Tax, Real Estate, Corporate & Estate Planning
Get Started 800.761.0432
High-Caliber Representation We take pride in providing the breadth of legal representation you need.

An 'Intentionally Defective' Trust Can Save Taxes

Under the right circumstances, an intentionally defective irrevocable trust (IDIT) can be an effective estate tax planning tool. These trusts are set up to purposely fail certain technical tests in the tax law, yet they still have the approval of the IRS and allow individuals to pass more assets on to their heirs.

Intentionally defective irrevocable trusts are sometimes called intentionally defective grantor trusts. These are two names for the same arrangement.

Here are a couple of points to keep in mind:

  • An IDIT is considered to exist as a separate taxable entity for federal estate tax purposes and general state law purposes.

  • However, an IDIT is considered to be a grantor trust for federal income tax purposes. As such, the IDIT's income and deduction items are treated as belonging to the grantor (the person who sets up the trust).

These trusts are confusing but in this article, we'll explain how an IDIT arrangement can work to your tax-saving advantage.

The IDIT Tax-Saving Strategy

If you own appreciating assets and want to get the future appreciation out of your estate, an intentionally defective irrevocable trust could be just what the doctor ordered. The strategy works as follows:

1. You establish the IDIT as a legal entity under applicable state law and name the trust beneficiaries (generally your children and grandchildren). Typically, you also make a gift of some cash to the IDIT to create some immediate liquidity for the trust (this is called "seed money").

2. You then sell appreciating assets to the IDIT in exchange for a note payable from the IDIT (in other words, an installment sale). Since the IDIT is ignored for federal income tax purposes, the sale has no federal income tax significance, because you are treated as selling the assets to yourself, which is not a taxable transaction.

3. To pay back the note owed to you, the IDIT uses cash from your gift of seed money, from income and gains generated by the trust's assets, and, if necessary, from asset sales.

4. Any income, gain, and deduction items related to the IDIT's assets are reported on your personal federal income tax returns, because you are still considered to own the assets for federal income tax purposes. You are allowed pay the income taxes with money from your own pocket. You need not dip into the trust. This allows you to leave more value in the IDIT for the future benefit of the persons you've named as the trust beneficiaries. In effect, you are allowed to make gifts of money to cover the trust's income tax bills without triggering any adverse federal tax consequences. (IRS Revenue Ruling 2004-64 and IRS Private Letter Rulings 199922062 and 200120021)

5. At the end of the day, the IDIT will have paid off the note owed to you, but the trust will still have a net worth equal to the appreciation in the value of the assets you put into it. The IDIT's net worth will ultimately go to the beneficiaries you've designated, and the net worth amount will not be included in your estate for federal estate tax purposes.

IRS: You Can Dip Into IDIT to Pay Income Taxes, But Be Careful

While you would generally like to pay any income taxes generated by the IDIT's assets with money from your own pocket (for the reason explained in number 4 above), those taxes could wind up exceeding what you can afford. If so, the IRS stated in a ruling that taxpayers can dip into the IDIT for the needed cash without any adverse federal tax effects. This favorable ruling resolved a troubling question in a taxpayer-friendly manner. So it was good news for taxpayers and estate planners.

Warning: The IDIT instrument should not require the trust to reimburse you for income taxes generated by its assets. Such a requirement would cause the trust's assets to be included in your taxable estate, which would ruin the whole strategy behind the intentionally defective irrevocable trust concept. (IRS Revenue Ruling 2004-64)

Bottom Line: The IDIT is considered to exist for estate tax purposes but not for income tax purposes. It is therefore described as "defective" but the defect is intentional. Thus the name intentionally defective irrevocable trust.

While the IRS-approved IDIT strategy can be effective in reducing the value of your taxable estate, it's a complicated arrangement that requires professional assistance. This article only covers the basics. Contact your estate planning advisor if you have questions or want more information.

 

Disclaimer of Liability

Ferrari Ottoboni Caputo & Wunderling LLP ("Ferrari et al.") has prepared the materials contained in this e-newsletter only for your information and they are not legal advice. These materials may not reflect the most current legal developments. Furthermore, the information contained in these materials should in no way be taken as an indication of future results.

Transmission of the information contained at the Ferrari et al. e-newsletter is not intended to create, and receipt does not constitute, an attorney-client relationship between you and Ferrari et al.  Readers of the e-newsletter should not act upon this information without seeking professional counsel.

In the event the information in the e-newsletter is not consistent with the rules governing communications of legal services in a particular state, Ferrari et al. is unwilling to assume the representation of clients from those states where the marketing materials contained in the Ferrari et al. e-newsletter do not comply with state bar requirements and where the client is generated as result of that communication.

Some links contained in the Ferrari et al. e-newsletter may lead to other web sites. Ferrari et al. does not necessarily sponsor, endorse, or otherwise approve of the materials appearing in such other web sites.

Reproduction, distribution, republication and retransmission of material contained within the Ferrari et al. e-newsletter is prohibited unless the prior permission of Ferrari et al. has been obtained.

IRS circular 230 disclosure

To ensure compliance with requirements imposed by the United States Internal Revenue Service, we inform you that any tax advice contained in this e-newsletter (including any attachments or website links) was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding tax-related penalties under the United States Internal Revenue Code or (2) promoting, marketing or recommending to another party any tax-related matters addressed herein.

Categories: