Preservation | Family Wealth Protection & Planning

A popular planning technique is an installment sale to an Intentionally Defective Grantor Trust (IDGT) in order to freeze the value of assets in an individual’s estate. Under this technique, the grantor sells assets (such as closely held business interests) to a trust in exchange for an installment note. A small “seed” gift is typically also made to the trust to ensure enough equity to support the loan and to allocate generation-skipping transfer (GST) tax exemption. The trust is structured as an IDGT so that there should be no income tax consequences resulting from the sale. In addition, during the grantor’s life, the interest payments on the installment note will not be deemed taxable income to the grantor, and the payment of taxes on the trust’s income provides an additional gift-tax-free benefit to the beneficiaries.

As described in our previous post, closely held business interests and family limited partnership interests provide a greater benefit because the interests will typically be sold at a discount, typically for an amount less than the pro-rata share of the entity’s underlying assets.

The installment note that will be held by the grantor typically has an interest rate equal to the Applicable Federal Rate (AFR). Thus, to the extent that the assets in the trust produce income or increase in value in excess of the interest due under the note, such increase will accrue to the benefit of the beneficiaries of the trust. Again, because many assets currently have depressed values that are likely to increase significantly at a later date, and the AFR is historically low, this maximizes the value that can be transferred to family members in a tax-efficient manner.

If properly structured, it is also possible to engage in income tax planning such as swapping high basis assets with trust assets having a low basis, at a later date. By including the low basis assets, rather than the high basis assets in the grantor’s estate, such low basis assets will receive a step-up in basis at the grantor’s death.

Finally, unlike a transfer to a grantor retained annuity trust (GRAT), GST tax exemption can be allocated to the IDGT at the time of the initial transfer, so that the trust assets will be able to be passed from generation to generation free of transfer taxes. That is, the IDGT can be designed to last in perpetuity.

For installment sales that have taken place in earlier years, the current environment may call for a re-evaluation. If the promissory note is still outstanding, a modification of the note may be considered to lower the interest rate. If the note is underwater – that is, the value of the assets in the trust have a value lower than the remaining note balance – the grantor could consider selling the note in a second, similar transaction, or contributing the note to a GRAT.

Please contact an attorney in our Trusts & Estates Practice Group if you have questions related to installment sales.

Stay tuned for Part 7 of this series, where we will discuss charitable giving.

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