Key Takeaways

  • When looking to transfer large amounts of assets to future generations, selling assets to an intentionally defective grantor trust (IDGT) may create greater tax savings than other gifting strategies.
  • With an IDGT, the grantor is considered the owner for income tax purposes and pays taxes on the income produced by the trust, but the trust assets are not considered owned by the grantor for estate tax purposes.
  • Selling highly appreciating or income-producing assets to an IDGT effectively “freezes” the value of those assets while allowing the growth of those assets to accumulate outside the estate.

Overview

Many ultra high-net worth families want to transfer significant assets to their children, grandchildren, or other beneficiaries with minimal gift tax cost. But making large gifts requires these families to use all, or a significant portion, of their lifetime gift/estate exemption ($12.92 million for singles, $25.84 million for married couples in 2023). Instead, selling assets to an intentionally defective grantor trust (IDGT) may produce significant gift and estate tax savings, because this strategy generally uses a much smaller amount of the lifetime gift/estate exemption. Furthermore, assets sold to an IDGT, including all future income and appreciation, are not included in the grantor’s taxable estate at death.

Who is it for?

Ultra high net-worth individuals or families (generally with at least $30 million net worth) who want to reduce their taxable estate while transferring highly appreciating or income-producing assets to their beneficiaries may be good candidates for selling assets to an IDGT. Because this strategy transfers a significant amount of assets from the grantor’s estate, candidates should have sufficient income and assets remaining after the transfer is complete to maintain their standard of living.

What is an IDGT?

An IDGT is a special form of irrevocable trust whose assets are considered owned by the grantor for income tax purposes, while not considered owned by the grantor for estate, gift, and generation-skipping tax (GST) purposes. While an IDGT is “defective” for income tax purposes, it is “effective” for transfer tax purposes. Because the income tax liability of an IDGT is the responsibility of the grantor, the taxes paid on behalf of the IDGT are considered additional tax-free gifts to the trust, which allow the trust assets to appreciate faster than had the tax been paid directly from trust assets.

How does it work?

The grantor first makes an initial “seed” gift worth at least 10% of the proposed property’s value that will be sold to the IDGT. This will give the IDGT enough economic substance (required by the IRS) to support a installment note back to the grantor in exchange for the property. The installment note is typically set up as a series of interest-only payments with a balloon payment due at death, which is what will be included in the grantor’s taxable estate. The primary benefit of this strategy is that all the income and appreciation of the assets purchased by the IDGT from the purchase date forward are not includable in the grantor’s taxable estate, which can exclude millions from estate taxation.

What are the tax ramifications of this strategy?

Income taxes. An IDGT is considered a grantor trust for income tax purposes. Therefore, the transactions between the grantor and the grantor trust have no income tax consequences. This results in no gain or loss recognized on the sale of assets to the IDGT and no income taxes to the grantor on the receipt of interest payments due on the installment note. However, the grantor is required to pay income taxes on all income earned by the IDGT each year. The payment of income taxes by the grantor allows the trust assets to grow unencumbered by taxes and is effectively a “free” gift to the trust each year.

Gift taxes. The initial “seed” gift (at least 10% of the value of the asset(s) sold to the IDGT) generally uses the grantor’s lifetime estate/gift exemption to avoid gift taxes. The asset(s) sold to an IDGT do not constitute a gift, because consideration of equal value is received in the form of the installment note.

Estate taxes. One of the primary benefits of selling assets to an IDGT for an installment note is the ability to “freeze” the value of highly appreciating assets for estate tax purposes. Once the asset(s) has been sold to the IDGT, any future income and appreciation derived from the asset(s) grow outside of the grantor’s estate, while the value of the installment note included in the grantor’s estate remains generally constant.

Case study

Julia and Harold are both 65 years old and recently retired. They have a net worth of approximately $53 million, and they want to transfer $33 million of their net worth to their children and grandchildren in a tax-efficient manner. They believe the remaining $20 million of net worth will be more than enough to sustain them in retirement.

Julia and Harold’s financial success has come from their closely held business, and they want to transfer the stock in the business to their children and grandchildren. Historically, the value of the stock has averaged 5% growth per year since the founding of the business. However, growth over the last three years has significantly outpaced the historical average, for an average of 10% annual growth.

