INTENTIONALLY DEFECTIVE GRANTOR TRUSTS

An Intentionally Defective Grantor Trust ("Defective Trust"), generally is an irrevocable trust created for the benefit of one?s children and grandchildren which is complete for gift and estate tax purposes, but "defective" for income tax purposes because the Grantor of the Trust remains responsible for the income tax burdens and consequences of the Trust. The Grantor Trust rules are set forth at Section 671 through 678 of the Internal Revenue Code ("Code"). These rules were originally designed to place the income tax burden on the Grantor of a trust when the Grantor is not the income beneficiary of the trust, but recently have been used as estate planning vehicles.

Defective Trusts are an effective estate planning tool because: (1) they allows one to "freeze" the value of assets transferred to the Defective Trust; (2) the appreciation occurs within the Trust tax free to the benefit of the children and grandchildren beneficiaries; and (3) the Grantor's ultimate estate tax burden is reduced by paying the income taxes on behalf of the Defective Trust.

First, the Grantor creates an irrevocable trust which is intentionally defective for income tax purposes by using one or more of the "Grantor Trust powers" contained in the Code. (For example, the power, in a non-fiduciary capacity, to re-quire the trust corpus by substituting a property of equivalent value, the trustee having discretionary power to spread income to the Grantor's spouse, and/or a non-adverse power having power to add beneficiaries other than after born and after adopted children) After the Trust is created, the Grantor makes a gift to the Trust for which a Gift Tax Return is required. There will be no gift taxes due from Grantor (or from the Grantor and his or her spouse) if there is an adequate unexhausted portion of the unified credit (currently $650,000, gradually phasing up to $1,000,000 in the year 2006), otherwise gift taxes will be paid with the return. The next step is a sale between the Grantor and the Defective Trust. In exchange for a deposit of approximately 10% of the sale price from the Defective Trust (presumably funded by the original gift), the Grantor transfers property to the Defective Trust and in return receives an installment note for the remaining 90% of the fair market value of the assets transferred. The interest rate should be no less than the applicable federal rate (AFR) (to avoid any gift tax ramifications or below market loans) and the duration and the manner of payment such as interest only with balloon payment, fully amortizing or partially amortizing with balloon payment, are dependent upon the cash flow needs of the Grantor which need to be seriously addressed at the outset.

There is no capital gain on transfer of appreciated assets to the Trust. In addition, interest payments to the Grantor are ignored and the Trust takes no interest deduction because for income tax purposes, it is a loan by the Grantor to an entity taxed to the Grantor. The Grantor is responsible for the payment of the income tax on the Defective Trust's dividends, interest, capital gains and any other tax consequences.

There will be a gift on the creation of the Trust when the Trust is funded, however, there should be no additional gift tax on the sale so long as the assets are properly transferred at fair market value and the interest rate is the AFR or greater. An appraisal by a qualified appraiser is normally required to determine the fair market value of the assets to avoid any partial gift if the sale price does not equate with the fair market value of the assets.

If the sale to the Defective Trust is properly structured, the only gift is the initial trust contribution which subsequently funds the down payment. Accordingly, the Grantor can allocate on a Gift Tax Return, the GST exemption based on the initial contribution. Since the remainder of the assets that come into the Trust are by way of sale and not by gift, the entire trust is eligible to be exempt from GST by allocating only the original contribution. This is one of the most attractive features of this format.

The note will be part of the Grantor's estate, however, it should be subject to a discount off of its face value because it is not investment grade and could not be sold to a third party for its face value.

Practically any type of property can be sold such as real estate, closely held stock (voting or non-voting), marketable securities, family limited partnership interests, limited liability company interests and alike. The key is that the assets are reasonably calculated to appreciate after the transfer because the installment note has the effect of freezing the value of the assets at the date of the transfer. Assets whose fair market value is subject to valuation discounts such as family limited partnership interests, closely held stocks, and fractional interest in real estate, provide greater leverage than the portfolio of marketable securities. In these instances, an appraisal is critical to set the fair market value of the assets with appropriate discounts for minority, lack of marketability and similar items. Since assets transferred to the Defective Trust will not receive a step-up in basis at the Grantor's death, highly appreciated assets are not appropriate property to be sold. Rather, low basis or moderately appreciated property is suitable.

Life Insurance Owned by Defective Trusts. Further, the Trustee can purchase life insurance on the Grantor's life and pay the premiums directly from the Trust's assets. Several commentators have recommended using an interest only balloon note when the Trustee purchases life insurance on the Grantor's life. Upon the Grantor's death, during the duration of the note, the Trustee uses the life insurance proceeds to pay off the principal. In addition to acquiring new life insurance coverage on the Grantor's life, if there is existing life insurance on the Grantor's life, the Grantor may sell or transfer the existing life insurance policy to the Defective Trust. By reason of the Grantor Trust status, the transfer should avoid the three-year survival requirement of Code Section 2035 and should be exempt from income taxation by the transfer for value rule.

