Intentionally Defective Beneficiary Trusts

The benefits of an intentionally defective grantor trust (“IDGT”) are well known. First, the grantor’s payment of the trust’s income taxes is essentially a tax-free gift to the beneficiaries of the trust. Rev. Rul. 2004-64. Thus, the assets in the trust grow “tax free”. Second, by paying the income taxes, the grantor is reducing his/her estate by the taxes paid and any future appreciation that would otherwise have been generated on the funds used to pay income taxes. Third, the grantor can sell assets to an IDGT (on installments) without any gain or loss recognition. Sales between a grantor and a grantor trust are disregarded for income tax purposes. Rev. Rul. 85-13. Fourth, a sale to an IDGT of a life insurance policy on the grantor’s life can avoid both the three-year rule and the transfer-for-value rule. Rev. Rul. 2007-13. Fifth, an IDGT qualifies as an eligible S corporation shareholder. IRC Section 1361(c)(2)(A)(i). But, at such time as the IDGT is no longer a grantor trust, the trust must then “convert” to a Qualified Subchapter S Trust (“QSST”) or an Electing Small Business Trust (“ESBT”). Finally, with proper design and drafting, grantor trust status can be “toggled” on and off for maximum flexibility.

The powers that are typically used to trigger grantor trust status for income tax purposes, but without causing inclusion of the trust’s assets in the grantor’s estate, are the following:

1. The power to substitute trust property with other property of equivalent value. IRC Section 675(4)(c).

2. The power in a non-adverse party to add charitable beneficiaries. IRC Section 674(b)(4).

3. The power to distribute income to the grantor’s spouse. IRC Section 677(a)(1) and (2).

4. The power to use trust income to pay premiums on policies of insurance on the life of the grantor or grantor’s spouse. IRC Section 677(a)(3).

5. The power of the grantor to borrow trust assets without adequate security. IRC Section 675(3).

That said, consider turning the tables and drafting the trust so that the beneficiary – and not the grantor – is taxed on the trust income. With an IDGT, the grantor cannot be a beneficiary or a trustee of the trust without adverse estate tax consequences (under IRC Sections 2036 and 2038). But, with an intentionally defective beneficiary trust (“IDBT”), the beneficiary can be both the primary beneficiary and the trustee of the trust. The reason is that the beneficiary is not the grantor of the trust. Instead, the grantor is usually the beneficiary’s parent or grandparent.

Although it may not be cited as precedent, PLR 200949012 provides planners with a road map on how to properly design an IDBT. Following are the facts in PLR 200949012:

1. The grantor proposes to create a trust for the benefit of beneficiary;

2. The beneficiary will be a co-trustee of the trust (along with two independent co-trustees);

3. The beneficiary will have the unilateral power to withdraw all contributions made to the trust. However, this power will lapse each calendar year in an amount equal to the greater of $5,000 or 5% of the value of the trust.

4. The beneficiary will also have the power, during his lifetime, to direct the net income and/or principal of the trust to be paid over or applied for his health, education, maintenance and support (“HEMS”), and this power will not lapse;

5. The beneficiary will have a testamentary limited (non-general) power of appointment to “re-write” the disposition of the trust assets upon his death;

6. The trust provides that neither the grantor nor the grantor’s spouse may act as a trustee, and that no more than one-half of the trustees may be related or subordinate to the grantor within the meaning of IRC Section 672(c); and

7. The trust contains various provisions assuring that the grantor will not be treated as the owner of the trust for income tax purposes under IRC Sections 671 – 679.

The IRS ruled that the trust did not contain any provisions that would cause the grantor to be considered the owner of the trust for income tax purposes. Instead, the IRS ruled that the beneficiary will be treated as the owner of the trust for income tax purposes – before and after the lapse of the beneficiary’s withdrawal rights. The IRS analysis was as follows:

1. The trust did not contain any grantor trust “triggers” under IRC Sections 673 (reversionary interests); 674 (power to control beneficial enjoyment); 675 (administrative powers); 676 (power to revoke); 677 (income for benefit of grantor); or 679 (foreign trusts).

2. Under IRC Section 678, the beneficiary will be treated as the owner because the beneficiary had the right exercisable solely by the beneficiary to vest trust principal or income in himself.

In order for a beneficiary to be deemed the owner of a trust (for income tax purposes) under IRC Section 678, the beneficiary must be given the unilateral right to withdraw all income or corpus from the trust and, if such power is “partially released”, after the release the beneficiary retains such an interest in the trust that it would be a grantor trust with respect to the real grantor (if the real grantor had retained such interest). But, when the power gradually lapses in its entirety (by $5,000 / 5% per year), is IRC Section 678 status lost? According to PLR 200949012, the answer is “no”. The ruling apparently treats a “lapse” as a “release” so that even if the unilateral right to withdraw eventually disappears (by $5,000 / 5% per year), the lapse would be partial only because the power to withdraw for HEMS remains. And the HEMS standard – if available to the grantor – would be a grantor trust trigger under IRC Section 677. Thus, under IRC Section 678, the beneficiary continues to be treated as the owner of the trust.

As to the beneficiary’s estate tax consequences, the power to withdraw trust assets for HEMS does not create a general power of appointment and, therefore, does not result in estate tax inclusion. IRC Section 2041(b)(1). But, the unilateral right to withdraw principal is a general power of appointment that will cause the trust assets to be taxed in the beneficiary’s estate (but only to the extent the power has not lapsed under the $5,000 / 5% rule). IRC Section 2041(b)(2). For example, if the grantor contributed $1 million to the IDBT, the unilateral power of withdrawal would lapse in 20 years (i.e., 5% x $1 million = $50,000), or even sooner if the trust assets grew in value.

An IDBT works particularly well where the beneficiary has a new business opportunity, but would like to keep the business out of his or her estate. The beneficiary convinces his/her parents or grandparents to give him/her an “advance” on his/her inheritance by making a gift to the IDBT. This will allow the beneficiary to operate the business (as the trustee of the IDBT). The beneficiary will also have access to the cash flow of the business, without inclusion in his/her estate (except to the extent the beneficiary’s unilateral withdrawal right has not yet lapsed under the 5% / $5,000 power). The beneficiary can also sell assets to the IDBT without any gain or loss recognition. Finally, the beneficiary’s payment of the IDBT’s income taxes reduces his/her estate and is a “tax-free” gift to the remaindermen of the IDBT (i.e., the beneficiary’s descendants).

In summary, an IDBT allows the beneficiary to achieve virtually all of his/her tax and non-tax planning objectives. When advising clients on estate planning matters, the planner should advise them to consider establishing IDBTs for their children and grandchildren, and/or advise them to ask their parents and grandparents to establish an IDBT for themselves.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION.

Julius Giarmarco, J.D., LL.M, is an estate planning attorney and chairs the Trusts and Estates Practice Group of Giarmarco, Mullins & Horton, P.C., in Troy, Michigan.

For more articles on estate and business succession planning, please visit the author’s website, www.disinherit-irs.com, and click on “Advisor Resources”.