Intentionally Flawed Grantor Trust: Income Tax Problems Wendel Rosen LLP


An intentionally defective transferor trust (“IDGT”) can be beneficial for estate transfer and lower inheritance taxes. With an asset transfer to an IDGT, the settlor effectively removes these assets from the settlor’s estate while retaining income tax for the income generated by those assets. By including certain powers in the trust (called “assignor powers”), the settlor is treated as the owner of the assets of the trust for income tax purposes and the income of the trust is taxed to the assignor as it is. he received the trust income directly (Section 671). The trust is called “intentionally defective” because the settlor relinquishes ownership of the assets for estate tax purposes, but retains ownership of the trust for income tax purposes. The main advantage of the transferor trust status is that the trust assets can continue to appreciate without being depleted by income tax payments, which is equivalent to an additional transfer of wealth to the beneficiaries of the trust who is not subject to transfer tax (Rev. 64).

The following is a discussion of various tax issues related to transfers of assets to an IDGT:

Will the transfer of encumbered assets result in a taxable gain?
The assignor’s trustor status offers an additional advantage when the assignors intend to transfer debt-encumbered assets to the trust. A transfer of encumbered assets could result in the realization of a taxable gain if the amount of the debt exceeds the assignor’s base in assets (IRC 1001). This raises concerns that the transfer of encumbered assets could be a tax event for the grantor. However, due to an IDGT’s assignor status, the settlor remains the owner of the trust assets for income tax purposes, and there will be no realization of gain on the transfer of the encumbered assets. .

Can income tax be transferred to the trust?
IDGTs can also be written to retain flexibility for the trust to pay its own income tax in the future. To provide such flexibility, and to allow for any future occasion in which the burden on the settlor to pay income tax outweighs the above benefits, the trust may include conditions that allow for disabling or disabling. “Deactivate” the settlor’s trust status. Exercising this “tipping power” transfers income tax from the settlor to the trust itself. Depending on the nature of the settlor’s powers, the settlor or a protector of the trust may exercise the power to switch under the trust to relieve the settlor of the settlor’s powers, and the trust immediately changes status to a non-settlor trust. However, the termination of the transferor trust status could be a tax realization event with respect to the initial transfer of the encumbered assets mentioned above. If the charge is a recourse, i.e. the debt holder retains the right to sue the grantor directly, there would be no taxable event for the grantor when the assets are transferred to the trust or at the time of the subsequent change of the statute of the settlor of the trust to a non-confidence of the grantor.

Can the settlor be reimbursed for income taxes paid?
Although the settlor cannot transfer the responsibility for income tax to the trust without losing the status of transferor trust, the settlor can be reimbursed by the trust for the income tax paid. Trust conditions may be included to allow the trustee to reimburse the grantor for income taxes paid at the discretion of the trustee.

Note that the IRS has ruled that if repayments are mandatory, or if there is evidence of agreement or collusion between the settlor and the trustee, the settlor has effectively retained the right to use the trust property for fulfill its own obligation to pay income tax, i.e. the full value of the trust assets must be included in the settlor’s estate (IRC 2036). Conversely, where the repayment is discretionary rather than mandatory and there is no discussion of the repayment between the settlor and the trustee, the assets of the trust are not included in the settlor’s estate due to the settlement. discretionary tax refund clause.

IDGTs are complex and must be carefully drafted and implemented. Wendel Rosen’s trust and estate lawyers can help you establish an IDGT that works in tandem with your estate planning goals.

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