Pre-Transaction Estate Planning Part 3: Installment Sales to Intentionally Defective Grantor Trusts (IDGTs)

Continuing from the first two parts of this series (the simple gift of business units and grantor retained annuity trusts), this installment is about the second leveraged gifting option—installment sales to intentionally defective grantor trusts, or IDGTs. I know…another acronym.

This transaction mimics a sale of business interests to a third party, but it is really a sale of business interests to a trust for the benefit of others that is disregarded for income tax purposes. Because it is disregarded, we call it “defective” and there are no capital gains on the sale.

An IDGT involves another irrevocable trust that is established by the grantor. Because it is a grantor trust, the grantor pays all the income taxes associated with the assets held in the trust.  The grantor establishes a trust to benefit others (usually children or grandchildren), and that trust will be the buyer of certain business interests.

Along with the creation of that trust, the grantor usually gifts some assets to the trust to fund it. Typically we recommend the gift represent about 10% of the value of the assets that will be sold to the trust. After the gift, the grantor usually sells business interests, at a price determined by an appraisal, in exchange for a promissory note. The assets are immediately owned by the trust, and thus any appreciation that happens after the sale is owned by the trust and eventually passed tax free to the trust beneficiaries.  Even if the grantor dies before the note is paid off, he or she is the owner of only the remaining payments on the promissory note, not the business assets.

The grantor retains the right to payments on the promissory note equal to the sales price for a specified term plus a prescribed interest rate.  The mid-term rate for August, or up to a nine year promissory note period, is only 0.88%.  The note can be structured to pay only interest with a balloon principal payment at maturity, or interest and principal payments for the entire note period.

As is the case with the GRAT example, this technique is especially successful if the grantor is expecting an appreciation event to happen.  If the stock is sold at a lower price to the trust, and then appreciates to a higher value, the trust beneficiaries retain that benefit tax free.

• Example. Business owner gifts $5,000,000 to an irrevocable trust. Subsequently, grantor sells $50,000,000 worth of stock to the trust in exchange for a $5,000,000 down payment and 9 year promissory note with interest-only payments. The business owner will receive eight annual payments of $396,000 based on August’s mid-term interest rate of 0.88% (an all-time low), and one final balloon payment of principal and interest of $45,396,000.  If the assets grow at 10% per year, the trust will contain over $75,000,000 after the nine years. All transfer tax free.  If the assets grow at 20% per year, the trust will contain over $200,000,000.

There are no income tax implications to selling the stock to the trust and only the initial gift has gift tax implications. This is a great technique if you are expecting an appreciation event, or even have steadily appreciating business assets. The owner continues to have an income stream, but removes the appreciation from his or her taxable estate.  This also passes some ownership interest without control, and the grantor can manage how that interest is voted and managed through the use of a trust.  This technique is a great way to take advantage of an appreciation event and the low interest rate environment, and to begin the succession planning process without giving up control of the entity.