Defective Grantor Trust

INTENTIONALLY DEFECTIVE GRANTOR TRUSTS PROTECT ASSETS FROM ESTATE AND GIFT TAXES

Highlights

  • Cummins & White, LLP developed a plan to help the owner of a successful business protect more than $30 million from estate and gift taxes by creating Intentionally Defective Grantor Trusts.
  • Based on its expertise in estate, gift, and income tax law, the firm created separate trusts—one for each of the owner’s children. This strategy allowed money to be moved out of the owner’s taxable estate and transferred gains to the heirs tax-free.

Attorneys

Case Study

Cummins & White, LLP provided assistance to the owner of a multi-million dollar business when she created Intentionally Defective Grantor Trusts for her children as a way to protect her assets from estate and gift tax upon her death.

Background

The proprietor of a mid-size manufacturing and development firm wanted to ensure that the family business would be passed to the children, and ultimately grandchildren without leaving these heirs with a sizeable tax bill.

The challenge was that the value of the business, combined with other components, was significant—close to $50 million—and that at the death of the first generation, the estate would be liable for millions of dollars in estate tax (the federal estate tax affects individual estates worth more than $3.5 million at a rate of 45%). Without proper planning, the estate would have been forced to liquidate business assets in order to pay the tax bill.

Legal Strategy

Cummins & White, developed a strategy whereby the client transferred approximately $30 million in business assets to the children (and ultimately, grandchildren) without incurring significant estate and gift tax, thereby preventing a fire sale of the business following the death of the business owner.

The Cummins & White estate planning team created Intentionally Defective Grantor Trusts, otherwise known as “IDGTs,” for each of the owner’s children. Intentionally Defective Grantor Trusts can be structured in many ways and save heirs significant estate tax. In this instance, the firm implemented a plan whereby the client loaned money to each of the trusts to buy shares of the family business (lump sum transactions). Each trust agreed to pay for the shares over 10 years, with interest payments due each year, as well as a balloon payment of principal and interest due at the end.

For income tax purposes, the transfers are considered incomplete—there was no reportable gain on the transfer of the shares to each of the trusts because the client is still considered the owner of the trusts. As dividend payments from the company are made to the trusts, the client pays income taxes due upon distribution of the dividends, the size of the taxable estate is reduced, and the benefit of this reduction is passed to the heirs without incurring any gift tax liability.

For estate and gift tax purposes, the sale of shares to each IDGT is considered complete—the value of any appreciation in the shares is not included in the taxable estate upon the client’s passing. Also, because the “sales” were considered “arms length transactions,” based upon paying appraised value, the “sales” did not count as taxable gifts, avoiding use of the $1 million lifetime gift allowance.

Result/Implication

The end result of each transaction was the freezing of the taxable estate at its present value, thereby reducing estate tax, and the transfer of capital appreciation free from gift tax. By choosing this strategy, the owner was able to transfer the family business to the children in a tax efficient manner and prevent the liquidation of the family business upon the client’s death.

According to Robert Lamm, counsel for Cummins & White, people who are looking for high-end estate planning are growing more familiar with Intentionally Defective Grantor Trusts and other types of estate freezing techniques, such as the transfer of assets to Grantor Retained Annuity Trusts. “Our client wanted to keep the business in the family,” Mr. Lamm said. “People who have spent a lifetime building their business want their children to share in that success. Without a well thought out and executed estate plan, estate taxes would be due, and in many instances, the heirs would need to either obtain a loan or liquidate the business in order to pay the tax bill. People don’t want to liquidate their businesses just to pay taxes. This type of transfer helps families retain ownership.”