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Intentionally Defective Grantor Trusts (IDGT) for Tax, Medicaid, & Asset Protection Planning

President Obama's proposed 2014 budget, if passed, could potentially remove the tax arbitrage opportunities possible via intentionally defective grantor trusts.

A grantor trust is a trust in which the grantor, sometimes called a settlor or trustor, retains an interest. One particular type of grantor trust, called an intentionally defective grantor trust (IDGT), leverages disparities in the federal income and estate taxes to provide opportunities for tax, Medicaid, and asset protection planning.

Tax Planning

An IDGT can allow a grantor to freeze his/her federal estate and/or gift tax obligations associated with an appreciating asset and allow the IDGT to receive the income from the asset free of federal income tax. An IDGT can also enable a grantor to become eligible for Medicaid coverage while permitting the grantor to claim some federal income tax exclusions and/or deductions.

Estate & Gift Tax

Although the federal estate and gift taxes are distinct taxes, in large part, they are both concerned with the same thing: the taxation of wealth transfers.

The law associated with both taxes effectively creates a lifetime unified credit against which a person can transfer assets without incurring federal estate or gift tax obligations, either while alive or at death. The credit is currently $5.25 million per person or $10.5 million per married couple. Further, this credit is indexed for inflation and has been increasing at a rate of 2.5% per year since such it was so indexed. As such, individuals with assets in excess of $5.25 million, or legally married couples with assets in excess of $10.5 million, may be able to substantially reduce the federal estate and/or gift taxes associated with their assets by transferring appreciating assets to IDGTs.

For example, if a man owns an asset that is appreciating in value, he can effectively "freeze" the value of the asset for federal estate and gift tax purposes by selling the asset to an IDGT for a note payable. When the man dies, only the remaining value of the note payable, if any, will be included in his gross estate and will be subject to any federal estate and/or gift taxes.

In addition to freezing the value of the assets, the grantor may be able to structure the trust so as to discount the value of some types of assets transferred to the trust, e.g. businesses.

Income Tax

The reason an IDGT is often called "intentionally defective" stems from the federal income tax laws that disregard the existence of the trust for federal income tax purposes, thereby imposing the federal income tax obligations associated with the asset upon the grantor as opposed to the trust. Although this may seem undesireable, it can actually enable the asset owner to transfer significant wealth to beneficiaries, tax-free.

For example, if a woman owns an asset that generates income, she can transfer the asset to an IDGT for the benefit of her heirs which will allow the trust to receive the income generated by the asset free of federal income tax because the woman will be required to pay such tax. Not only does this allow the income to be received by the trust free of federal income tax, it also decreases the value of the woman's estate by reducing any federal estate and/or gift tax obligations associated with her estate.

Defects

The interests that cause a trust to be defective are set forth in sections 671 through 677 of the Internal Revenue Code (IRC).

The following is a list of some interests that can cause a trust to be defective, that are often considered significant interests, and that often do not result in a substantial reduction in the value of the interest retained by the grantor outside of minority and/or marketability discounts:

  • Power to revoke (IRC § 676);
  • Power to vote or direct the voting of stock or other securities of a corporation in which the holdings of the grantor and the trust are significant from the viewpoint of voting control (IRC § 674); or
  • Power to control the investment of the trust funds either by directing investments or reinvestments, or by vetoing proposed investments or reinvestments, to the extent that the trust funds consist of stocks or securities of corporations in which the holdings of the grantor and the trust are significant from the viewpoint of voting control (IRC § 675).

The following is a list of some interest that can cause a trust to be defective, that are often considered less significant interests, and that often do result in a substantial reduction in the value of the interest retained by the grantor outside of minority and/or marketability discounts:

  • Power to alter beneficial enjoyment (IRC § 674);
  • Power to deal for less than adequate and full consideration (IRC § 675);
  • Power to borrow without adequate interest or security (IRC § 675); or
  • Power to reacquire the trust corpus by substituting other property of an equivalent value (IRC § 675).

Medicaid Planning

Individuals can also leverage the same disparities between the federal income and federal estate tax laws during Medicaid planning, i.e. structuring ownership of assets to enable eligibility for coverage through Medicaid.

For example, if a man transfers his house to trust and meets the lookback requirements and other requirements of his state, e.g. not retaining a significant interest in the trust, in addition to the requirements of Section 121 of the IRC, he may be able to claim the capital gain exlcusion on the sale of the residence as set forth in IRC § 121.

Asset Protection Planning

In addition to the federal tax and Mediciad planning opportunities enabled by IDGTs, if structured correctly, an IDGT can also shield a person's assets from liabilities associated with the asset, thereby providing significant asset protection to the extent the grantor has not retained significant interests in the assets via the trust. Principally, this is because IDGTs are irrevocable trusts, and the trust assets generally cannot be attached to satisfy judgments against a grantor if the assets were not illegally transferred to the trust and if the trust grantor has not retained significant rights or interests in such assets.

For example, if a man transfers his interest in a business to an IDGT in 2013, causes a car accident 2014, and is required to pay a judgment in excess of his automobile insurance policy coverage in 2015, the judgment creditor will not likely be able to attach the interest transferred to the IDGT to satisfy the judgment. However, if the man transferred the business interest to the IDGT after the judgment was entered, the judgement creditor may be able to attach the transferred business interest to satisfy the judgment.

This brief overview of some important considerations associated with intentionally defective grantor trusts (IDGTs), tax planning, mediciad planning, and asset protection is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

Arizona AttorneyDouglas K. Cook is an attorney with over 40 years of experience. Although Cook & Cook's office is located in Mesa, Arizona, the attorneys at Cook & Cook represent clients throughout the Phoenix, Arizona Metropolitan area including the following east valley cities: Scottsdale, Paradise Valley, Tempe, Chandler, & Gilbert.

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