Irrevocable Defective Grantor Trust by psa10127

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									                                                    O c t o b e r 2 0 0 1   w w w . n a i f a . o r g   w w w . a d v i s o r t o d a y . c o m




EXPERTTOEXPERT
RACHNA D. BALAKRISHNA, JD

Intentionally Defective Irrevocable Trusts
The new tax rates make IDITs an attractive option.
       state planners have been using the            spouse possesses certain powers over the                                                purposes. These powers can include the

E      Irrevocable Life Insurance Trust (ILIT)
       for many years to increase wealth and
liquidity outside the taxable estate. Howev-
                                                     trust that cause the grantor to be the owner
                                                     for income tax purposes. These powers are
                                                     described in certain tax code provisions
                                                                                                                                             power of a nonfiduciary person to reac-
                                                                                                                                             quire the trust assets by substituting prop-
                                                                                                                                             erty of an equivalent value. They also
er, transfers to ILITs are often subject to gift     known as the “grantor trust” rules (Internal                                            include the power of the grantor to reac-
tax, and irrevocable trusts typically pay            Revenue Code Sections 671-678).                                                         quire trust assets by exchanging the assets
income tax at the highest rate.                          If the grantor trust rules apply to a trust,                                        for other property of equivalent value, or
    One of the most effective techniques             then the trust income, deductions and cred-                                             the power to use trust income to pay pre-
estate planners use to reduce income tax             its are carried through to the grantor’s indi-                                          miums on insurance on the life of the
and provide greater leverage is the Inten-           vidual income tax return and income tax is                                              grantor or the grantor’s spouse. (The last
tionally Defective Irrevocable Trust (IDIT).         paid at the grantor’s individual tax rate. Pay-                                         power is included in many ILITs, causing
An IDIT is a “defective” grantor trust for           ment of income taxes by the grantor allows                                              them to be grantor trusts.) To avoid estate
which trust income is attrib-                                                 the IDIT assets to                                             tax inclusion, the grantor/insured should
uted to the grantor, rather                                                   continue growing                                               not be named as a trustee of the IDIT.
than the trust. The lower          For clients with income-                   without being dimin-                                              Step 2: The grantor makes an initial gift of
income tax rates included in                                                  ished by income tax-                                           assets to the trust. Some or all of the gift may
the 2001 tax bill that was         producing assets,                          es. The trust income                                           not be subject to gift tax because of the gift
recently signed by President                                                  will be available to                                           tax annual exclusion and the applicable
Bush make IDITs an even            an IDIT can be an                          fund large insurance                                           exclusion amount. The IDIT can also be
more attractive planning                                                      premiums for either                                            used to leverage the GSTT exemption. To
technique.                         excellent planning tool.                   single-life or sur-                                            keep the trust exempt from GSTT, the
    Although many ILITs are                                                   vivorship policies.                                            grantor should file a gift tax return and allo-
only funded with life insur-                                                      In addition, the                                           cate GSTT exemption to the trust for the
ance policies, clients interested in transferring    grantor can process transactions with the                                               amount of the initial gift (and for each year
other assets to an irrevocable trust should          trust, such as installment sales, without any                                           that a gift is made to the trust). The grantor
consider using an IDIT. Funding an IDIT              adverse income tax consequences. Under                                                  may consider gifting cash or marketable
during their lifetimes enables individuals to        Revenue Ruling 85-13, the existence of a                                                securities to the IDIT initially, rather than
significantly reduce their taxable estates by        grantor trust is disregarded for income tax                                             closely held stock or partnership interests, to
paying income taxes from nontrust assets.            purposes. As a result, transactions between                                             avoid having to “check the box” on the gift
For clients with income-producing assets, an         the grantor and the IDIT have no income tax                                             tax return for a valuation discount.
IDIT can be an excellent planning tool.              consequences. Gift tax issues are also avoid-                                              Step 3: After the initial gift, the grantor
Because the trust is not diminished by               ed with an IDIT, since the “three-year look                                             enters into a sales agreement with the IDIT
income taxes, it can use the income on trust         back” rule applies to gifts, not sales.                                                 trustee, under which the trustee agrees to
assets to purchase a life insurance policy and                                                                                               purchase additional assets from the grantor,
other assets without incurring any gift, estate      Getting started
or generation-skipping transfer tax (GSTT).          Clients can use the following approach to                                               Rachna Balakrishna, JD, is associate
    IDITs are irrevocable trusts that are            effectively establish and fund an IDIT:                                                 counsel and assistant vice president of the
drafted so that the grantor is the “owner” of            Step 1: The client establishes an irrevoca-                                         Advanced Markets Group at Manulife
the trust assets for income tax purposes, but        ble trust that keeps trust assets outside the                                           Financial. She develops advanced
not for estate tax purposes. An IDIT is a            taxable estate and gives the grantor (or the                                            marketing programs. She can be reached at
“defective” grantor trust for income tax pur-        grantor’s spouse) certain powers that cause                                             617-854-4423 or via email at
poses because the grantor or the grantor’s           the trust to be a grantor trust for income tax                                          rachna_balakrishna@manulife.com.
                                                  EXPERT                                  EXPERT

