Intentionally Defective Grantor Trust
(PA)

Summary

This template is an intentionally defective grantor trust (an IDGT) that may be used in Pennsylvania. This type of trust can be a very powerful weapon in the estate planner’s arsenal. This template includes practical guidance and drafting notes. By intentionally causing an irrevocable trust to be taxable to the grantor under Sections 671 through 679 of the Code for income tax purposes, it is still possible to avoid having the assets transferred to the IDGT included in the grantor’s estate at death, while removing further assets from the grantor’s estate through grantor’s retention of the liability for income taxes imposed on the income those assets generate subsequent to the transfer. However, the scrivener must be careful to ensure that the IDGT does not inadvertently cause those assets to be drawn back into the estate under Sections 2036 or 2038 of the Code. Leveraging is perhaps the most useful aspect of establishing an IDGT. One of the “estate freeze” techniques that may be used with an IDGT is a sale of property from the grantor to the IDGT for a so-called balloon note. In essence, the balloon note would provide for the payment of interest only for a period of time (not more than 20 years usually) with principal being paid at a future date. During the current period of generally low Applicable Federal Rates (AFRs), a sale of appreciating property to an IDGT by the grantor in exchange for a balloon note can remove substantial amounts from the grantor’s estate as only the principal amount due on the promissory note should be included in the grantor’s gross estate. Assuming that the property appreciates at a rate in excess of the AFR, the difference between the AFR interest rate payable on the note and the asset’s growth rate is removed from the estate. Of course, this means that the greater the differential between the AFR rate and the rate of asset growth, the greater the benefits that are derived from the transaction. On the other hand, if an asset is depreciating, then the value added back to the grantor’s estate through the interest payment on the note will cause an increase in the death taxes payable on the grantor’s death. Accordingly, selection of the appropriate assets to sell to the IDGT cannot be overemphasized. It should also be noted that the grantor will have to “seed” the IDGT through a gift of money or other assets, typically with those other assets having at least 10% of the value of the assets being purchased by the trust, in order to give the transaction sufficient economic substance to be respected by the IRS. One popular method to avoid the income tax consequences of an outright sale of a closely held business interest to younger generations is to structure the sale as one to an IDGT established by the owner. The IDGT is treated as a grantor trust for income tax purposes and therefore, the sale is ignored as the IRS views the sale as having been made between the same taxpayer. In particular, see the provisions at Sections and of the sample trust which cause the trust to be a grantor trust for income tax purposes only. The purchase price of the interest is usually set at an amount equal to the current fair market value of the interest so that it acts as an “estate freeze” to hold down the value of the owner’s taxable estate and not generate any gift tax liability. A promissory note of 10 to 20 years, bearing interest at the applicable federal rate in effect on the date of the transfer, is used to pay the purchase price. The principal balance of, and any accrued but unpaid interest on, the note will be included in the owner’s estate if the note has not been paid in full at the time of his or her death. Given the sustained low interest rate environment that is reflected in applicable federal rates in the past decade, this technique had been an excellent way in which to transfer future appreciation to later generations with little or no gift or income tax consequences. However, the increasing interest rates of more recent vintage will tend to have a chilling effect on the opportunities to use this technique. One other open issue that remained unresolved with respect to IDGT sales is the basis of the business interest in the hands of the trust following the owner’s death. Arguably, the trust’s basis should be equal to the purchase price paid by the trust for that interest. However, because the sale was ignored for income tax purposes under the grantor trust rules, that result is not assured. Moreover, because the business interest is not includable in the seller’s estate (rather the promissory note and its proceeds are), it does not appear that the interest would be eligible to receive a stepped up basis on the owner’s death pursuant to Code Section 1014. The Service has now clearly taken the position that the trust’s basis is equal to the owner’s basis at the time of the initial sale since no other Code provision would apply to modify that tax basis. Note also that at the end of March 2023, the IRS and Treasury issued Revenue Ruling 2023–2 regarding I.R.C. Section 1014 basis adjustments and defective grantor trusts. The Revenue Ruling poses the question whether there is a basis adjustment under I.R.C. Section 1014 to the trust in cases where the individual owner of the trust dies, and the assets are not included in the individual owner’s estate for estate tax purposes. The facts of the revenue ruling involve an irrevocable grantor trust funded with assets the transfer of which was a completed gift for gift tax purposes. I.R.C. Section 1014(b) lists the seven types of property that are considered to have been acquired from or to have passed from the decedent for purposes of Section 1014(a), including, “[p]roperty acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent.” I.R.C. § 1014(b). Revenue Ruling 2023-2 holds that the assets do not fall into any of the seven categories; therefore, the basis of the assets is not adjusted. Put another way, the IRS determined that the basis “step-up” under I.R.C. Section 1014 does not apply to assets gifted to an irrevocable grantor trust by completed gift in cases in which such assets are not included in the gross estate of the owner of the trust for federal estate tax purposes. Under Revenue Ruling 2023-2, the basis of the assets in the grantor trust immediately after the grantor’s death is the same as immediately prior to the death. For more information on intentionally defective grantor trusts, see Characteristics and Uses of Trusts (PA); Requirements and Restrictions on Trust Purposes and Administration (PA); and Revocation, Amendment, and Termination of Trusts (PA).