Eating an Elephant
A Primer on IDGTs
How do you eat an elephant? One bite at a time.
Annual exclusion gifts are like eating an elephant – assets are shifted from you to heirs one bite at a time. If done consistently each year, in time an heir will have received a sizeable amount. However, your remaining elephant – or estate – could still be sizeable even after decades of dutiful gifting. Especially if your elephant is growing faster than you can chew. Using the lifetime exemption is like butchering the elephant and putting a whole flank in your heirs’ deep freeze. (Not condoning the harm of elephants; I’m just making a point.)
I’ve been a vegetarian for nearly 14 years, so I’ll drop the meat analogy here.
When you have a taxable estate, annual exclusion gifts are small potatoes (vegetables are more my style). As I write this, you can only give $18,000 to any person in one year. Gifts beyond $18,000 dip into lifetime exemption, which is the $13.61 million you can give away to heirs during your lifetime or at death before paying estate taxes. Assets exceeding the lifetime exemption are taxed at 40% upon your death unless left to a spouse or charity. Given its size, lifetime exemption is a far more efficient tool for quickly moving assets, and perhaps more importantly, their future growth and income.
Exclusion gifts are often large enough to merit using a trust. Rarely does it make sense to gift millions of dollars outright. Besides lacking the structure and protection of a trust, an outright gift often is tax inefficient for the recipient who now needs to plan for estate taxes on the same assets.
So how does one make a large gift to:
· Utilize exemption and reduce their taxable estate,
· Shift future growth and income of an asset,
· Provide protection and professional management for the beneficiary, and
· Not create an estate tax problem for the beneficiary?
There are several different methods, but we’ll start with the Intentionally Defective Grantor Trust or IDGT. This trust is at the opposite end of the spectrum from annual exclusion gifts and can efficiently transfer lots of money.
My profession is terrible at naming things. See Crummey notices. The IDGT has “defective” in its name, which is what most people get caught up on when first introduced to this trust. To understand the “D” you have to understand the “G”. This type of trust is a “grantor trust” meaning the Grantor, the person who creates and funds the trust, is responsible for the income taxes. If you venture into the boilerplate of a grantor trust you’ll find some retained power, like the ability to swap assets of equal value, which, per the income tax code, makes the grantor the taxpayer. The estate tax is a separate section of the Internal Revenue Code. The trust is not the grantor’s asset for estate taxes but is the grantor’s asset for income taxes. This less than complete separation from the grantor, this defect, is very much on purpose.
Why would you ever do this? Because the Grantor pays the income taxes due from outside assets, further reducing their estate. Payment of taxes on behalf of the trust is not considered a gift, so no additional exemption is used. The assets essentially grow tax free inside the trust while the Grantor is living. The IDGT is an extremely powerful tool for minimizing estate tax liability because the initial gift is followed up by the annual payment of income taxes, which continues to shift wealth for years.
A Grantor might be comfortable with making a one-time large gift, but not so much with also paying the income taxes due each year. Often mechanisms can be built into the trust to toggle off grantor-trust status if it does become too much of a strain on the Grantor’s cash flow.
Beyond the powers making the trust a grantor trust, the Grantor doesn’t retain control or use of the assets. Whether the Grantor can be trustee really depends on the facts and circumstances, but often they name someone else to emphasize giving up control and the removal from their estate. The Grantor will need to be comfortable with giving up control of the asset. For this reason, these trusts are often funded with assets where control is a lesser concern, like non-voting shares of family business. It’s not uncommon for a business to recapitalize to have voting and non-voting shares for the purpose of gifting.
The trust’s beneficiaries are the ones who get to enjoy the assets, not the Grantor. This is another sticking point for many potential Grantors. They need to be able to maintain their desired standard of living without the assets. Running the numbers is incredibly important before making this kind of gift. For smaller estates, a large gift to an IDGT may not make sense.
In designing the trust, the Grantor will determine how and when the beneficiaries will access the assets. The Grantor’s legacy intentions are key. What’s an acceptable use of the assets? What do they hope these assets will allow the beneficiaries to do? While a legal document can support certain outcomes, it is no substitute for communicating intentions with the beneficiaries and educating them on their roles.
Depending on where the trust is located, the trust can be designed to keep the assets outside of the transfer tax system for generations to come, efficiently passing the assets down from generation to generation. Compound growth over decades is attractive, but we cannot predict the future. It’s important to build flexibility in irrevocable trusts like an IDGT that allows beneficiaries to make necessary changes to reflect personal circumstances (for example, directing assets for a special-needs child). Trust protectors might also be included to provide flexibility considering the ever-changing tax code or some other unforeseen circumstances.
Certainly, an IDGT is not for everyone. Control and cash flow issues should be given adequate attention. Diligence in designing a trust to last across generations is a must. But, given the right circumstances, it’s one powerful vehicle for taking a big bite out of a taxable estate.
