itself to sustain the payments further). The installment note pays interest back to the grantor at the Applicable Federal Rates - which are quite low in today's interest rate environment - while the business generates a return between dividends and appreciation that hopefully exceeds the interest rate. To the extent the business grows faster than the installment note, the grantor has effectively traded a rapidly-appreciating asset outside the estate for a slow-growing asset - the installment note payments - that come back into the estate; at the grantor's eventual death, the entire assets of the trust will distribute estate-tax-free to the trust beneficiaries, and only the value of the note payments (either already paid and held in the estate, or those still due) are included in the grantor's estate. With a rapidly appreciating business (or some other similar high-appreciation asset), the amount of money removed from the estate can be very significant over the span of many years of growth (especially since the assets inside the trust effectively grow "tax free" because the taxes are being paid from the grantor's assets, further reducing his/her estate, not the trust's assets). And all it cost the grantor to get the future growth of a $10,000,000 highly-appreciating asset out of the estate was a $2,000,000 "seed money" gift!

The Administration's Proposal

In its fiscal year 2013 budget, the administration has proposed a change to the income and estate tax laws that would effectively kill the IDGT strategy. The key elements of the proposal (you can see the full details on page 83 of the Green Book) are:

To the extent that the income tax rules treat a grantor of a trust as an owner of the trust, the proposal would:

(1) include the assets of that trust in the gross estate of that grantor for estate tax purposes,

(2) subject to gift tax any distribution from the trust to one or more beneficiaries during the grantor’s life, and

(3) subject to gift tax the 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.

In essence, the proposal would mean that any power which triggers grantor trust status under IRC Sections 673 to 677 will automatically trigger inclusion of the trust assets in the grantor's estate, regardless of whether the retained powers are enumerated in IRC Sections 2036 or 2038. Accordingly, powers to substitute assets, borrow without adequate interest or security, or other such provisions that previously triggered grantor trust status without causing estate inclusion, would now cause estate inclusion simply by virtue of the fact that they are grantor trust powers.

In the context of a strategy like an IDGT, the new rules would cause the entire value of the IDGT to be included in the grantor's estate, simply due to the fact that it is a grantor trust (by whatever power it was that triggered grantor trust status). In fact, the new rule would kill the entire concept of an Intentionally Defective Grantor Trust that is a grantor trust for income tax purposes but not included in the grantor's estate, because grantor trust status itself would trigger estate inclusion!

Thus, the only way to avoid having such a trust included in the estate would be to make it not be a grantor trust at all. However, losing grantor trust status would make any sale of assets to the trust a taxable sale to a third party - since Revenue Ruling 85-13 specifically treats the sale as non-taxable because it is a sale between the grantor and his/her grantor trust. Consequently, not only would the entire concept of an IDGT be eliminated by the new rules, but so too would the opportunity to sell assets to a grantor trust in a non-taxable manner to get appreciation out of the estate. Instead, the assets would either have to be sold in an income-taxable sale, or would have to be gifted, subject to gift tax laws. And notably, given the 2nd and 3rd prongs of the proposal noted above, it wouldn't be sufficient to simply have the IDGT try to distribute assets out of the trust before the grantor dies - obviously, distribution of assets would avoid estate tax inclusion (since they'd be gone by the time the grantor died) - because the trust distribution itself would trigger gift taxes under the new rules, eliminating any benefit (as the grantor could just gift the assets personally if they've going to be gift-taxable anyway).

Planning Implications

The good news is that the proposed rules stipulate that they would only apply to new trusts created on/after any enactment date, so trusts that have already been created should be safe - although the proposal does suggest that new contributions to pre-enactment trusts made after the effective date may be subject under the new rules. The proposal also indicates that the new rules will not apply to any form of trust otherwise explicitly allowed under the tax code, including qualified personal residence trusts (QPRTs) and grantor-retained annuity trusts (GRATs) (although a separate Green Book proposal would alter GRATs to require a minimum 10-year term).

In addition to having future-trusts-only applicability, it's notable that the proposed new rules are at this time only proposed. Not everything in the President's budget proposals is always enacted into law, and indeed at this time it's not even clear that the President will still be the President for all of the government's 2013 fiscal year. 

Nonetheless, the fact that a shutdown of the IDGT has been proposed at all suggests some risk that the days may be numbered for the strategy, given the current fiscal outlook and the Treasury's estimate that the new rules could raise $910 million of tax revenue over the next decade (not to mention the fact that the strategy is typically only used amongst ultra high net worth clients, who are being targeted by many more-restrictive tax proposals in the current environment). And given the complexity of the IDGT strategy and the time it often takes to establish the trust, gift to it, and structure and complete the sale of assets to the trust, clients who are considering an IDGT sale strategy in the coming years may wish to get started sooner rather than later, just in case.

So what do you think? Do you use IDGTs with your clients? Is the administration's proposal an appropriate crackdown on a tax "loophole" or an inappropriate assault on a legitimate tax strategy? Will you be accelerating the setup of any IDGTs in the coming years in light of the potential for the rules to change in the future? 

(Editor's Note: This article was featured in Tax Carnival #103: June Tax Swoon on Don't Mess With Taxes.) 

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Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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