This handout is designed to illustrate the use of an Intentionally Defective Grantor Trust (“DGT”) in an estate planning context and answer some questions you may have with regard to its use.

1.0 WHAT IS A DGT?

A defective grantor trust is a form of Irrevocable Trust. The trust is structured so that the grantor of the trust retains powers over the trust causing it to be “defective” for income tax purposes (i.e., any income earned by the trust is taxable to the grantor rather than to the trust or the trust beneficiaries). However, the trust is structured so that transfers to this trust are completed transfers for estate and gift tax purposes.

2.0 HOW IS A DGT DIFFERENT FROM OTHER TRUSTS?

2.1 Rather than being taxed to the trust or the trust’s beneficiaries, all income from the DGT will be attributed to the grantor, who is legally obligated to pay the tax attributable to the income.

2.2 The DGT is structured so that the entire value of the trust will escape estate tax inclusion at the grantor’s death.

2.3 The grantor and DGT are treated as a single entity for income tax purposes, and thus no income tax will have to be paid on the sale of property (even if appreciated) to a DGT as long as the grantor is living.

2.4 The grantor retains the power to reacquire the trust property for cash or other assets. This may allow the grantor to obtain the stepped-up basis at death on the assets transferred to the trust by reacquiring those assets before death.

3.0 HOW CAN I USE A DGT TO ACHIEVE ESTATE TAX SAVINGS?

By gifting or selling property to a DGT (see below), the grantor:

(a) Reduces his or her estate immediately through minority and marketability discounts taken on the property transferred to the DGT;

(b) Freezes the value of the property transferred to the DGT and allows all appreciation in the property to pass to the trust beneficiaries without gift or estate tax;

(c) Will make gift tax-free transfers to the trust’s beneficiaries equal to the annual income tax liability of trust;

(d) May retain control of the underlying property transferred to the DGT without causing inclusion in the grantor’s gross estate; and

(e) Has the opportunity to obtain the stepped-up basis that he would otherwise receive for holding the property until death.

4.0 WHO IS A GOOD CANDIDATE FOR A DGT?

4.1 Family Business Owners. If you would like to pass a family business to a child (rather than taking on Uncle Sam as a partner when you die), a DGT can make that possible with little or no gift or estate tax. It also allows you to retain control over the business until you die without causing inclusion of the value of the corporation in your estate.

4.2 Clients Holding Income Producing Property. If you currently hold property that produces substantial annual income, a DGT can produce substantial estate tax savings for you as well as your children (by combining with generation skipping provisions).

(a) Real Property. Income producing property is especially good property to use with a DGT because the discounts for transfers of the property to the trust are typically high.

(b) Property Expected to Appreciate. Because a transfer to a DGT effectively “freezes” the value of the property at the date of transfer, property that is likely to rise in value is an excellent candidate for a DGT.

5.0 HOW DOES A SALE TO A DGT WORK?

5.1 Transformation of Property.

(a) Closely-held Stock. If the grantor wishes to transfer stock in a closely-held corporation to the DGT, the corporation should be recapitalized into 1% voting stock and 99% nonvoting stock. This will allow the grantor to transfer the majority of the value of the corporation to the DGT without relinquishing control. If the Corporation is currently a C Corporation, an S election should be made so that all income from the Corporation passes to the DGT without an additional level of income taxation.

(b) Other Property. If the grantor holds real property or other income producing property outside a corporate entity, these assets should be contributed to a limited liability company (“LLC”). The membership units of the LLC would also need to be capitalized as voting and nonvoting stock. A family limited partnership (“FLP”) could also be used to conduct the transfer of the property to the DGT through the transfer of limited partnership interests.

5.2 Creation of DGT.

(a) An irrevocable trust would be created with all the necessary grantor trust provisions.

(b) While the grantor can simply name his or her children as beneficiaries of the DGT, it can be especially useful to give one’s children the ability to access the trust property for their needs during their lifetimes and to pass the remainder to one’s grandchildren or great-grandchildren. This allows the grantor and the grantor’s children to avoid estate tax from the assets at their respective deaths.

