The COVID-19 pandemic created unique opportunities in wealth and estate planning. In many situations, assets are temporarily depressed in value, providing an opportunity to transfer more value out of the estate with an increased likelihood of appreciation being passed to beneficiaries. One such way is through a gift and/or installment sale to an intentionally defective grantor trust (IDGT).
I recently “Zoomed” with Baker Tilly wealth and estate planning professional, John Loew, and the father/son team of Sanford and Ethan Schmidt of Schmidt Financial Group to discuss the timely use of IDGTs to transfer family wealth during this time of crisis.
John Loew has extensive experience in estate planning, estate and gift tax planning and business succession planning, having practiced law for over 15 years. Sanford “Sandy” Schmidt, founder and Chairman of Schmidt Financial Group, has been advising affluent families and their team of core advisors on intelligent solutions to protect, transfer, leverage and integrate their wealth for over 30 years. Ethan Schmidt, Co-CEO (with his brother Jordan) of Schmidt Financial Group, provides quantitative wealth management strategies to ultra-high-net-worth families.
Our discussion centered on the wealth transfer opportunities created by the COVID-19 pandemic, in particular using IDGTs to transfer wealth to the next generation. I asked John, Sandy and Ethan a series of questions to help us understand how to use IDGTs.
Now is a very good time to consider wealth transfer strategies due to current tax laws and the size of the lifetime exemptions. Currently, the lifetime exemption is the largest it has ever been at $11.58 million per individual. Moreover, with the presidential election looming and the possible need to recoup some of the major government expenditures made during the pandemic, there is a chance that significant changes will arrive in early 2021 which would greatly increase the total tax cost of transferring wealth. Finally, with many asset values impacted by the pandemic, it is opportune to transfer the assets at lower values and allow the recovery to occur for the benefit of your beneficiaries.
An IDGT is an acronym for an intentionally defective grantor trust. It is a special type of trust in which the creator of the trust – the grantor – is treated under the grantor trust rules as the “owner” for income tax purposes, but not for estate tax purposes. As such, the grantor must pay the income taxes on all trust income annually at the grantor’s income tax bracket while the value of the trust assets grows outside the grantor’s taxable estate.
A key benefit to the grantor is the ability to move assets out of his or her estate without incurring a gift tax through the use of an installment sale. The grantor will sell assets to the IDGT in exchange for a promissory note of some length of time such as 10 or 15 years. The note would pay back to the grantor with interest based on the applicable federal rate (AFR) to satisfy the sale of the asset. Any appreciation of the asset over and above the promissory note value would be out of the grantor’s estate.
The IDGT beneficiaries are typically the grantor’s children or grandchildren who will ultimately receive estate tax-free assets which have also been able to grow without reduction for income taxes since the grantor has been paying the income taxes.
The IDGT can be a very effective estate planning tool if structured properly, allowing a grantor to lower his or her taxable estate by paying income taxes on IDGT assets, and thereby essentially gifting extra wealth to beneficiaries. Moreover, the growth on the IDGT assets will be estate tax-free since the growth has occurred in the IDGT and not in the taxable estate of the grantor or the IDGT beneficiaries.
Additionally, when assets are sold to the IDGT, there is no recognition of capital gain, which means no taxes are owed. This is a much different result than if the grantor had sold the assets directly to his children or grandchildren, in which case the sale would be subject to capital gains on the amount by which the sales proceeds exceeded the grantor’s tax basis in the sold assets.
Funding the trust can be done either through annual exclusion gifts of currently $15,000 per year per individual, or by gifting some or all of the lifetime exemption per individual of currently $11.58 million. Alternatively, as mentioned above, another funding option is for the grantor to sell assets to the IDGT in exchange for an installment promissory note.
Distributions from the IDGT are made at the discretion of the IDGT trustee, and subject to the terms of the IDGT document. The grantor has wide latitude in establishing the terms of the IDGT and its allowable and/or required distributions.
Note, however, that if an installment sale were undertaken, before making any distributions to beneficiaries, the IDGT trustee must make any required interest and/or principal payments to the grantor called for under the promissory note.
Yes. Under generally accepted trust principles, the trustee of an irrevocable trust, such as an IDGT, is authorized to withhold distributions to trust beneficiaries who are facing known creditors. For instance, in the midst of a trust beneficiary’s divorce, the assets in the IDGT are nearly universally unreachable by the divorce court. This is because the IDGT assets are “for the benefit” of the beneficiaries, but are not technically their personal assets.
Yes. Life Insurance is quite often used inside an IDGT. The benefit of having a life insurance policy inside an IDGT is you eliminate the gift to the trust to pay the life insurance premium. The life insurance premium is typically paid from the cash flow from the assets already inside the IDGT.
