Exploring the Advantages of Intentionally Defective Beneficiary Trusts

The Mechanics of Intentionally Defective Grantor Trusts (IDGTs)

An Intentionally Defective Grantor Trust (IDGT) is a type of irrevocable trust that is purposefully structured to be defective for income tax purposes but effective for estate planning. The "defect" allows the trust's income to be taxed to the grantor, not the trust itself or the beneficiaries, which can lead to significant tax savings. Here are some key benefits of IDGTs:

• Tax-Free Growth: The grantor's payment of the trust's income taxes is essentially a tax-free gift to the beneficiaries, allowing the trust assets to grow without the burden of income taxes (Rev. Rul. 2004-64).
• Estate Reduction: By paying the trust's income taxes, the grantor reduces their taxable estate, potentially saving on future estate taxes.
• No Recognition of Gain or Loss: The grantor can sell assets to an IDGT without recognizing any gain or loss, as sales to a grantor trust are disregarded for income tax purposes (Rev. Rul. 85-13).
• Life Insurance Policy Sales: Transferring a life insurance policy to an IDGT can avoid the three-year rule and the transfer-for-value rule (Rev. Rul. 2007-13).
• S Corporation Shareholder Eligibility: An IDGT can be a shareholder of an S corporation, which can be beneficial for business succession planning (IRC Section 1361(c)(2)(A)(i)).
• Flexibility: Grantor trust status can be toggled on and off, providing flexibility in trust management.

To achieve grantor trust status without including the trust's assets in the grantor's estate, certain powers are typically incorporated:

1. The power to substitute trust property with property of equivalent value (IRC Section 675(4)(c)).
2. The power to add charitable beneficiaries (IRC Section 674(b)(4)).
3. The power to distribute income to the grantor's spouse (IRC Section 677(a)(1) and (2)).
4. The power to use trust income to pay life insurance premiums on the grantor or spouse (IRC Section 677(a)(3)).
5. The power for the grantor to borrow trust assets without adequate security (IRC Section 675(3)).

The Innovation of Intentionally Defective Beneficiary Trusts (IDBTs)

An Intentionally Defective Beneficiary Trust (IDBT) is a variation of the IDGT where the beneficiary, rather than the grantor, is taxed on the trust income. This structure allows the beneficiary to be both the primary beneficiary and the trustee without adverse estate tax consequences, which would not be possible in an IDGT due to IRC Sections 2036 and 2038.

Private Letter Ruling (PLR) 200949012 provides insight into the proper design of an IDBT, although it may not be cited as precedent. The ruling confirmed that the beneficiary, not the grantor, would be treated as the owner of the trust for income tax purposes, both before and after the lapse of the beneficiary's withdrawal rights.

Key Features of the IDBT in PLR 200949012:

• The beneficiary has the unilateral power to withdraw contributions, which lapses annually by the greater of $5,000 or 5% of the trust's value.
• The beneficiary retains the power to direct trust income and/or principal for their health, education, maintenance, and support (HEMS).
• The beneficiary has a testamentary limited power of appointment over trust assets upon death.
• The trust ensures that the grantor will not be treated as the owner for income tax purposes under IRC Sections 671 – 679.

Estate Tax Implications for the Beneficiary:

• The power to withdraw trust assets for HEMS does not create a general power of appointment, avoiding estate tax inclusion (IRC Section 2041(b)(1)).
• The unilateral right to withdraw principal is a general power of appointment, causing estate tax inclusion to the extent the power has not lapsed under the $5,000 / 5% rule (IRC Section 2041(b)(2)).

Strategic Uses of IDBTs

IDBTs are particularly useful for beneficiaries with new business opportunities who wish to keep the business out of their estate. By receiving an "advance" on their inheritance through a gift to the IDBT, beneficiaries can manage the business and access its cash flow without significant estate inclusion. Additionally, selling assets to the IDBT without gain or loss recognition and the beneficiary's payment of the trust's income taxes can further reduce their estate.

Conclusion: The Versatility of IDBTs in Estate Planning

In summary, IDBTs offer beneficiaries a comprehensive solution to achieve their tax and non-tax planning objectives. Estate planners should consider advising clients on the benefits of establishing IDBTs for their descendants or encouraging them to request that their elders create an IDBT for their benefit.

Please note that this article is for informational purposes only and is not intended as legal or tax advice. Taxpayers should consult their own legal and tax advisors for advice specific to their situation.

Internal Revenue Service Revenue Rulings Private Letter Rulings