For clients who are high-net-worth entrepreneurs, continued growth and success in their business is, of course, a good thing – but not always when it comes to estate taxes.

An increasingly popular strategy for advisers to help their HNW clients manage this issue is something known as the intentionally defective grantor trust. This unique type of structure allows the income of a trust to be the client’s for income tax purposes, while the assets of the trust are excluded from the estate.

In other words, the trust is effective for estate taxes, but defective for income taxes.

The fact that the trust is defective for income tax purposes is a positive, as it means the client can pay all of the IDGT’s income tax bills, without being deemed a gift, and can sell the family business to the IDGT in exchange for an interest-only installment note. This can be done without triggering capital gains taxes, because the client is effectively selling the business to themselves.

Thus, the client has transmuted their assets from a potentially high-return, high-growth family business into a low-yield bond.

The opportunity for estate tax savings in using an IDGT is significant in the long run, simply for the ability of a successful family business to out-earn and outgrow today’s ultra-low-interest-rate environment. In fact, an IDGT is often designed to be a multi-generational dynasty trust, or in states where it is permissible, a perpetuity trust, to ensure its assets continue to grow outside of any estate tax exposure for the indefinite future.

HOW IT WORKS

Let’s take a look at an example. Say a client is the founding owner of a business that’s worth $20 million, and generates about $1.5 million to $2 million per year in profit distributions. As a result, the client has a significant estate tax problem, which will only get worse as the business distributes ongoing profits.

The client could gift about 25% of the business to family members or an irrevocable trust, eliminating that portion of the business value and its subsequent growth from his estate, but he’d still be stuck with the other 75%.

Instead, the client could sell the business to the IDGT, in exchange for a promissory note from the trust that agrees to make interest-only payments of 2% per year for the next 15 years, followed by a balloon payment of the principal. At this interest rate, the trust will only need to make interest payments of $400,000 per year, which is easily covered by the available cash from the business’ profit distributions.

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The opportunity for estate tax savings in using an IDGT is significant in the long run, simply for the ability of a successful family business to out-earn and outgrow today’s ultra-low-interest-rate environment.

Immediately after the transaction, the client’s net worth and estate tax exposure have not changed. He’s simply swapped from a family business worth $20 million to a promissory note worth $20 million. Because he sold the business to himself for income tax purposes, there are no capital gains taxes due on the transaction, and the cost basis of the business simply carries over into the trust.

However, going forward, the promissory note will grow by its simple 2% yield, while the business is already producing almost four times that amount of cash flow, plus the potential for the business to appreciate further.

For instance, if at the end of the first year, the business appreciated to $21 million, plus generated profits of $1.5 million, and then paid out $400,000 in interest, its value would be up to $22.1 million.

By contrast, the client’s estate would still be worth $20 million, plus the $400,000 of interest, but reduced by the income tax liabilities it must pay. The end result is that the trust’s value finishes at over $22 million, while the client’s estate will be slightly lower than $20 million, producing a $2 million shift in value to the trust – and outside the client’s estate. At a 40% top estate tax rate, that’s an $800,000 savings.

Notably, the client was able to push not just the growth on 25% of the business out of his estate, but the growth on 100% of the business.

IRS SCRUTINY
It is perhaps not surprising that, given the substantial potential estate tax savings available with an installment-sale-to-IDGT strategy, the IRS will scrutinize the transaction to affirm it is a legitimate sale and not merely an indirect gift of the business to the trust.

The first requirement for an IDGT to be respected is that the promissory note itself must use a legitimate and not below-market interest rate, even though the client may have the power to borrow from the trust later at a below-market interest rate, in order to trigger grantor trust status in the first place.

Under IRC Section 7872, a below-market-rate loan is defined as one that fails to use the published applicable federal rates (AFR) of IRC Section 1274. Fortunately, though, given the overall low-interest-rate environment today, the required AFR to include with the promissory is still extremely low. Even for long-term loans that will extend more than nine years, the AFR is a mere 1.90% (as of August 2016). This provides a rather easy total-return hurdle rate that the assets sold to the IDGT need to clear.

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Given the substantial potential estate tax savings available with an installment-sale-to-IDGT strategy, the IRS will scrutinize the transaction.

The second requirement is that, in order for the IRS to respect the sales transaction, the IDGT itself should already have some liquid assets. After all, who would realistically sell their business to a third party that has no income and no assets, and makes no down payment?

