Although the IDIOT Trust® can be a valuable estate planning technique, it will not provide the desired effect in all circumstances. First and foremost, for the technique to work, the assets sold to an IDIOT Trust® must be reasonably expected to appreciate (in terms of both income and capital growth) at more than the AFR, which is the measure used to compute the interest rate on the promissory note. Otherwise, neither an IDIOT Trust® nor any other estate freezing technique makes sense.
Second, although the IDIOT Trust® does generate an interest income stream back to the seller-grantor, those persons who will likely need all of the income from their assets for a prolonged period should consider alternative methods of planning. The interest payments from the IDIOT Trust® are generally less than the actual income stream from the assets. The interest income stream may also end at some point, if the note is paid off during the seller-grantor’s lifetime. If the interest income stream does end, the seller-grantor either must be able to replace the lost income, or have no need for that income.
Third, life insurance is an integral part of the IDIOT Trust® design, and individuals who are extremely elderly or not in good health -and so are subject to higher premiums for coverage - should be careful to avoid having the full premiums paid from the trust. Although the cost of life insurance increases with age or ill health, much of the negative impact of higher premiums on an IDIOT Trust® can be mitigated by using a split-dollar life insurance plan between the trust and another entity or individual.9
Fourth, if there is a risk that the assets sold to the IDIOT Trust® will not generate enough income to make the interest payments to the seller-grantor, this strategy may not be as effective. If insufficient income is being generated, the trustee of the IDIOT Trust® will have to return some of the trust assets to the seller-grantor to satisfy the promissory note’s interest payment requirement. Assuming these assets are appreciating, the technique will still be advantageous, but not as advantageous as if there were sufficient income to pay interest. The reason is that not all of the appreciating trust assets will be required to be returned to the seller-grantor in lieu of interest payments, and thus some value will remain in the trust. (Paying interest "in kind" is called a "leaky" freeze.)
Specifics of The Strategy
To put the IDIOT Trust® strategy to work, an individual first makes a "seed money" gift to the trust, as noted above. Many practitioners think that this gift should be at least 10% of the (discounted) sales price of the property that will be sold to the trust. After making the gift, the grantor sells appreciating assets to the trust in return for a promissory note, which pays interest back to the seller-grantor at the AFR, with a balloon principal payment due at the end of the term of the note. Only the note will be included in the seller-grantor’s estate, and all post-sale appreciation will be immediately excludable from the estate.
As stated previously, because the trust is a grantor trust, the current IRS position is that no capital gain is recognized from the sale, and the seller-grantor’s basis carries over to the trust. Furthermore, interest on the note is not taxable to the seller-grantor, nor deductible by the trust.
Although the seed-money gift is subject to gift tax, the assets sold are not, as their sale to the trust is assumed to be a bona fide sale for adequate and full consideration. Gift tax annual exclusions and unified credit can be used to exempt at least a portion of the seed money gift from gift taxes, although it may inadvisable to use annual exclusions for the one-time gift contemplated by the IDIOT Trust® technique.10 Assuming annual exclusions are used elsewhere, the IDIOT Trust® does not have to contain "Crummey" withdrawal powers, avoiding their complexities and uncertainties.
In addition, the $1 million generation-skipping transfer tax (GSTT) exemption can be used to exempt the trust from generation-skipping transfer tax for gifts up to this amount. Again, the GSTT exemption need be allocated only against the seed-money gift. This allows the trust to be multi-generational (a "Dynasty" trust).
Gift-splitting is also allowed. This means that married couples can apply both spouses’ applicable gift tax annual exclusions (if used), unified credits, and GSTT exemptions to the gift, effectively doubling the amount of the tax-free gift.
The property sold to the IDIOT Trust® can be almost any kind of property, including S corporation, C corporation, or publicly traded stock, a partnership or limited liability company interest, and real estate. A key characteristic of the property is that it should have the potential for future appreciation, in excess of the note interest, which will be frozen out of the seller-grantor’s estate.
The IDIOT Trust® then purchases individual life insurance on the seller-grantor’s life (or survivorship insurance on the lives of the seller-grantor and spouse). Further transfer tax "leverage" can be achieved by using a split-dollar life insurance plan. However, the insurance can also be ledger (or non-split-dollar), depending on trust cash flows.
At the seller-grantor’s death, only the note (plus any accumulated interest) will be included in his estate, and all post-sale property appreciation will be excluded from the estate. In addition, the seller-grantor’s payment of income taxes on the IDIOT Trust® income (which is permissible without being subject to gift tax because the trust is a grantor trust) further reduces his estate.11
The IDIOT Trust® then applies the insurance proceeds that it receives to repay the note, if it is not paid off during the seller-grantor’s life. (If the note is paid off during the seller-grantor’s life, the insurance proceeds can be used to replace, or "cost recover," the trust assets expended to repay the note, plus perhaps cost of money or appreciation forgone on those assets.) Using the insurance proceeds allows the trust to pay off the note without having to sell assets to generate the necessary cash. This is an important factor, because the trust assets are typically low-basis - resulting from the carryover of the seller-grantor’s basis to the trust - and will have appreciated substantially in value. Thus, the insurance not only funds payment of the note, but it also avoids triggering taxation of the built-in gains had the trust assets been sold to pay the note. Any additional insurance proceeds can be injected into the estate in the usual way, by the trust purchasing assets from the estate or making loans to it. The estate then uses the cash that it receives from the IDIOT Trust® to pay estate taxes and to fund other estate liquidity needs.
