August 23, 2023
Though the name may sound odd, an intentionally defective grantor trust can be useful in planning for farm successions.
An IDGT is set up in such a manner that the assets held by the trust are considered separated from the grantor (trust maker) for estate tax purposes but are treated as owed by the grantor for income tax purposes. Think about it this way, the grantor transfers assets such as entity shares or real estate to the IDGT; they no longer own or receive the benefit of these assets, but they still need to pay the income taxes on the income generated by these assets.
One way this setup can be helpful is when selling appreciated assets such as real estate or entity shares to a successor beneficiary. The appreciating asset is sold to the IDGT by the grantor. This sale can be done on a promissory note. Since the IDGT is defective for income tax purposes, it is as if the grantor is transferring the asset to himself or herself. Because the income tax liability is not changing hands, there will not be a recognition of capital gain on this sale. After the sale the asset is owned by the IDGT, the grantor will receive the payments on the promissory note from the IDGT, and eventually the successor who is the beneficiary of the IDGT will receive the asset sold to the IDGT.
Avoid capital gains
For example, a farmer owning a farm entity may want to transfer this entity to their children, but they also want to continue to receive money from this operation for a period of time. If they sold the operation directly to their children, they would generate a capital gain on the sale. To avoid the capital gain, the farmer could create an IDGT naming the children as the beneficiaries and trustees of the IDGT. The farmer can then sell the farm entity to the IDGT on a promissory note.
The trust makes payments to the farmer on the promissory note. The children, as the beneficiaries of the IDGT, eventually own the farm entity. This promissory note can be designed to protect the farmer’s estate from estate taxes, and as a tool for gifting with canceling terms. When using an IDGT, the farmer should be sure to consult with their tax professional to ensure this provides an overall tax advantage to them — when taking into consideration they will be required to pay the income tax on the income earned by the IDGT.
Balzarini is an attorney at law with Hellmuth & Johnson PLLC. Contact him at [email protected].
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