With inheritance tax under debate, consider an IDGT
According to Benjamin Franklin, the only certainties in life are death and taxes. Unfortunately, for the latter, there appears to be only uncertainty as to what proposed changes may be on the horizon.
What almost anyone can agree on at this point is that the current estate and gift thresholds are probably the best we’ll see for a while.
Currently, each individual has an inheritance and gift exemption amount of $ 11.7 million, or $ 23.4 million per married couple. Without new legislation, those numbers are expected to drop in 2026 to around $ 6 million per individual, and President Joe Biden’s proposals include further lowering the estate and gift thresholds to 2009 levels. This would translate into an estate threshold of $ 3.5 million – $ 7 million per married couple – and $ 1 million for the lifetime non-charitable donation tax exemption per person – $ 2 million per married couple.
Whether or not the laws change before 2026 and what they may look like, many farmers have made large taxable donations in 2020 and plan to do so again in 2021 before the numbers change.
One of the tools that farmers can use when they don’t want to give their kids big gifts is an intentionally flawed grantor trust.
What is that?
Simply put, an IDGT is a trust that is “defective” for income tax purposes but “not defective” for estate tax purposes. In other words, the person placing the assets in the trust would pay any tax on the income generated by the assets placed there, but for the purposes of the estate, the asset would no longer be considered part of his estate. .
In addition, the main advantage of donating is that the future appreciation of that asset comes from the taxpayer’s estate. Donating $ 3 million into an IDGT that appreciates to $ 15 million over the next decade would allow that $ 15 million to pass to the next generation without that person making the donation being subject to estate tax.
The other non-tax benefit that trusts can provide is the ability to protect creditors’ assets. Additionally, since divorce can pose a threat to family wealth, a next generation farm trust can further protect those assets in the event of marriage dissolution.
Here’s how IDGT might work
After a proper appraisal, a farmer makes a taxable donation of $ 3 million of farmland to an IDGT for the benefit of his children who will take over the farm. Under the current rules, its $ 11.7 million exemption would be reduced to $ 8.7 million.
A donation tax return would be required and the farmer would be responsible for reporting any taxable income on his return. However, farmland currently valued at $ 3 million – plus any future added value – will remain in the IDGT, therefore not included in the farmer’s domain and reverting to the next generation.
It may seem that the farmer paying tax on the income generated – in this case farm rents – would be a bad thing, but that is not necessarily true. The farmer can pay the tax, further reducing their estate, and the good news is that paying these taxes is not considered a gift.
The main disadvantage is that the farmer makes a taxable donation and therefore uses part of his lifetime exemption amount.
Sell to trust
The other way to use an IDGT is to “sell” a high yielding asset to the IDGT. The good news, at least for federal tax purposes, is that there is no tax payable on the transaction. This approach would be ideal for a business generating large profits on a consistent basis. Please note, however, that state taxation will not necessarily follow, so it is important to always review state tax rules.
There are a few key points to making sure the sale to the IDGT is done well. The first is to ensure that the promissory note uses an adequate interest rate, or the applicable federal rate. The long-term AFR rate is currently hovering below 1.7%.
The second is that the IDGT should already have seed money. The consensus, in this regard, is 10% of the asset to be sold to the IDGT. This initial capital of 10% will be considered as a taxable donation. Finally, as with any gift, proper documentation via a business valuation should be considered.
Another twist of an IDGT involves a Lifetime Spousal Access Trust. In these cases, the settlor’s spouse is a current beneficiary of the trust with the next generation.
Disadvantage of the gift
The downside to donating is that the increased base on death is not available.
For example, if a farmer donates $ 1 million of farmland in an IDGT purchased for $ 600,000, then that $ 600,000 is the base cost of that asset in the trust. If kept until death, the new fair market value would be increased to $ 1 million, which could reduce future capital gains taxes.
The good news here is that an IDGT can be structured with “surrogate power,” meaning that that farmer could take $ 1 million from another asset – like cash – put it in the trust and take back the land.
As long as the assets are of equal value, this is acceptable.
At the end of the line
An IDGT offers farmers a way to maximize and protect their assets for the next generation while minimizing property taxes. This year may be the last year that these high inheritance and gift thresholds are available for the foreseeable future.
A tailor-made plan unique to you and your operation using such a strategy should only be considered after careful discussion with your team of advisors.
Arezzo is Senior Tax Advisor for Farm Credit East.