Beneficiary Defective Irrevocable Trusts (Part 1)
The benefits of an intentionally defective grantor trust (“IDGT") are well known. First, the grantor’s payment of the trust’s income taxes is essentially a tax-free gift to the beneficiaries of the trust. Rev. Rul. 2004-64. Thus, the assets in the trust grow “tax free". Second, by paying the income taxes, the grantor is reducing his/her estate by the taxes paid and any future appreciation that would otherwise have been generated on the funds used to pay income taxes. Third, the grantor can sell assets to an IDGT (on installments) without any gain or loss recognition. Sales between a grantor and a grantor trust are disregarded for income tax purposes. Rev. Rul. 85-13. Fourth, a sale to an IDGT of a life insurance policy on the grantor’s life can avoid both the three-year rule and the transfer-for-value rule. Rev. Rul. 2007-13. Fifth, an IDGT qualifies as an eligible S corporation shareholder. IRC Section 1361(c)(2)(A)(i). But, at such time as the IDGT is no longer a grantor trust, the trust must then “convert" to a Qualified Subchapter S Trust (“QSST") or an Electing Small Business Trust (“ESBT"). Finally, with proper design and drafting, grantor trust status can be “toggled" on and off for maximum flexibility.
The powers that are typically used to trigger grantor trust status for income tax purposes, but without causing inclusion of the trust’s assets in the grantor’s estate, are the following:
- The power to substitute trust property with other property of equivalent value. IRC Section 675(4)(c).
- The power in a non-adverse party to add charitable beneficiaries. IRC Section 674(b)(4).
- The power to distribute income to the grantor’s spouse. IRC Section 677(a)(1) and (2).
- The power to use trust income to pay premiums on policies of insurance on the life of the grantor or grantor’s spouse. IRC Section 677(a)(3).
- The power of the grantor to borrow trust assets without adequate security. IRC Section 675(3).
That said, consider turning the tables and drafting the trust so that the beneficiary – and not the grantor – is taxed on the trust income. With an IDGT, the grantor cannot be a beneficiary or a trustee of the trust without adverse estate tax consequences (under IRC Sections 2036 and 2038). But, with a beneficiary defective irrevocable trust (“BDIT"), the beneficiary can be both the primary beneficiary and the trustee of the trust. The reason is that the beneficiary is not the grantor of the trust. Instead, the grantor is usually the beneficiary’s parent or grandparent.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.
Julius Giarmarco, J.D., LL.M, is an estate planning attorney and chairs the Trusts and Estates Practice Group of Giarmarco, Mullins & Horton, P.C., in Troy, Michigan.