n tumultuous economic times, intentionally
defective irrevocable trusts (IDITs) offer taxpayers a
powerful triple play: an estate-freeze and wealth-transfer
technique, as well as an estate planning opportunity—despite
terrorism, the market’s vagaries and recent estate tax
legislation. CPAs should become become familiar with IDITs
to help eligible clients preserve wealth.
WHAT IS AN IDIT?
IDIT is an irrevocable trust; it takes advantage of a
disparity between the income and estate tax treatments
offered certain trusts under IRC sections 674 and 675.
Because an IDIT is deemed a grantor trust for income tax
purposes, the trust grantor reports the trust’s income
annually; however, the trust assets are not includable in
the grantor’s estate for estate tax purposes. A grantor can
sell appreciating assets to an IDIT in exchange for a note,
“freezing” the value of his or her estate and transferring
wealth by converting an appreciating asset into a
fixed-yield asset (for example, an interest-bearing note).
HOW DOES IT WORK?
grantor “seeds” an IDIT with cash or property that creates a
taxable gift. He or she then sells an asset to the IDIT for
an installment note. Under regulations section 1.1001-2(c),
example 5 (see also revenue ruling 85-13 and Madorin
, 84 TC 667 (1985)), the grantor does not recognize
gain or loss on a sale of an asset to the IDIT. Similarly,
the grantor pays no tax on the interest payments received on
the note, but pays tax on all of the trust’s income. If the
grantor dies during the note’s term, the IRS might argue
that under Madorin the gain should be recognized.
However, the grantor’s estate may be able to defer the gain
under the section 453 installment-sale rules, until the note
is fully paid off (see Sun First Nat’l Bank of Orlando,
607 F2d 1347 (Ct. Cl. 1979)).
With an IDIT, a
grantor can discount assets transferred or sold due to lack
of marketability or a minority interest, reducing their fair
market value, the taxable gift and the promissory note.
Grantors should carefully choose the assets to be sold to
maximize the wealth-transfer opportunity.
Despite the anticipated steady
decline in estate tax rates, the estate tax will return in
2011. Even though high-net-worth taxpayers hope for
permanent tax repeal, this seems unlikely. The uncertainty
of repeal, coupled with the turbulent times, however, make
an IDIT a viable estate planning tool. For example, a
grantor can benefit from low asset valuations and interest
rates. He or she needs a smaller amount of seed money, thus
reducing gift tax. Because low interest rates cap annual
interest payments on a promissory note, the grantor can
manage cash flow better until the note matures.
consideration of all the possibilities makes an IDIT an
appealing estate planning tool and can give taxpayers
experiencing difficult economic times realistic expectations
of the results to be achieved. With IDITs, CPAs can help
clients weather the economic storm.
information, see the column, Personal Financial Planning, by
Alev Lewis, in the January 2003 issue of The Tax
—Lesli Laffie, editor
The Tax Adviser
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