In addition, payment of the note can be deferred until the death of the seller-grantor’s surviving spouse, if desired. This allows for funding the note payment with less costly survivorship life insurance, either split-dollar or ledger. Furthermore, the note is an excellent asset to transfer to a marital trust for the benefit of the surviving spouse because it provides the surviving spouse with a lifetime income, without appreciating in his estate.
Although life insurance is central to the IDIOT Trust® technique, some of the same estate planning advantages can be achieved through the use of an Intentionally Defective Irrevocable Trust (IDIT), which is an uninsured IDIOT Trust®. The author feels, however, that combining either individual or survivorship life insurance with this technique maximizes the transfer tax leverage.Income Tax Considerations During the Life of the Seller-Grantor
The IDIOT Trust® is a "grantor" trust under the Internal Revenue Code.12 A grantor trust is one in which certain powers exist that cause all of the income of the trust to be taxable to the seller-grantor, rather than to the trust itself. It is therefore possible for a seller-grantor to be taxed on income, including capital gain income, that he never receives.
While it is usually not the best idea to be taxed on income that one does not receive, there are estate and gift tax advantages to this result. When the seller-grantor pays the income tax on trust income, he is effectively making a gift of the tax paid to the trust beneficiaries, and lowering his own taxable estate, without suffering any gift or estate tax penalty.
Example. Trust income is $100 and the resulting income tax is $40. If the grantor pays this $40 tax, in effect he has made a gift of the $40 to the trust beneficiaries (the trust income remains at $100) and reduced his estate by the same amount. The result is that the seller-grantor’s estate is reduced by the amount of income taxes paid on trust income, but the seller-grantor is not treated as having made a gift of these amounts.
Why are the seller-grantor’s income tax payments not taxable as gifts? Because the seller-grantor is merely complying with the terms of the income tax law, i.e., he is not paying tax on income taxable to the trust or its beneficiaries, but satisfying his own legal tax obligation. The IRS purportedly does not like this result.13 However, most tax professionals agree that despite IRS reluctance to accept this concept, the law is clear that no gift is made when the grantor pays income tax on grantor trust income.14
In the context of the IDIOT Trust® technique, grantor trust status is crucial because of the current IRS position that no gain is recognized by a grantor who sells property to a grantor trust. The rationale for this position is that the seller-grantor is in effect selling to himself, which is not a taxable event. While the IDIOT Trust® is "defective" for income tax purposes, it is "effective" for estate tax purposes, with the result that all post-sale appreciation in the value of the property sold to the trust is excluded from the seller’s estate. It is these features that make the IDIOT Trust® work so effectively.
The grantor-trust nature of the IDIOT Trust® also offers another potential advantage. The trust can be drafted to allow the seller-grantor to "buy back" the assets held in trust at any time, although the seller should have no legal right to repurchase these assets because that could result in adverse estate tax consequences.
Example. A seller-grantor would like to make a sale or gift of income-producing real estate to the trust, but would like the opportunity, prior to the expiration of the trust’s term, to buy the property back at its then-fair market value. When the buy-back occurs, even if the purchase price is in excess of the trust’s basis in the property, there is no taxable gain recognized.
The reason for nonrecognition of gain is that under the grantor trust rules, the seller-grantor is considered to be buying back the property back from himself. As in the sale to the trust, one does not have to pay income taxes when buying something from (or selling something to) oneself. Thus, a seller-grantor can sell or give property to a grantor trust for a period of time and buy it back (at current fair market value) with no income tax consequence.
An advantage of such a buy-back is that the repurchased property will receive a step-up in basis at the seller-grantor’s death because it will be included in his estate. However, once the assets are back in the seller-grantor’s estate, they will continue to appreciate and add to that estate for estate tax purposes. This creates a "leaky" freeze, and wholly or partially defeats the purpose of the IDIOT Trust® transaction in the first place.Income Tax Considerations at the Death of the Seller-Grantor
One of the inherent risks in using an IDIOT Trust® is that the seller-grantor may die during the term of the promissory note. In fact, the estate freeze effect will be maximized if the note is outstanding at death and the seller is not repaid during his or her lifetime.
