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Intentionally Defective Irrevocable Trust Planning (IDIT)

Purpose: To sell an asset to an IDIT without incurring a capital gain tax and to freeze the value of the sold asset (future appreciation in value of the asset occurs in the IDIT). Assets owned by the IDIT (if properly drafted) will not be taxable in the estate of the Grantor.

Steps:

  1. Determine the fair market value of the asset to be removed from the taxable estate and the Grantor's basis.
  2. Create the IDIT - include a provision that makes the Trust a Grantor trust for purposes of income taxation (IRC sections 671 - 679). All items of income and deduction are reported on the Grantor's income tax return.
  3. Determine how many primary and contingent beneficiaries exist for purposes of annual exclusion gifts to the Trust (Crummey withdrawal rights).
  4. Gift an amount of cash to the IDIT that will equal 10% at least of the asset to be purchased. This amount is used as a down payment for the purchase of the asset from the Grantor. The balance of the purchase price is paid with a promissory note at Applicable Federal Rate (AFR) (interest due to the Grantor). This step requires a determination as to amount of the gift that qualifies as an annual exclusion gift and the excess is a gift using the One million lifetime exemption. If any amount of lifetime exemption is used, a Gift Tax Return (709) is required.
  5. Create separate IDIT account to hold the asset if needed.
  6. When the asset is purchased, the Trustees pay the down payment amount to the Grantor and execute the promissory note. Because the Grantor is both the Seller of the asset and the Buyer (as the Grantor of the IDIT) no capital gain recognition occurs. The Trustees of the IDIT will take the Grantor's basis in the asset as the basis for the IDIT (in other words there is no step up in basis). Complete transfer paperwork - e.g. deed, interest in realty trust, assignment of stock, etc.
  7. If the amount of cash needed for the 10% down payment is more than the Grantor can come up with at one time, consider multiple transactions. The Grantor contributes an amount to the IDIT and that amount is used as a down payment to purchase some of the asset. The Grantor receives the cash back and can then make a second gift to the IDIT with this cash and do a second sale transaction. The timing of the second gift will require that a new AFR be used.
  8. If the Note is structured as a demand note, then the short term AFR may be used.
  9. To prepare the Crummey withdrawal letters and to execute a 706 by April 15, of the year following the gift, information that is needed includes:
    • Full name and address, and social security number of the Grantor;
    • Full name and address, social security number and date of birth for each beneficiary and if the beneficiary is a minor, the name and address of the parent;
    • What was gifted and the date of the gift (if cash only amount and date of gift is needed; if other than cash a valuation of the asset is needed if there is no readily ascertainable value available and the basis of the asset is needed);
    • Whether a contribution instrument was used by the Grantor so that the beneficiaries receiving the gift are other than as stated in the IDIT (default beneficiaries for purposes of withdrawal rights);
    • Whether earlier Gift Tax returns were filed for the Grantor (need copies of all prior returns);
    • Whether the gift is a GST exempt or non-exempt gift (whether the Grantor's generation skipping tax exemption should be allocated);
  10. Follow up may be necessary, e.g. Grantor Trust Income Tax Return (1041) and Grantor Letter for each year that the IDIT is in existence and has taxable income during the lifetime of the Grantor. (At the death of the Grantor, a separate tax I.D. number will be required and separate tax returns (non-grantor trust return); continuing Crummey letters for new gifts or to lapse hanging power gifts, new Gift Tax Returns if new gifts exceed the annual exclusion available, bookkeeping, etc. And upon the death of the Grantor the IDIT may require that separate shares are created for each primary beneficiary (FBO shares), which will require separate tax I.D. numbers and an allocation of IDIT assets.