An 'Intentionally Defective' Trust Can Save Taxes

Under the right circumstances, an intentionally defective irrevocable trust (IDIT) can be an effective estate tax planning tool. These trusts are set up to purposely fail certain technical tests in the tax law, yet they still have the approval of the IRS and allow individuals to pass more assets on to their heirs.

Here are a couple of points to keep in mind:

• An IDIT is considered to exist as a separate taxable entity for federal estate tax purposes and general state law purposes.

• However, an IDIT is considered to be a grantor trust for federal income tax purposes. As such, the IDIT's income and deduction items are treated as belonging to the grantor (the person who sets up the trust).

These trusts are confusing but in this article, we'll explain how an IDIT arrangement can work to your tax-saving advantage.

The IDIT Tax-Saving Strategy

If you own appreciating assets and want to get the future appreciation out of your estate, an intentionally defective irrevocable trust could be just what the doctor ordered. The strategy works as follows:

1. You establish the IDIT as a legal entity under applicable state law and name the trust beneficiaries (generally your children and grandchildren). Typically, you also make a gift of some cash to the IDIT to create some immediate liquidity for the trust (this is called "seed money").

2. You then sell appreciating assets to the IDIT in exchange for a note payable from the IDIT (in other words, an installment sale). Since the IDIT is ignored for federal income tax purposes, the sale has no federal income tax significance, because you are treated as selling the assets to yourself, which is not a taxable transaction.

3. To pay back the note owed to you, the IDIT uses cash from your gift of seed money, from income and gains generated by the trust's assets, and, if necessary, from asset sales.

4. Any income, gain, and deduction items related to the IDIT's assets are reported on your personal federal income tax returns, because you are still considered to own the assets for federal income tax purposes. You are allowed pay the income taxes with money from your own pocket. You need not dip into the trust. This allows you to leave more value in the IDIT for the future benefit of the persons you've named as the trust beneficiaries. In effect, you are allowed to make gifts of money to cover the trust's income tax bills without triggering any adverse federal tax consequences. (IRS Revenue Ruling 2004-64 and IRS Private Letter Rulings 199922062 and 200120021)

5. At the end of the day, the IDIT will have paid off the note owed to you, but the trust will still have a net worth equal to the appreciation in the value of the assets you put into it. The IDIT's net worth will ultimately go to the beneficiaries you've designated, and the net worth amount will not be included in your estate for federal estate tax purposes.

IRS: You Can Dip Into IDIT to Pay Income Taxes, But Be Careful

While you would generally like to pay any income taxes generated by the IDIT's assets with money from your own pocket (for the reason explained in number 4 above), those taxes could wind up exceeding what you can afford. If so, the IRS stated in a ruling that taxpayers can dip into the IDIT for the needed cash without any adverse federal tax effects. This favorable ruling resolved a troubling question in a taxpayer-friendly manner. So it was good news for taxpayers and estate planners.

Warning: The IDIT instrument should not require the trust to reimburse you for income taxes generated by its assets. Such a requirement would cause the trust's assets to be included in your taxable estate, which would ruin the whole strategy behind the intentionally defective irrevocable trust concept. (IRS Revenue Ruling 2004-64)

Bottom Line: The IDIT is considered to exist for estate tax purposes but not for income tax purposes. It is therefore described as "defective" but the defect is intentional. Thus the name intentionally defective irrevocable trust.

While the IRS-approved IDIT strategy can be effective in reducing the value of your taxable estate, it's a complicated arrangement that requires professional assistance. This article only covers the basics. Contact your estate planning advisor if you have questions or want more information.