Intentionally Defective Irrevocable

An Intentionally Defective Irrevocable Trust (IDIT) is a trust that contains certain provisions set forth in the Internal Revenue Code, which imputes the income to the Grantor as the creator of the trust, but excludes the trust assets from the Grantor’s estate for estate tax purposes. In other words, as trust maker the Grantor must pay the income tax on all trust income, but trust assets will not be subject to estate tax at the Grantor’s death. An effect of the Grantor paying the income tax is to further leverage the transfer to the Grantor’s beneficiaries at no additional gift tax cost.

Grantor trusts are useful planning tools in several circumstances, particularly where it is desired to sell appreciated assets to the trust without incurring income tax. Under the Internal Revenue Code, when you sell an asset you must pay income tax on the amount above your “basis” in the property. In its most simplified sense, basis is the amount you paid for an asset when you purchased it, or if you received it by gift, it is the donor’s basis in the property.

A typical sale of appreciated property causes imposition of income tax. However, a grantor trust is treated “as you” for income tax purposes. Since you cannot “sell” property to yourself, a sale to a grantor trust is ignored for income tax purposes. After the sale, the trust will have as its basis the amount it pays for the property.

Significantly, the sale must be for full fair market value – a sale for less than full market value will be treated as part sale, part gift. How does the trust obtain the ability to purchase the assets? One way to accomplish this is by making a gift to the trust followed by the trust purchasing assets using an interest-bearing promissory note (with terms similar to a financing transaction with a third-party lender), using the minimum interest rate established by the IRS. Another method is for beneficiaries to guarantee the payments in a commercially reasonable manner.

Advantages

  • Value of IDIT assets are not included in grantor’s estate at death and often are not subject to generation skipping transfer taxes
  • Assets in trust grow income tax free because grantor pays income taxes
  • To provide leveraged transfers to beneficiaries in an asset protected manner (the leverage occurs by the Grantor’s payment of the trust income tax)
  • To provide a vehicle to purchase your assets without incurring income tax
  • To reduce estate taxes
  • Can use the lower §1274 Rate (Rather than §7520 Rate)

Disadvantages

  • Grantor pays income taxes on income earned by the IDIT
  • For information on how to get started on your estate plan visit our Estate Planning Process page.
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