Yes, with careful planning. If the grantor of an IDGT is concerned about irrevocably transferring away possibly “too much” of his or her estate, the grantor could name his or her spouse as an allowable beneficiary of the IDGT, along with children or grandchildren. This type of IDGT is known as a spousal lifetime access trust (SLAT).
Yes. A dynasty trust is an IDGT designed to last for multiple generations without being subject to estate tax at the death of successive beneficiaries. Generation-skipping language can be written within the IDGT document to allow for trust assets to pass estate tax-free to the beneficiaries over multiple generations. For families of considerable wealth, this is an enormous opportunity to greatly reduce the impact of estate taxes.
The answer is generally no, assets cannot be accessed by the grantor. If the grantor merely gifted assets to the IDGT, he or she would be prohibited from receiving back anything of value from the IDGT. To take anything of value back from the IDGT would render it entirely includible in the taxable estate of the grantor, defeating its main purpose.
If, however, the grantor sold assets to the IDGT in exchange for a promissory note, the trustee would be able to repay the grantor the value of the unpaid promissory note and the resulting interest. A grantor receiving anything beyond that value would again defeat the IDGT’s main benefit.
Recall, however, that through the grantor’s spouse’s allowable access in a SLAT, the grantor could have access to the IDGT assets in a roundabout way. Finally, the trustee of the IDGT, if allowed in the IDGT document and if bearing an appropriate interest rate and security, could lend IDGT assets back to the grantor.
Yes. Since assets inside the IDGT grow outside of the grantor’s taxable estate, the grantor would want to transfer assets into the IDGT that have the greatest potential for appreciation.
Note, however, that the assets that are contributed to an IDGT by the grantor will not receive an income tax basis adjustment at the grantor’s death, as would be the case if the same assets were a part of the grantor's estate. So, while there is a clear estate tax benefit to removing an appreciating asset from the grantor’s taxable estate, if the trustee of the IDGT later sells that appreciated asset, there will likely be a considerable capital gains tax to pay.
Recall, though, that if the IDGT remains a “grantor trust” for income tax purposes, the grantor could pay the capital gains tax on behalf of the IDGT and such payment would not be considered a taxable gift.
Depending on how the IDGT is structured, the grantor can typically control very little of how the IDGT operates. The grantor cannot be a beneficiary of the IDGT. The trustee of the IDGT, and not the grantor, controls the investments inside the IDGT as well as its distributions. That said, the IDGT can give the grantor the right to remove and replace a trustee with an independent trustee, which in a sense, is retaining considerable control.
Most IDGTs are established between family members. Sometimes, a grantor appoints his or her spouse as trustee. Quite often, there is a co-trustee along with the spouse to reduce control issues of the trust. Children are frequently named as trustee as well. Some IDGTs have third-party trustees such as a professional or institution.
Jennifer is the owner of a depreciated apartment complex LLC worth $20 million, which generates $1 million/year in profit distributions. Jennifer clearly has an estate tax problem with wealth greater than the $11.58 million exemption amount, which will only worsen as the LLC distributes annual profits to her. By utilizing her lifetime exemption of $11.58 million, she could choose to give away over 50% of the LLC to her children or an irrevocable trust, eliminating that portion of the LLC’s value and its subsequent growth from her estate, but she’d still retain the other approximate 50% and all of its income and have no remaining lifetime exemption.
Instead, Jennifer elects to gift $1 million of LLC units to an IDGT and sell the remaining $19 million of LLC units to the IDGT, in exchange for a promissory note from the IDGT that requires it to make interest-only payments of 1.12%/year for the next 15 years, followed by a balloon payment of the principal. At this low interest rate (the August 2020 long-term AFR), the IDGT will only need to pay Jennifer $212,800/year of interest payments. The IDGT has plenty of cash to make this required interest payment, considering that the LLC distributes to the IDGT all of its $1 million annual profits.
Following the part-gift and part-sale, Jennifer’s net worth and estate tax exposure have not changed. She has simply exchanged her ownership of the LLC, worth $20 million, for a very low interest rate promissory note worth $19 million instead. Since she’s sold the LLC to “herself” for income tax purposes, there are no capital gains taxes due on the transaction, and Jennifer’s cost basis in the LLC simply carries over into the IDGT.
Each year for the next 15 years, Jennifer’s $19 million promissory note will barely “grow” by its simple 1.12% yield, while the LLC produces many times that amount of cash flow, plus the potential for the apartment complex to appreciate further – the entire upside of which is captured in the IDGT.
