Planning for Flexibility with Intentionally Defective Grantor Trusts

Find a Wealth Advisor

Author: Nick Hudson, CFP^®, CPWA^®, AVP, Wealth Strategist, Fifth Third Private Bank

An intentionally defective grantor trust (IDGT) is a popular tax-planning strategy often used by high-net-worth individuals and families with sizable estates. Various forms of this trust, including spousal lifetime access trusts (SLATs), offer similar advantages to the individual who creates and funds the trust (grantor): the ability to transfer wealth outside their taxable estate, potentially lowering future transfer taxes, and providing a layer of asset protection when properly drafted and administered.

Fundamentals of an IDGT

An IDGT is an irrevocable trust established by a grantor for the benefit of one or more beneficiaries, typically a spouse or descendants. To initiate this strategy, the grantor makes a gift to the IDGT utilizing a portion of their lifetime exemption.¹ No gift or estate taxes are incurred by this gift. Once these gifted assets are owned by the IDGT, the value of the assets and all future appreciation are out of the grantor’s taxable estate, ultimately passing to the beneficiaries of the trust free of estate and gift tax.

In addition to removing the assets and appreciation from the grantor’s taxable estate, IDGTs have an added benefit. With an IDGT, taxable income from the trust will be treated as taxable income of the grantor. While this may seem like a negative, it allows the grantor to essentially "gift" more to the trust without utilizing any additional lifetime exemption. The trust itself will continue to grow without the need to liquidate assets to pay for these taxes, while the grantor will simultaneously be spending down their taxable estate in the form of income tax payments.

Parting with assets can be challenging

Despite the significant tax benefits of an IDGT, some clients understandably struggle with the idea of parting with substantial assets. The psychological challenge of relinquishing access to wealth, especially during economic downturns, can cause hesitation even among the wealthiest individuals. Even in the case of a SLAT, which involves the grantor gifting to an irrevocable trust for the benefit (and under the control) of their spouse, there are still pain points to consider. What happens if the beneficiary spouse predeceases or divorces the grantor? Suddenly, assets to which the grantor had indirect access have become less accessible. What options are there to guard against these situations, or to potentially provide the grantor with access to trust funds if needed?

