The Defective Trust is an Effective Asset Protection and Estate Tax Planning Tool
An IDIT is a grantor trust within the meaning § 671 of the Internal Revenue Code (the “Code") and trust property is treated as being owned by the taxpayer that formed the trust (the “grantor") for federal income tax purposes. Therefore, transactions between the trust and the grantor are ignored when paying federal income taxes. However, these transaction are respected for estate tax and other purposes because the trust is irrevocable. This allows for many planning opportunities including the “sale" of income producing property to an IDIT in exchange for a note as described in this material.
Although the grantor will not recognize any income from the “sale" or the interest on the “note" under § 671 of the Code and Revenue Ruling 85-13, the property is immediately removed from the taxable estate and the reach of creditors. See, IRS, PLR 2006030402.
When selling property to an IDIT, the property must be income producing real or personal property (taxpayers can use a similar trust for their qualifying residential property). Common types of property sold to IDIT’s include, commercial real estate, rental property, certain publicly traded stock, private equity investments and interests in family or closely held businesses.
After the “sale," the taxpayer or individual can pay income taxes on trust income using trust assets or non-trust assets without worrying about gift taxes. This allows grantors to pay the tax obligation for their beneficiaries without increasing his or her total tax obligation and reduces compliance and accounting costs normally associated with trusts.
In addition, IDIT’s help with business succession planning, avoiding probate and can provide significant asset protection for the grantor’s beneficiaries.
When selling property to an IDIT, the taxpayer or individual must create and fund the IDIT and then “sell" the income producing property to the trust in exchange for a “note." Depending on the asset, the taxpayer or individual may also need to form a new business entity or have an existing entity issue new ownership interests.
The IRS provided guidance on how to create and fund IDIT’s in Private Letter Ruling 2006030402. In that 2006 Private Letter Ruling, the IRS conceded that a taxpayer would receive the desired tax treatment if the trust complied with § 673 of the Code, the grantor trust provisions, and was funded with “seed money" equal to 10 percent of the value of the property being transferred. Id.
When seeding an IDIT the grantor can use cash or other property to serve as collateral for the loan. Although the “seed money" is a gift, most taxpayers can avoid federal wealth transfer taxes by using their annual gift tax exclusions (see, Sidebar: Gifting, infra). For more valuable property, the taxpayer may “sell" the asset over a number of years to avoid or minimize gift taxes.
After seeding the IDIT, the grantor sells the assets to the trust in exchange for an installment or demand note (the terms of the note depend on the purposes for forming the trust as well as other factors). The note is ignored for income tax purposes but
transfers the property from the taxable estate and out of the reach or creditors. See, Rev. Rul 2006-64; IRS, PLR 9535026.
The grantor may not notice a significant change in the way he or she interacts with or does business with the trust propertyhowever, the result of the transaction is a completed "sale" of the property. This provides an additional advantage to the trust beneficiaries.
As a completed sale, the trust’s basis is determined under the related party transaction rules and not the gift tax rules. Under these rules, The seller cannot take a loss at the time of sale; however, this unused loss is aded to the buyer’s basis in the property. This can provide a more favorable basis for the trust property compared to gifting where the basis may be limited to the fair market value at the time of transfer.
Type of taxpayers or individuals that should consider using the IDIT
Taxpayers that currently have, or will likely have, a net-worth of $5 million for individuals or $10 million for couples should consider using an IDIT for the reasons in this publication. If Congress does not pass a new estate tax by the end of 2011, taxpayers with net-worths of $1 million or more and income producing property may want to consider using an IDIT to avoid uncertainty.
Individuals that want to protect their assets from creditors or lawsuits should also consider using IDIT’s. IDIT’s are popular among professionals who are personally liable for certain types of malpractice claims (i.e., lawyers, doctors, accountants and engineers). Theses trusts provide security against litigation, leverage during negotiations and, most importantly, peace of mind for defendants who may be at the mercy of unpredictable juries.
Individuals engaged to be married (or their families) can also use the IDIT as a form of pre-material asset protection. An IDIT is quick and easy to establish and avoids the awkwardness of asking for a prenuptial agreement. In some cases, the IDIT is also more effective than a prenuptial agreement.
All taxpayers should take some time to evaluate their estate tax planning in 2011 because of the changes to the estate tax laws and the development of more sophisticated and cost effective planning techniques (like the IDIT). Even taxpayers that already have an estate plan should review their plan in light of the new rules; especially if that estate plan is more than a year or two old.
Like any tax planning, there are some risks when selling property to IDIT’s because tax rates are subject to change. In addition, taxpayers setting up IDIT sales should make sure to comply with Private Letter Ruling 2006030402 and other guidance in the area. However, in the worst-case scenario, most taxpayers who use an IDIT will be no worse off than had they not engaged in any planning in the first place. In addition, even if the IDIT fails to remove the asset from the taxable estate, the taxpayer or individual will have still enjoyed other IDIT advantages such as asset protection and probate avoidance.
John and Jane Doe have two children and own an income producing piece of real property (two unit commercial duplex). The property is in a Florida Limited Liability Company (most income producing property is in such an entity but that is not a prerequisite). John is an engineer and, together, John and Jane have an estate of $6 million.
The income producing property is currently worth $400,000 and produces yearly rents of $55,000 from leases with John’s engineering firm and another unrelated business. John and Jane acquired the income producing property for $600,000 in 2005 (thereby, freezing out future appreciation from the estate).
The first step is to form an IDIT for the benefit of their two children and fund the trust with seed money of $40,000. John and Jane do not have to worry about gift taxes because their seed money is less than the annual gift exclusion; however, the seeding of larger amounts can be accomplished by planned gifting over multiple years.
The next step is to issue a new type of interest in the LLC, a “limited partnership interest" (or “limited membership unit"). The limited partnership interest has no control but right to 99 percent of the liquidation (sale) and 99 percent of current distributions (rents). John and Jane “sell" the limited partnership interest for $400,000. The sale is done in the form of an installment note paying $55,000 per year for 8.5 years. John and Jane retain their managing partner (or managing member) interests and continue operating the building as they did before forming the trust. The other tenant never knows about the formation of the IDIT or the change in the. Buildings ownership.
John and Jane do not have to actually make payments on the note and there are no negative income tax consequences. Merely setting up the grantor trust allows John and Jane are also able to pay the taxes on $55,000 each year without having to pay additional wealth transfer taxes. John and Jane would have to pay the taxes on the $55,000 even if they did not set up the trust and therefore, John and Jane are able to “give" their children the taxes on $55,000 per year for the life of the trust (this amount is in addition to their yearly gift tax exclusion and makes a great source for seed money on larger assets in the future).
Furthermore, three years after setting up the IDIT, John is sued for professional malpractice. The plaintiff learns that Doe’s largest asset is in a LLC and an IDIT and therefore, very difficult to obtain a judgment against. The case is without merit but the Doe’s do not need to worry about the unpredictability of litigation knowing their income is secure. The plaintiff and his or her attorney do not want to wait to obtain judgements against the IDIT or LLC so they settle beneath the policy limits.
This document is not intended to substitute for the advice of a competent tax professional. You should talk you tax professional before implementing tax planning technique to make sure that the strategy is appropriate for you and your situation.
This document is intended to provide general guidance to clients, interested individuals and professionals. The publication, dissemination or receipt of this material, does not constitute an attorney-client privilege.
This material is not intended to be used by any taxpayer to avoid tax penalties. Although addressing tax related services, this publication was not written to support the promotion of any matter within the meaning of Circular 230.