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IRS Ruling Boosts IDTs as Estate Planning Technique

A new ruling by the IRS is expected to give a boost to a clever estate planning technique. The edict provides greater flexibility when using an “intentionally defective trust” (IDT) that shields assets from federal estate tax.

As the name implies, an IDT is structured expressly so that it will fail the “grantor trust” rules in order to realize certain tax benefits. Normally, you might transfer assets—such as cash, securities, or other income-producing property—to a trust that pays out annual income to designated beneficiaries. If you give up all rights to the assets, you won’t have to pay income tax on the earnings. This can be particularly beneficial if you’re already in a high federal income tax bracket. Instead of your paying income tax on earnings generated by the property, at a rate as high as 35%, the trust generally foots the tax bill.

But that can be counterproductive if you’re trying to minimize the amount going to the IRS. Tax rates for trusts, as for individuals, begin at low rates (a minimum of 15% for trust income) but quickly move higher, with a 35% rate for trust income above $11,150 in 2009. So the trust could easily end up paying more tax on its income than you would have as an individual.

That’s where an IDT can help. If the trust document is properly structured, the trust will be treated as a grantor trust, with language that allows you to retain certain rights and interests. One result will be that, as grantor, you’ll be responsible for paying the tax on trust income—even though that money is going to the trust or its beneficiaries, rather than to you.

If you’re already in the top personal income bracket, this move won’t reduce the taxes paid on trust income, though the outlay will reduce the size of your estate and maximize the amount going to trust beneficiaries. But there could also be another benefit of establishing an IDT. With current interest rates very low, your potential gift tax for transferring property to the trust will be minimized. That liability is based on the amount the IRS believes will ultimately go to trust beneficiaries. The lower the current interest rate, the smaller that projected value of trust assets and the less gift tax you’ll owe.

The estate tax rules for IDTs can present a thornier issue. Your taxable estate generally includes assets you’ve transferred to trusts and individuals if you have retained possession or enjoyment of the transferred property. That could apply to assets in an IDT, returning the assets to your estate and inflating the estate tax bill owed by your estate. Thanks to the new ruling, however—IRS Ruling 2008-22—there’s a way you can maintain some power over assets transferred to an IDT without adverse estate tax consequences.

In the case that prompted the ruling, a grantor established and funded an irrevocable trust for the benefit of his descendants. The trust document specifically bars the grantor from serving as trustee. However, he retains the power, which he can exercise at any time, to acquire property in the trust by substituting other property of equivalent value. The grantor doesn’t have to get the trustee’s consent (or any other approval) before switching the property. He only has to certify in writing that both properties—the property originally transferred to the trust and the substitute property—are of equivalent value.

In its ruling, the IRS noted the grantor is not subject to the strict standards that would be required if he were a fiduciary of the trust. But it emphasized the significance of the requirement for using replacement property of equivalent value. That ensures he won’t be able to decrease the value of the trust or increase the value of his personal holdings even though he retains the power to substitute trust assets. Furthermore, the trust is set up so it must have an independent trustee who will safeguard the rights of the beneficiaries. Based on these facts, the IRS ruled that although the grantor retained the power to use substitute property, trust assets would not be considered part of his gross estate.

This ruling gives grantors and their advisors more flexibility in structuring IDTs that can benefit the grantors’ heirs. But these are sophisticated estate planning vehicles, and there are still plenty of pitfalls that could trip you up. If you think an IDT might help meet your family’s needs, we can work with you and your attorney to gauge its potential benefits and avoid problems.


This article was written by a professional financial journalist for Legend Financial Advisors, Inc.® and is not intended as legal or investment advice.

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