Sales to Grantor Trusts
In a Sale to a Grantor Trust, a client sells property to a grantor trust (known as an Intentionally Defective Grantor Trust, or “IDGT”) for the benefit of the grantor’s children and grandchildren in exchange for an installment note bearing interest at the Applicable Federal Rate (“AFR”), as published each month by the IRS, in order to avoid adverse gift tax consequences.
The AFR is broken into three tiers depending on the term of the loan: the short-term rate applies to loans of up to three (3) years, the mid-term rate applies to loans with a term between three (3) and nine (9) years, and the long-term rate applies to loans with repayment terms of greater than nine (9) years. For October 2020, the short-, mid-, and long-term AFRs are 0.14%, 0.38%, and 1.12%, respectively.
An IDGT is a trust which is recognized for federal estate tax purposes, but ignored for income tax purposes. This means that property transferred to an IDGT will not be included in the grantor’s taxable estate, but the grantor will be taxed on all trust income. This is, in fact, advantageous for many reasons. In the Sale to Grantor Trust arrangement, when the grantor sells assets to the IDGT in exchange for a promissory note, the value of the assets are frozen at the amount of the note. Since the trust is not distinct from the grantor for income tax purposes, the sale does not result in any recognition of capital gain and there are no income tax consequences associated with the grantor’s payment of the taxes on behalf of the trust.
At the end of the IDGT term, to the extent that the total return on the trust assets exceeds the currently low interest rate on the note, you can shift growth and income to your beneficiaries without incurring any transfer tax liability. While any asset can be sold to an IDGT, this strategy is particularly effective with property having a low current valuation, potential for appreciation, and/or is valued at a discount due to lack of marketability or control.
Note that our SLATs and Dynasty Trusts are often also IDGTs, and therefore we can combine several gifting strategies together.