After consulting with their trusted financial, legal, and tax advisors, Julia and Harold initiate the following:

  • Working with their estate planning attorney, Julia and Harold create an IDGT that allows them to be recognized as the owners of the trust assets for income tax purposes, but not estate tax purposes. Note: Neither Julia nor Harold are named as trustee of the IDGT to avoid estate inclusion of the trust assets. It is good practice to have an unrelated third-party serve as trustee.
  • To satisfy IRS requirements, Julia and Harold, using a portion of their lifetime gift/estate exemption ($25.84 million in 2023), make a lump-sum cash gift of $3 million to “seed” the trust and give the IDGT’s installment note economic substance in exchange for the business. Many tax advisors recommend a minimum “seed” gift of 10% of the total asset value that will be sold to the IDGT.
  • After the “seed” gift has been made, Julia and Harold sell $30 million worth of closely held non-voting stock to the IDGT in exchange for an interest-only installment note with a balloon payment payable at death. Because the IDGT is a grantor trust, the sale of assets to the trust results in no gain or loss being recognized.
  • The trustee of the IDGT projects that the trust will earn $1.5 million of income per year, which can be used to pay the interest on the interest-only installment note Julia and Harold now hold. The remaining income can either be distributed to Julia and Harold’s children and grandchildren or added to the principal of the trust.
  • While Julia and Harold are alive, they pay the income tax on the income earned by the assets of the IDGT. Also, the annual interest paid to them from the IDGT is not considered taxable income.
  • After Julia and Harold have both died, the $30 million installment note plus any accrued interest will be included in their taxable estate. The assets sold to the IGDT, plus all future income and appreciation, are not includable in their taxable estate.

Self-Cancelling Installment Notes (SCINs)

A Self-Canceling Installment Note (SCIN) used in conjunction with a sale to an IDGT has become more popular in low-interest rate environments. As the name describes, a SCIN provides that at the seller’s death, the obligation to make further payments ceases, and any outstanding obligation is not included in their taxable estate, which results in the balance due escaping federal estate taxes.

Many practitioners consider the use of a SCIN with a sale to an IDGT an aggressive strategy for wealth transfer that could trigger an IRS audit. Therefore, anyone considering using one should work closely with a highly experienced estate planning attorney to ensure compliance with IRS requirements.

Bottom line

A properly structured sale of assets to an IDGT can transfer significant assets to children, grandchildren, or other beneficiaries with minimal gift tax cost and help “freeze” the value of highly appreciating assets in an estate while transferring those assets to their beneficiaries with a reduced gift tax cost. To further understand how a sale to an IDGT strategy can be a powerful tool in a comprehensive estate plan, seek guidance from trusted, professional advisors.

 

 

 

 

Schwab Center for Financial Research
Austin Jarvis, JD Director
As Director of Estate, Trust, and HNW Tax for the Schwab Center for Financial Research, Austin provides analysis and insights on topics including complex estate, gift, and trust planning, advanced charitable strategies, business succession, and executive compensation.
Important disclosures The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Supporting documentation for any claims or statistical information is available upon request.
This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
This material is approved for retail investor use only when viewed in its entirety. It must not be forwarded or made available in part.
The Schwab Center for Financial Research (SCFR) is a division of Charles Schwab & Co., Inc.
Charles Schwab & Co., Inc. (“Schwab”) is affiliated with Charles Schwab Trust Company (CSTC), the corporate trustee for Schwab Personal Trust Services (SPTS). Schwab may introduce clients to CSTC but does not evaluate whether SPTS is appropriate for each client or recommend SPTS for any particular client. It is the client’s responsibility to ensure that CSTC meets his or her trust needs and to conduct any due diligence that may be required before engaging CSTC.
The Charles Schwab Corporation provides a full range of brokerage, banking and financial advisory services through its operating subsidiaries. Its broker-dealer subsidiary, Charles Schwab & Co., Inc. (member SIPC), offers investment services and products, including Schwab brokerage accounts. Its banking subsidiary, Charles Schwab Bank (member FDIC and an Equal Housing Lender), provides deposit and lending services and products. Access to Electronic Services may be limited or unavailable during periods of peak demand, market volatility, systems upgrade, maintenance, or for other reasons.
© 2023 Charles Schwab & Co., Inc. All rights reserved. Member SIPC. SCFR 0623-34MK