If death occurs while the note is outstanding, an argument can be made when the trust subsequently pays the balloon principal payment to the seller-grantor’s estate that this payment creates income in respect of a decedent (IRD).15 The result is that the payment is both income and estate taxable, with an offsetting deduction for the estate tax against the income tax. There are also respectable arguments that this payment is not IRD.16
Even if IRD, the amount in question is confined to the face amount of the promissory note, and all of the post-sale appreciation escapes taxation in the seller-grantor’s estate. Moreover, the trust may receive a step-up in basis for the assets purchased,17 and the insurance proceeds received by the estate on payment of the note can also be applied to pay any income tax generated, as well as the estate tax on the note. This is another advantage of using life insurance with the IDIOT Trust® technique.Trustees
To avoid estate tax problems, the seller-grantor should not serve as a trustee of an IDIOT Trust®, nor should he have the right to appoint and remove trustees. In a properly drafted IDIOT Trust®, anyone other than the grantor can act as trustee, as long as he is not a minor or otherwise legally incapacitated. This includes the grantor’s child or children, or spouse (assuming the spouse is not also a grantor of the trust). In order for a seller-grantor to preserve control of a business entity, he should transfer a nonvoting interest in the entity to the trust, rather than act as trustee.Protection from Creditors
Assets that are sold or given to an IDIOT Trust® have been irrevocably parted with; even though a seller-grantor owns the trust’s promissory note, he no longer owns the assets transferred. If, after the sale or gift is made, the seller-grantor has creditor problems, the assets that he sold or gave to the trust cannot, absent fraud, be taken by creditors. However, creditors can reach the note itself.
With respect to the beneficiaries of an IDIOT Trust®, generally, so long as the assets remain in trust, the beneficiaries have creditor protection (assuming an adequate spendthrift provision in the trust document). However, income or principal that is actually paid out of the trust to the beneficiaries is subject to the claims of their creditors.GSTT Considerations
The IDIOT Trust® is an excellent candidate for use of the GSTT exemption. The law allows a seller-grantor to immediately allocate, to the seed money gift only, his $1 million GSTT exemption ($2 million for spouses who gift-split). All of the assets subsequently sold to the trust are not subject to the GSTT because they are the product of a bona fide sale for adequate and full consideration. Thus, the entire trust can be exempted from the GSTT at the outset, assuming sufficient GSTT exemptions to allocate to the seed money gift. This characteristic of the IDIOT Trust® is what makes it so suited to multigenerational, Dynasty trust planning.Planning Risks and Detriments
An estate tax risk occurs in using an IDIOT Trust® if the seller-grantor dies during the term of the promissory note. The IRS could argue that the sale of the property to the trust was in effect the retention of an income interest in the property transferred to the trust. This argument, if successful, would result in inclusion of the trust property (not just the note) in the seller-grantor’s estate at his death. It could also result in a taxable gift at the time of the sale.
A proposed solution to this problem is to ensure that (1) payment of the note interest is not in any way tied to or dependent on trust income (the appreciating trust assets themselves can be used to pay interest in kind, if necessary); and (2) the seed money gift is substantial in relation to the sales price, generally at least 10% of the sales price. These steps should rebut the argument that the seller is relying only on the property sold for his interest income payments and therefore has retained an income interest in that property. Of course, the trust’s promissory note should be bona fide, and interest should be paid at the AFR in accordance with the terms of the note. In addition, a qualified appraiser should value the property to be sold so that the purchase price equals the property’s fair market value.
As stated above, the trust’s payment of the balloon principal payment to the seller-grantor’s estate at his death may be both income and estate taxable as IRD. However, even if it is IRD, the insurance proceeds received by the seller’s estate in payment of the note can be applied to these taxes.
A further danger is that the assets held in the IDIOT Trust® may not produce sufficient income to support the interest payments. If this occurs, the interest can be paid in kind from the appreciating trust assets themselves. This is not as effective an estate freeze as having trust income adequate to pay interest. Any assets that are returned to the seller-grantor immediately begin to appreciate in his estate, again inflating the estate tax value. However, as long as the assets remaining in the trust are appreciating in value, payment of interest in kind will not exhaust trust assets. Even such a partial or leaky freeze will save some estate taxes.
Yet another problem can occur if the IDIOT Trust® produces income in excess of the required interest payment amount, and the seller-grantor reports this phantom income on his income tax return. While this result is good from an estate planning perspective - the trust beneficiaries will get more assets and the seller-grantor’s estate will be reduced at no gift tax cost - it may present an obstacle to some clients. There are measures for dealing with this issue if the grantor does not want to pay the income tax on trust income.
Those who are older or not in good health should carefully consider whether to use this strategy because life insurance is an integral part of this plan, and the cost of life insurance increases with age or ill health. However, much of the negative impact of higher premiums on the IDIOT Trust® technique can be mitigated through the use of a split-dollar life insurance plan.Conclusion
While the IDIOT Trust® estate planning technique, like other planning strategies, is not effective for all situations, it should be seriously considered by individuals with highly appreciating assets that they want to pass on to their beneficiaries without incurring large gift or estate tax liabilities. By using insurance, the IDIOT Trust® technique also provides the trust with funds to repay the note (or to recover the cost of repayment) and the grantor’s estate with liquidity to pay taxes and other estate costs that arise at the grantor’s death.
Nothing contained in this article is to be considered as the giving
of tax, legal, accounting, or investment advice. Each reader is
responsible for consulting with his own tax advisors, lawyers,
accountants, and investment advisors concerning the validity or
applicability of the technique or techniques presented.
of Asset Protection - Volume 4 Number 3 - January/February
We do not express any opinion on the investment, legal, or tax consequences of this plan, and you are responsible for consulting your own investment advisors, legal counsel, and accountants for all such advice.
Weinberg Group Inc.
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