often at a discounted value. Ideally, the trust    Trust (GRAT), a grantor does not have to out-                makes an initial gift of $400,000 cash and
should buy income-producing assets, such           live the term of the note to obtain significant              stock to the IDIT. Following the gift,
as limited partnership interests or S-corpo-       estate tax benefits. Although the unpaid bal-                Matthew and Andrea will sell $4 million
ration stock. Valuation discounts can be tak-      ance of the note will be included in the                     of FLP interests to the trust in exchange
en by appraisers for a variety of reasons,         grantor’s taxable estate if he or she does not               for a 15-year note at 6 percent interest.
including minority interests and lack of mar-      outlive the note term, the future income and                 The FLP interests have been discounted at
ketability. The sales agreement is generally       appreciation of the assets sold to the trust will            30 percent—the value of the assets sold to
structured as an interest-only note for a term     continue to grow outside the taxable estate.                 the trust without a valuation discount is
of years, with the principal balance due at        As the trust assets appreciate, the grantor can              approximately $5.7 million.
the end of the term.                               make additional “installment sales” to the                       During the first year, the IDIT will earn
    The initial gift made by the grantor           trust in future years.                                       $40,000 of income on the initial gift of
should total at least 10 percent of the value                                                                   $400,000, and $1.14 million of income on
of the assets being sold to the trust to pro-      Putting it into practice                                     the limited partnership interests. After the
vide greater security for the sale. Typically,     A hypothetical example can help illustrate                   trust pays interest on the note of $240,000
the interest rate on the note is the Applica-      the benefits of an IDIT. Matthew and Andrea                  to Matthew and Andrea, the remaining
ble Federal Rate (AFR) at the time of the sale.    Berman, both age 68, have a Family Limited                   income of $940,000 can be used for pay-
    Step 4: The assets transferred to the IDIT     Partnership (FLP) funded with real estate                    ment of insurance premiums, distributions
appreciate and earn income each year,              that earns 20 percent income annually. They                  to trust beneficiaries or purchase of addi-
which accumulates inside the trust, free of        have a combined estate of $10 million and                    tional assets. Since Matthew and Andrea
gift tax and GSTT. After the trust pays inter-     are interested in reducing their estate size                 will be recognizing the trust income on their
est on the note to the grantor, the remaining      and funding a survivorship life insurance                    individual income tax return, the trust’s
trust income can be used to fund a large life      policy with a $5 million death benefit.                      growth will be even greater than in a tradi-
insurance policy.                                  However, they want to minimize gift tax on                   tional ILIT. In the first year alone, the trust
    The grantor will pay the tax due on trust      transfers to an irrevocable trust that will                  could be reduced by nearly $472,000 in
income, but doing a sale or exchange of assets     ultimately benefit their daughter, Sandy, and                income tax, if the trust had to pay the tax.
with the trust will not have any income tax        her two children.                                            Since the Bermans are paying the tax on the
consequences to the grantor. After the                 The Bermans have decided to fund an                      trust income, the trust assets will be able to
grantor’s death, the trust assets will be out-     IDIT with Sandy as the trustee. Although                     appreciate at a much higher rate.
side the grantor’s taxable estate.                 Matthew has already used his entire                              IDITs are a sophisticated planning tech-
    An IDIT can achieve maximum leverage           applicable exclusion amount, Andrea can                      nique that can create significant tax benefits
if the grantor outlives the term of the note.      currently gift up to $675,000 to an IDIT                     for clients who want to fund an irrevocable
However, unlike a Grantor Retained Annuity         without incurring any gift tax. Andrea                       trust during their lifetime. AT




                                                   Reprinted with permission from Advisor Today, October 2001
                                                               by The Reprint Dept., 800 259-0470

								
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