Comparison to Irrevocable Life Insurance Trusts ("ILITs"). The Defective Trust owning Life Insurance on the Grantor's life has several advantages over the ILIT. First, since the transaction is an installment sale and not a gift (other than the initial deposit) there is no need for the administratively burdensome: annual Crummey letters to ensure that the premiums gifted qualify for the gift tax annual exclusion; and the accounting for the "Hanging Crummey" powers to avoid lapses of power of appointments greater than $5,000 or 5% of the trust assets. Second, GST can be easily allocated to the Trust, based only upon the initial gift to the Trust and not upon the assets sold to the Trust. This results in the filing of only one gift tax return allocating GST exemption to the Trust, as opposed to annual gift tax returns commonly used in ILITs to allocate GST exemption to the gifted amounts and not to the death benefits. Third, the Defective Trust should avoid the three year survival rule and the transfer for value rule in the case of pre-existing policies transferred to the Trust.

The legal authority for the Defective Trust, in a large part, emanates from Rev. Rul. 85-13. In this ruling, stock was sold to a Grantor Trust and the Service ruled that all of the Trust?s income tax attributes (such as deductions and credits) were reportable on the Grantor?s Income Tax Return. Specifically, the Ruling also stated that: no capital gain was recognized on the sale by the Grantor; that the trust assumed that Grantor's basis in the stock; the trust did not receive a deduction for the interest paid to the Grantor on the installment note and the Grantor did not include the installment note interest in its taxable income; the sale is not a gift to the extent that fair market value of the stock transferred does not exceed the fair market value of the note.

Illustration. Assume that Grantor has $1,000,000 of assets available to create a Defective Trust. Upon creation of the Trust, Grantor transfers $100,000 in cash to the Trust. His children and grandchildren are the beneficiaries. The Trust has one or more of the powers making it a Grantor Trust. The Grantor and the Trust then enter into an installment sale whereby the Trust buys $1,000,000 worth of assets from the Grantor in exchange for $100,000 down payment and a $900,000 promissory note. The note is interest only at the then AFR of 6.4% and its duration is for ten years when it then balloons. The Grantor files a Gift Tax Return for the $100,000 gift to the Trust and for the next ten years receives a cash flow of $57,600. The value of the note is frozen at $900,000 and remains in the Grantor?s estate. During the first year of the Trust, the Trustee purchases a $1,000,000 life insurance policy on the Grantor and pays the premium from the Trust assets. At the end of the 9th year the Grantor dies when the Trust?s assets are then worth $2,000,000; and the Grantor has cumulatively recognized $700,000 of income from the Trust and paid $280,000 income taxes. The Grantor removed $1,000,000 in appreciation from his estate and further reduced his estate by paying taxes on the dividends, interest and capital gains of the Trust during the nine-year period.

Note: With the Defective Trust, the $900,000 Note is paid from the $1,000,000 life insurance proceeds and the and the Trust retains the $2,000,000 in assets + the $100,000 excess insurance proceeds.

What are the risk factors and disadvantages?

1.   Notwithstanding Rev. Rul. 85-13, there is little specific authority directly on point whereby the courts have specifically sanctioned the sale to the Defective Grantor Trust as an estate freeze method.

2.   From the estate tax perspective, there is the risk that the IRS will argue that the trust corpus inclusive of its appreciation is inside the estate of the Grantor, upon death, because it is a deemed retention of income interest under Code Sections 2036 and 2038. The reasonable counter argument is that the payment of the interest and/or installments on the note is independent of trust income and the 10% initial down payment demonstrates that it is a true sale and not a sham. From a gift tax perspective, the IRS may deem the sale a gift to the extent that it is successful in proving that the promissory note is less than the fair market value of the assets transferred. An appraisal by a qualified appraiser should serve to substantially reduce this risk, however, there is always a subjective element to the valuation assets especially those subject to discount.

3.   During the term of the installment note, the trust assets may fluctuate and there may not be sufficient income to support the note payments. On the other hand, if the income from the trust greatly exceeds the note payments, the Grantor may be faced with too much of an income tax burden by reason of the "phantom income". If the Grantor dies before the balance of the note is paid in full, then the balance may be income with respect to decedent (IRD) resulting in the estate paying additional income tax on the note. The potential for IRD can be greatly reduced by discounting the estate tax value of the note and by reason that the estate or its beneficiaries will receive an income tax deduction for the estate taxes attributable to the IRD.

Sales to Defective Trusts are a viable estate "freeze" technique. There are gift, estate, income and generation-skipping transfer tax advantages to setting up sales to Defective Trusts. With the Trustee owning life insurance, there is considerable leverage and many advantages over the traditional ILIT. The risks and rewards need to be evaluated for each individual family situation, but it is an estate planning tool worth considering in conjunction with other planning techniques.

Not intended as legal advice.