(c) In order to have a sale that will be recognized for tax purposes, we recommend that the grantor “seed” the DGT by making a gift to the DGT prior to the sale to provide an arm’s length down payment. This gift can be cash or other property (including nonvoting shares of the above mentioned entity).

5.3 Sale of Nonvoting Shares to DGT for Promissory Note.

(a) The nonvoting shares sold would be entitled to a discount for lack of marketability and lack of control. Depending upon the underlying property, the discounts could be between 20-50% of the fair market value of the underlying property. Thus, the face value of the promissory note payable to the grantor from the DGT would be substantially less than the value of underlying property.

(b) Because the grantor and DGT are treated as a single taxable entity for income tax purposes, the grantor would recognize no income tax on the sale as long as the note is paid in full prior to the grantor’s death.

(c) Because the shares are being sold at their appraised fair market value, no gift tax is imposed on the sale (even though the value of the underlying property is much greater).

5.4 Income Distribution from S Corp. As income is generated within the S Corp or LLC, the entity would distribute the income to its shareholders according to each shareholder’s ownership interest. Since the DGT now owns up to 99% of the S Corp, the DGT would receive 99% of the income of the entity.

5.5 Repayment of Promissory Notes. The DGT uses the income paid to it by the S Corp to repay the interest and principal due on the notes. Because the DGT receives these funds income tax-free (because the income tax is attributed solely to the grantor), the income should be more than sufficient to repay the note over 10-20 years.

5.6 Payment of Income Tax from S Corp/LLC Earnings. The grantor uses a portion of the principal and interest paid by the DGT to pay its income tax liability from the earnings of the S Corp.

5.7 Repayment of Outstanding Promissory Note. Depending upon level of income generated by the underlying property, the promissory note can be structured as either a 10 or 20 year note. Upon full repayment of the note, the note as an asset in the grantor’s estate disappears.

6.0 HOW DOES A GIFT TO A DGT DIFFER?

Not much. Instead of selling the nonvoting units to the DGT, the grantor would simply gift the nonvoting shares to the DGT. Similar to the sale, all future income tax liability from the DGT would be attributable to the grantor (and thus allow for annual gift tax-free transfers to the DGT beneficiaries), the value of the property transferred would be discounted for lack of marketability and control, and none of the transferred property would be subject to estate tax at the grantor’s death. However, a gift to a DGT that exceeds the grantor’s unified credit can cause immediate gift tax to be imposed.

7.0 WHAT IF I NO LONGER WANT TO PAY THE DGT’S INCOME TAX?

The DGT will be structured so that the grantor retains the ability to cancel the “grantor trust provisions” and cause the income tax to be apportioned to the S Corp shareholders according to ownership (i.e., 99% to DGT) thereafter. While the grantor’s right to cancel can be exercised during the term of the note or anytime thereafter, once canceled, the grantor cannot re-establish the grantor trust provision and begin recognizing the income tax liability again.

8.0 WON’T MY HEIRS LOSE THE STEPPED-UP BASIS AT MY DEATH?

8.1 Typically, the heirs of any person who dies holding appreciated property will receive a new income tax basis equal to the fair market value basis in those assets of those assets at death and will not have to recognize gain to that extent upon later sale of the property. For this reason, many clients hold their property until death. While their heirs receive the stepped-up basis, the assets are then subject to estate tax at a rate of up to 45%.

8.2 With a transfer to a DGT, the grantor’s basis in the transferred property will carry-over to the trust. If the DGT were then to sell the property to a third party, capital gain would have to be recognized. Even if this could not be avoided, the transfer to the DGT would still produce tax savings because of the great disparity between capital gain and estate tax rates (i.e., maximum 25% combined state & federal capital gains rate vs. maximum 45% estate tax rate).

8.3 However, even the loss of the stepped-up basis can be avoided where the grantor has sufficient liquidity outside the trust and the trust has assets for which it makes economic sense for the grantor to reacquire. An advantage of using a DGT is that the grantor retains the ability to replace the trust property from the DGT for other property of equivalent value. Using this power, the grantor can exercise, at some point prior to death, his or her replacement right by transferring cash or other non-appreciated assets to the DGT in exchange for the trust property. This exchange is completed at the then fair market value of the trust property, so the grantor has effectively removed all appreciation in the property from his or her estate. Then when the grantor dies, the property reclaimed from the trust will receive a stepped-up basis equal to its fair market value.