Accordingly, it’s common practice to seed at least 10% of the expected purchase price into the IDGT as a separate gift before the sale transaction occurs. The assets aren’t necessarily used for a down payment, but they at least help secure the ability of the IDGT to make the initial installment note payments, until the business transferred into the IDGT can generate enough cash flow to pay its own way from there.

Notably, this requirement to seed the trust with some assets, in order to be able to substantiate the subsequent installment note sale, means the grantor will still end up using at least some portion of the lifetime gift-tax exemption. Still, given a need to seed just 10% of the targeted purchase price, this means the owner of a $20 million business would simply need to gift $2 million to the trust to do the subsequent installment sale to the IDGT that removes the growth from all $20 million.

In practice, the $2 million gift will typically be done with cash or otherwise reasonably liquid assets, to further substantiate that the trust really has the means to make payments on the installment note.

Third, the valuation of the business itself (or whatever is being sold to the IDGT) should otherwise be reasonable and substantiated.

If the sale-to-IDGT transaction is not for the full value of the business, the IRS may recharacterize the transaction as being part sale and part gift, which can accidentally absorb most or all of the client’s remaining gift-tax exemption, or even trigger a taxable gift for the excess. However, bona fide valuation discounts – including for lack of control and lack of marketability – may still be considered.

It’s worth it to note that recently proposed Treasury Regulations to crack down on a wide range of discounts on family partnerships and other intra-family transactions could soon end such valuation discounts, including in most sale-to-IDGT transactions.

THE BAD NEWS
For clients who actually do want to remove not just the growth on the business asset, but also the value of the asset itself, it’s also possible to use a self-cancelling installment note. The significance of a SCIN is that, when the client dies, the remaining value of the note goes to $0.

The bad news is that, with a SCIN, the required payments from the IDGT back to the client will be higher (or the purchase price should be higher in the first place), as an objectively valued SCIN should offer larger payments to compensate for the risk that the value goes to $0 when the client dies.

The good news, however, is that, because the SCIN’s value is reduced to zero at the grantor’s death, the entire value is eliminated from the estate. To ensure that the SCIN is respected, though, the grantor must actually be in reasonable health, such that the SCIN and its payments are legitimately valued given their uncertainty.

Doing an IDGT sale for a SCIN with a client who was already in poor health and expected to die within a year or two would rapidly evaporate significant value from the estate, but it would not likely be honored by the IRS.

POTENTIAL ELIMINATION?
While the IDGT strategy and its legitimacy are now well-established, it is nonetheless a strategy that the IRS and Treasury are concerned about. This is because, again, it does effectively allow high-net-worth individuals to “magically” transmute their stocks (e.g., businesses or actual portfolio stock investments) into low-rate, fixed-yield bonds, shifting all the equity growth to occur outside of the estate, at a tax cost of zero.

There have been attempts to crack down on this practice in the past. In 2012, President Obama’s budget proposals included a recommendation that would automatically treat any trust that was a grantor trust for income tax purposes as part of the grantor’s estate.

Ultimately, the proposal was not implemented – in part because such a wide-reaching provision would adversely impact a number of other non-abusive grantor trusts. A modified version of the proposal has continued to come up in the president’s budget proposals, emphasizing that this is a strategy on Washington’s radar screen.

Until a crackdown is implemented, however – which in all likelihood would only be forward-looking and not retroactive – the IDGT strategy remains legitimate, as long as its rules are respected.

For the time being, the strategy can be further leveraged by obtaining a valuation discount (whether for a family business, or forming a family limited partnership in order to obtain such a discount), though, again, the days for discounts on family entities are likely numbered and may be gone by sometime in 2017.

Notably, because the long-term value is really for the future growth to shift out of the client’s estate and into the IDGT, the sale-to-IDGT approach will remain effective even without valuation discounts. This will be the case as long as there’s a lengthy time horizon to compound, and especially when low interest rates can be locked into the promissory note.

Michael Kitces

Michael Kitces

Michael Kitces, CFP, a Financial Planning contributing writer, is a partner and director of wealth management at Pinnacle Advisory Group in Columbia, Maryland; co-founder of the XY Planning Network; and publisher of the planning blog Nerd’s Eye View. Follow him on Twitter at @MichaelKitces.