At the end of year one, the IDGT’s LLC units remain worth $20 million. It will have received profits of $1 million and then paid out $212,800 in interest. Thus, its value would be up to $20.8 million. By contrast, Jennifer’s note receivable would still be $19 million, plus the $212,800 of interest, but reduced by the income tax liabilities she must pay on all $1 million of profits (assumed to be about $400,000 in income taxes at 40% rate).
The end result is that the IDGT’s value is about $20.8 million, while Jennifer’s estate will be approximately $18.8 million, producing an approximate $2 million shift in value to the IDGT – and outside Jennifer’s taxable estate. At a 40% top estate tax rate, that’s an $800,000 estate tax savings.
If you are contemplating wealth transfer or family business ownership transition and need counsel, please contact Gary Plaster, the “Family Business Strategist” at the Baker Tilly Center for Family Business Strategy.
Sanford “Sandy” Schmidt, CFP®, ChFC, CLU
As the Founder and Chairman of Schmidt Financial Group, Sandy has been advising affluent families and their team of core advisors on intelligent solutions to protect, transfer, leverage and integrate their wealth for over 30 years. Sandy believes that the wisdom and knowledge acquired developing unique estate plans for the ultra-wealthy over three decades benefit the individuals and families whom he serves.
Sandy attributes the success of Schmidt Financial Group to the core values, personalized planning and strategic and critical thinking utilized in the solution design process. Sandy has partnered with some of the top law and accounting firms to structure estate and insurance plans for their high-net-worth clients.
Sandy earned his Bachelor of Science in accounting from the University of Illinois at Chicago. He has also earned the financial credentials of CFP (Certified Financial Planner), International Board of Certified Financial Planners, ChFC (Chartered Financial Consultant), CLU (Chartered Life Underwriter), and has FINRA Series 6, 63, 65, & 22 securities registration. Sandy is a lifetime member of the AALU, Forum 400 and Million Dollar Round Table (MDRT – Top of the Table).
Ethan Schmidt, CFP®, CRPC®
After growing up in a family where there is a strong influence in financial planning, Ethan’s ascendancy was clear. Ethan graduated cum laude from the W.P. Carey School of Business at Arizona State University with a degree in finance and is pursuing his Masters in Personal Financial Planning from the College of Financial Planning.
Ethan joined Schmidt Financial Group after spending several years at Merrill Edge. He worked as a financial advisor assisting clients to achieve their financial objectives and grow assets under management, and he built long-standing relationships. Ethan’s expertise lies in providing quantitative wealth management strategies with investment, retirement, income tax, insurance and estate planning strategies. At Schmidt Financial Group, Ethan’s primary goal is to offer uniquely intelligent solutions to the complexities of financial planning.
Ethan is a Certified Financial Planner™ (CFP®), Chartered Retirement Planning Counselor (CRPC®), licensed insurance advisor and holds securities Series 7 and Series 66 securities registrations with FINRA.
John Loew, JD
John is a senior manager in the individual services team at Baker Tilly, with nearly 25 years of experience in the estate planning area. John joined Baker Tilly in 2014. He frequently provides high-net-worth individuals and families throughout the United States with integrated advice on how to hold, manage and transfer wealth in a tax-efficient manner. On a near weekly basis, John reviews estate plans and provides insights on improving those plans. For clients focused on reducing estate taxes, or thoughtfully transferring ownership of privately held businesses, John routinely develops and takes part in implementing wealth transfer techniques including GRATs, ILITs, IDGTs and CRTs. Finally, he provides tax planning for individuals, trusts and flow-through entities, and is involved in the preparation and review of fiduciary income tax returns, gift tax returns and estate tax returns.
John graduated from the University of Wisconsin–Madison with a Bachelor’s in Business Administration as well as finance. He also earned a Juris Doctorate from the University’s law school.
Gary Plaster is the partner-in-charge of the Baker Tilly Center for Family Business Strategy. He is an accomplished strategist, author and consultant with more than two decades of experience advising C-level executives. As an experienced chief strategy officer, he has led strategic consulting practices at global firms and is a nationally recognized thought leader in the area of growth strategy and managing growth. Gary is also a clinical professor at DePaul University's Kellstadt Graduate School of Business, Center for Strategy, Execution and Valuation.
His wide range of expertise spans strategy development, strategic planning, market analysis, competitive analysis, customer value analysis, operational effectiveness, profit improvement, M&A and organization design. Gary specializes in advising family-owned businesses as well as manufacturing and distribution companies.
Gary holds a degree in industrial engineering and an MBA in finance from the University of Wisconsin–Madison. He co-authored: “Beyond Six Sigma: Profitable Growth through Customer Value Creation” and “The Road to Success: How to Manage Growth,” both published by Wiley & Sons.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.