A favorite estate planning transaction used by many sophisticated estate planning attorneys across the country involves the use of an “intentionally defective grantor trust” (IDGT). The “grantor trust” rules of the Internal Revenue Code instruct that a grantor trust is not taxed as an entity separate from the grantor (the person creating the trust) and that the assets transferred to a grantor trust still belong to the grantor for income tax purposes. The result of transferring assets to a trust that qualifies as a grantor trust is that the person has not made a transfer for income tax purposes. Many estate planning attorneys use the grantor trust rules to their advantage and they carefully draft a trust that is “intentionally” drafted to qualify as a grantor trust for income tax purposes, yet the carefully drafted trust can also be treated as a completed transfer for the gift tax and estate tax. Therefore by using an IDGT and transferring appreciated assets to a trust a person can shift the value of the asset from his or her taxable estate for estate tax purposes while at the same time the transfer will not count as a taxable transfer for income tax purposes that could trigger capital gains.
The Obama Administration’s revenue proposal for 2013 recommends a change to the long-standing grantor trust rules. The proposal would require more consistent treatment of transfers to a grantor trust and would eliminate the powerful estate tax planning that can be accomplished using the IDGT. The proposal would include assets in a grantor trust in the grantor’s taxable estate and would therefore take away the advantage described above. The proposal does not purport to affect grantor retained annuity trusts, qualified personal residence trusts, and grantor retained income trusts.
It is possible that a grantor trust created and funded prior to a change in the law could be “grandfathered” into existing law. This could bring some great advantage to someone willing to establish an IDGT under current law and fund that trust with sufficient assets this year in order to hedge against any possible changes to the law.
Luckily, this is only a proposed change in the law that is presented by the Department of the Treasury and hopefully this proposal will never make it into our legislative system. We will be watching this topic carefully and we hope that the favorable laws that apply to IDGTs can continue on for many more of our clients and that the IDGT will not become an estate planning endangered species.
Attorney Jason Walker