Solutions

• Before funding: Before making any gifts, individuals should collaborate with their team of advisors (attorney, CPA, wealth advisor, etc.) to determine an affordable gift level. This involves a comprehensive financial analysis that includes future cash flow, current balance sheet, assumed market returns and risk tolerance.
  • One solution to consider is for a client to purchase life insurance on the life of the beneficiary spouse. If the beneficiary spouse predeceases the grantor, the grantor would receive a death benefit that could offset the loss of indirect access to trust assets. In exploring this option, consider having the beneficiary spouse establish a separate life insurance trust, with the grantor as beneficiary, to keep the death benefit out of the grantor’s taxable estate.
• Provisions to consider: After careful planning and determining a prudent amount to gift to a trust, the grantor should discuss any concerns over loss of access with their attorney. Below are several trust provisions that could be discussed:
  • Substitution power: A substitution power allows the grantor to swap assets within the trust for assets of substantially equal value. For example, the grantor may gift a low-basis asset, such as ownership in a closely held business, to "freeze" its value and push future appreciation outside of the grantor’s taxable estate. As any asset included in the grantor’s taxable estate receives a "step up" in cost basis as of the grantor’s date of death, it may be advantageous from an income tax planning standpoint to swap this low-basis asset out of the trust and back into the grantor’s estate at a future date. While the power does not necessarily aid a grantor who needs assets to fund their lifestyle, it can give comfort to those uncomfortable with the idea of gifting away a certain asset.
  • Power to borrow trust assets: A common provision included in IDGTs is giving someone in a non-fiduciary capacity² the power to lend trust assets to the grantor on an unsecured basis. The grantor should pay adequate interest on ³ any such loan to avoid estate inclusion on the loaned assets. Including this power could allow the grantor a means ⁴ of access in the event of a spousal beneficiary passing, though payment of interest may not be a viable option for a grantor in need of funds.
  • Tax reimbursement clause: While having the grantor pay the taxes on an IDGT can be an excellent tool to further reduce future transfer taxes, large tax bills from the sale of highly appreciated assets can become burdensome to one’s financial stability, especially with no direct access to the proceeds from such a transaction. Inclusion of a tax reimbursement clause can give the grantor’s trustee the discretion to reimburse the grantor for any income taxes that they have paid on the trust. In administering these clauses, it is recommended that reimbursements not be made with any regularity, and to have the grantor’s tax advisor provide the trustee with tax estimates whenever the trustee decides to exercise such discretion. Improper administration could lead to assets in the trust being included in the ⁵ grantor’s estate.⁶
  • Floating spouse: For IDGTs where the grantor’s spouse is the primary beneficiary (e.g., SLATs), inclusion of a f loating spouse provision can help protect the grantor against loss of indirect access, whether through death of the beneficiary spouse or divorce. Rather than naming the grantor’s existing spouse by name, the document states it is for the benefit of the grantor’s spouse and gives clear parameters as to when someone shall be considered a spouse. If the grantor were to later remarry, their new spouse could be added in as a beneficiary, with the grantor regaining the indirect access that they temporarily lost.
  • Special power of appointment trust (SPAT) : ⁷ A SPAT provision grants an individual (typically a non-fiduciary and non-beneficiary) the power to appoint trust property to anyone in a class of beneficiaries that includes the grantor (e.g., descendants of the grantor’s maternal grandmother). This appointment would not be adding the grantor as a beneficiary of the trust but would instead allow the holder of the power of appointment to, in their discretion, distribute assets to the grantor, potentially mitigating some risk of remaining trust assets being reached by creditors or included in the grantor’s estate. While a properly drafted and administered SPAT could provide the grantor with a means of indirect access, there is the potential that the IRS and creditors could argue there was a "hand-shake agreement" between the grantor and the power holder, causing trust assets to be included in the grantor’s estate, or accessible to creditors. Careful consideration should be given before any appointment of assets to the grantor, as assets appointed back to them will be included in their estate, causing a potential waste of any lifetime exemption that was allocated to the initial gift.

Mitigating risk

While the above provisions can provide the grantor with access to trust assets, each comes with its own risks. These provisions may be scrutinized by the IRS or creditors, potentially leading to the inclusion of trust assets in the grantor’s estate, or such assets being subject to creditors’ claims. Working closely with a team of advisors is crucial to mitigate these risks.

• Appointment of corporate trustee: The administration of a trust is just as important as the drafting when it comes to protecting the grantor from claims of creditors or from the IRS. A corporate trustee will be able to provide assurance that the trust document is being followed and administered by an impartial professional trustee. Additionally, one common theme that the IRS looks for when trying to attack these trust structures is the idea that there was some form of prior agreement between the grantor and the trustee as to the grantor’s interest in the trust. Hiring a neutral corporate trustee, who is regulated as a fiduciary and who is not controlled by the grantor, can help provide an extra layer of protection.
• Trust jurisdiction: Certain states have laws that are more favorable to a grantor gaining access to trust funds and can offer better creditor protection than others. The grantor is not required to establish a trust in their home state but can choose to have their trust governed by the laws of one of these more favorable jurisdictions. A best practice is to discuss the pros and cons of these favorable trust jurisdictions with a qualified attorney based on an objective evaluation of the client’s goals and objectives.

Final thoughts

Parting with assets can be psychologically challenging, even with thorough planning. For those who wish to take advantage of the estate tax savings and creditor protection offered by an IDGT, it is essential to work with advisors to carefully consider provisions that allow access to trust funds. While each strategy has its risks, close collaboration with an estate attorney and other trusted advisors can help mitigate these risks and achieve optimal results.

For more information, contact your Fifth Third Private Bank advisor.