9.0 HOW IS THIS DIFFERENT FROM A GRAT?

9.1 Grantor Retained Annuity Trust (“GRAT”). A GRAT is an irrevocable trust whereby the grantor transfers property to the GRAT in exchange for the right to receive fixed annuity payments from the trust for a specified period of time. At the end of the retained term, the trust’s beneficiaries own the trust property and the trust property is not subject to estate tax upon the grantor’s death.

9.2 Sale to a DGT vs. a GRAT. While both provide for a fixed sum to be paid to the grantor in exchange for the transfer of property (i.e., as promissory note payments vs. annuity payments), there are several important differences between a sale to a DGT and a GRAT:

(a) With a GRAT, death during the repayment term causes the entire value of the trust property (including appreciation) to be subject to estate tax in the grantor’s estate. With a sale to a DGT, only the outstanding principal balance on the note is included in the grantor’s estate. Thus, if the grantor does not survive the term, a defective grantor trust will achieve a far superior estate tax result.

(b) With a GRAT, the grantor will have made a “gift” of the remainder interest passing to the trust beneficiaries at the conclusion of the retained term. Because the sale to the DGT occurs at full fair market value, there is no gift associated with the sale and no gift tax is imposed.

(c) With a GRAT, the rate of the annuity payment is set artificially high by statute. By structuring the promissory note correctly with a sale to a DGT, the interest rate charged to the DGT can be less.

(d) With a GRAT, the grantor cannot allocate his GST exemption to the trust property until the end of the retained term, and then must allocate at its then fair market value (including appreciation). In contrast, because no gift is being made on the sale to the DGT, no GST exemption must be used with respect to the amount of the sale and the entire trust may be made exempt from generation skipping transfer tax through a modest use of the grantor’s GST exemption. This allows the transfer to skip several generations and save estate taxes at the death of the grantor and the grantor’s children.

10.0 WHAT ARE THE POSSIBLE DISADVANTAGES TO USING A DGT?

10.1 The IRS could argue that either the payment of the income tax liability of the trust is a “gift” by the grantor or that the sale to the DGT will cause gain to be recognized by the grantor. However, we believe it is more likely than not that the IRS would lose such arguments and the IRS has basically conceded the invalidity of these arguments in recent private letter rulings.

10.2 The IRS could argue that sale is actually a “gift” under the retained interest section of the Code or that death during the term should cause estate tax inclusion. However, as long as the sale is structured as a transfer for full fair market value, is not dependent on the income from the property, and appropriate funds are “seeded” into the DGT prior to the sale, this argument likely can be avoided. The IRS recently conceded this point in private rulings as well.

10.3 An unexpected death prior to the note being paid in full may result in gain being recognized for income tax purposes. The IRS may argue that under the installment method, the balance of the payments due under the note must be recognized as income upon the death of the grantor. In this case, the income tax basis of the property held in the DGT would presumably be increased to the extent of income tax paid by the grantor. However, the law in this area is unclear and we believe that there is a good argument that the grantor’s death produces no income tax consequences. This tax cost could be offset through the purchase of term life insurance.

10.4 If the IRS determines that the minority and marketability discount taken on the non-voting interests transferred to the DGT, or the value of underlying property, were incorrectly calculated, the IRS could argue that a portion or all of the DGT property would be included in your estate and/or that an additional gift (of up to the amount of the transfer) was made when the original transfer occurred. For this reason, it is imperative to obtain an accurate appraisal from a qualified professional appraiser of the underlying property and the non-voting interests transferred to the DGT. To further prevent this problem, the trust documents should be carefully drafted with a “revaluation” clause whereby the amount of the transfer could be later amended to more accurately reflect the value of the property. However, the IRS has not ruled specifically on the validity of such a provision. For this reason, as stated, it is imperative to obtain accurate qualified appraisals of the property at the time of the original transfer.

Clay R. Stevens © 2010