The estate tax exemption is set to drop significantly after the Tax Cuts and Jobs Act (TCJA) provisions expire at the end of 2025. And while the results of the November 2024 election mean it’s possible those tax provisions could be extended with 2025 legislation, it’s also possible they will not. As such, it’s prudent to continue advancing your estate plan as if the sunset will occur as scheduled at the end of the year.
One great planning strategy to consider is lowering the value of your gross estate in the future, therefore potentially minimizing the “death tax,” which could be as high as 40%. “IDGTs,” or Intentionally Defective Grantor Trusts, are a tool in the savvy taxpayer’s estate tax planning toolkit that offers many key advantages to accomplish this goal.
An IDGT is a tax planning strategy that establishes a “defective” trust, on purpose, by including a provision that allows any gift to the trust to be consider complete for gift tax purposes but not for income tax purposes. This irrevocable grantor trust acts as a separate legal entity to facilitate the gifting of assets outside of the grantor’s estate, resulting in a gift tax filing and the use of the gift tax exemption. An IDGT offers taxpayers several tax advantages:
A popular and beneficial way to fund an IDGT with assets is through an installment sale. The process generally starts by funding the trust with a gift, if it doesn’t already have other assets. While the exact amount can vary, grantors generally fund the trust with between 10% to 20% of the total assets they would like to move into the trust. These assets serve as collateral for a subsequent installment note.
In most cases where this strategy is used, minority interests in a privately held family business or investment real estate are sold to the trust. After an initial gift to establish some trust equity for collateral, shares are then sold to the trust in exchange for a note. The note terms are flexible, so they could be set up to amortize over a period of time, or simply pay interest on an annual basis with a balloon payment due at the end of the note term. The interest rate on the note should be at least as high as the IRS proscribed interest rate — the Applicable Federal Rate (AFR) — in force at the time of the loan. This rate is published monthly by the IRS for various repayment terms. As mentioned above, the sale does not trigger a taxable event since the grantor is in effect selling assets to themselves, so there is no gain or loss to report in the year of the sale. That said, the note is an enforceable note, and the payment terms should be followed to demonstrate the legitimacy of the transaction.
This approach generally gives the grantor the opportunity to sell these illiquid and/or hard-to-value business interests at a discount from full market value. A formal appraisal is required to document the final valuation of any privately held assets that are gifted and/or sold. The appraiser will consider these discounts as part of the valuation, including discounts for lack of control, lack of marketability and lack of voting rights, if applicable. Regardless of the type and amount determined by the appraiser, any discounts will help minimize the grantor’s estate tax obligations down the line by reporting smaller gift and sale amounts, and thus minimizing the amount of estate exemption used and note balance.
Once the assets are sold, the grantor's basis in the appreciated property would carry over to the trust, since it wasn’t a true sale for income tax purposes. The assets in the trust would then hopefully appreciate as part of this separate entity and, for estate tax purposes, this growth would be outside the grantor’s taxable gross estate. Note that the value of the unpaid note receivable from the trust is considered an asset of the grantor’s estate and will reduce the value of the trust assets as it is paid back. In many cases, the trust can begin repaying principal on the note in the year after the sale using cash distributions from the profits of the business interests that it owns. This approach allows the trust to pay off the note with cash flow from the business, while providing cash income to the grantor/seller to replace the income they previously received from the shares that were gifted and sold.
Regardless of whether you are new to estate planning or have already transferred significant wealth, IDGTs offer many estate tax advantages. With so much uncertainty around estate tax legislation, now is the time to talk to your advisers and attorneys to consider whether an IDGT or other estate planning tool may be right for you.
Contact Chad Shields, Anna Ward or a member of your service team to discuss this topic further.
Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.