IDIT BASICS

An IDIT is "intentionally defective" in that the drafter structures it so the grantor continues to be responsible for the income tax attributable to the trust. Sections 671-679 of the Code, known as the "grantor trust rules," outline the elements of a trust that will cause this "defect." For example, the trust might give the grantor the power to substitute property of equivalent value, or the power to borrow from the IDIT for less than adequate interest or without security. Either power would cause the IDIT to be initially classified as a grantor trust.

The goal is to both remove significant assets from the grantor's taxable estate upon initial transfer to the IDIT and to continue to remove assets as the grantor uses his or her assets to pay income tax attributable to the IDIT. Frequently, a client will first transfer assets to an FLP, achieve significant discounts on the transfer of limited partnership (LP) interests, and then have the FLP sell the LP interests to an IDIT on an installment payment basis. This affords a client the opportunity to transfer more assets for little or no gift tax.

IDIT planning often attempts to reduce the client's taxable estate to a bare minimum by the time the client reaches life expectancy, which calls for flexibility in the event the client lives much longer or flexibility for other unforeseen changes. For example, there may come a time when the client's taxable estate is reduced to the point where the client/grantor is no longer able to pay the income tax attributable to the IDIT. The authors suggest including an "on/off" switch, or a "toggle," into the IDIT to turn grantor status on and off and provide flexibility.

TRADITIONAL APPROACHES TO SWITCHING GRANTOR STATUS ON AND OFF

The IDIT can give the grantor the option to release whatever grantor power a drafter originally included in the IDIT to cause grantor status, which would allow the IDIT to begin paying its own income tax. However, if the grantor's taxable estate once again grew to a significant size or other unforeseen factors enter the picture, the grantor might again desire grantor status for the IDIT. The authors suggest the grantor can give the IDIT trustee the power to regrant the previously released power to the grantor.

However, the control issues of traditional "toggle switch" IDIT planning can cause problems for the grantor, such as problems under Sections 2036, 2038, or 2041. Specifically, the authors suggest the Service might make the following arguments based on this traditional planning:

1. Implied agreement. The grantor's power to repeatedly release and reacquire powers that initially caused classification as a grantor trust gives rise to an "implied agreement." The circumstances of a given case might imply that the grantor has retained control of property transferred to the IDIT. If this argument prevails, IDIT property would be includible in the grantor's estate for estate tax purposes.
2. Agency/control. The IDIT trustee is simply acting as the grantor's agent, once again possibly resulting in estate inclusion of IDIT assets.
3. Substance over form. The grantor's ability to switch powers on and off could suggest that the trust was able to become a grantor trust at any time. Thus, the Service might classify the IDIT as a "perpetual" grantor trust, negating any opportunity to turn off grantor trust status when necessary.

FOREIGN TRUST STATUS: AN ALTERNATIVE TOGGLE

The authors suggest reliance on Section 679 to avoid the appearance of both tax-only motivation and grantor/trustee collusion. Unlike Sections 671-678, Section 679 does not depend on grantor-held powers as its trigger for grantor trust status. Rather, grantor trust status under Section 679 depends on the following:

1. a U.S. person transfers property;
2. the transfer is to a foreign trust; and
3. there is a U.S. beneficiary.

Since most U.S. trusts meet items one and three, the element that "the transfer is to a foreign trust" is key to this alternative toggle switch. The grantor can accomplish this by either drafting the trust to give the grantor the power to change the trustee to a foreign trust, or by giving the trustee the power to change the applicable law of the trust to a foreign jurisdiction. Under either approach, the power to toggle the trust to grantor status rests with either the grantor or the trustee, but not both, which helps negate the Service's argument of the two working in harmony.

Using the offshore alternative to trigger grantor trust status may now raise at least the following three non-tax motivations:

1. the grantor is pursuing estate planning integrated with asset-protection motivation;
2. the grantor can plan to take advantage of foreign jurisdictions that have abolished the rule against perpetuities; and
3. the grantor has proactively chosen a foreign investment manager or trustee for their expertise.

The authors note that Section 684(b) avoids taxation on gain when a U.S. grantor transfers appreciated assets to a foreign trust when it is a grantor trust. While it is true that grantor status will "toggle off" when the grantor dies, the recognition and taxation of appreciated assets will be a liability of the estate that can further reduce estate tax after the grantor's death. However, the burden of taxation under Section 684 may be too great for some estates to bear. In such cases, the authors suggest three possible approaches:

1. Keep the trust as a domestic trust by not toggling on grantor status.
2. Draft the trust with language that causes it to automatically become a domestic trust upon the grantor's death.
3. Have an entity that "does not die," such as an FLP, settle the IDIT.

In the first two approaches, the IDIT is a domestic trust that will, by definition, avoid Section 684 taxation. Under the third option, the advisor and client must be clear from the start that they do not foresee needing the option to purposely accelerate income tax under Section 684.

PRACTICE APPLICATIONS & COMMENTARY

In their discussion of foreign grantor trust status, the authors take the position that, under Section 684, there is a deemed transfer for income tax purposes from the grantor to the trust at the grantor's death. Thus, grantor trust status would cease with the grantor's death and the appreciation in the trust's assets would be recognized. However, other commentators have argued that Section 684 should not apply at all at the death of the grantor, or, if it does, that Section 1014 would afford trust assets a full step-up in basis at the instant of the grantor's death, thereby negating any recognition of appreciation of trust assets.

The IDIT has proven to be a valuable tool in an advisor's arsenal, especially when combined with other tools such as FLPs and GRATs. Few techniques have quite the same potential for dramatically reducing a client's estate and transferring assets to beneficiaries in a highly leveraged fashion.

Like many techniques, however, the IDIT does have potential disadvantages. Having "toggled" grantor status on or off, clients may find themselves in an inflexible position, unable to respond to changes in current circumstances or goals. The advisor must counsel clients from the inception regarding both the attendant risks of IDIT planning and the potential need for flexibility as years pass. Using foreign trust status as the toggle provides another tool in the advisor's toolbox to provided additional flexibility.

THE LAW

The Economic Growth and Tax Relief Reconciliation Act of 2001, Public Law 107-16 (June 7, 2001).

IRC §§ 671-679, 684(a)-(b), 2036, 2038, 20417701(a)(30(E),

Treas. Reg. §§ 1.684-2(e), 20.2036-1,

Rev. Rul. 85-13, 1985-1 C.B. 184.

Rev. Rul. 95-58, 1995-2 C.B. 191.

Rothstein, 735 F.2d 704 (2nd Cir. 1984).

Skinner's Estate, 197 F.Supp. 726 (DC Pa, 1961).

Estate of Barlow, 55 T.C. 666 (1971).

Estate of McCabe, 475 F.2d 1142 (Ct. Cl. 1973).

Helvering v. Elias, 122 F.2d 171 (2nd Cir. 1941).

Moskin v. Johnson, 115 F.Supp. 565 (DC N.Y., 1953), aff'd 217 F.2d 278 (2nd Cir. 1954).

Holdeen v. Ratterree, 166 F.Supp. 694 (DC N.Y. 1958).

ADDITIONAL REFERENCES

Bove. Thought-Provoking Ways of Circumventing Code Section 684, (or) Taming the Paper Tiger, 2 ASSET PROTECTION J. 3, Autumn 2000, at 11.

Engel. Trusting the Act, SHORE TO SHORE, Summer 1998, at 55.

Engel, Lockwood, and Merric. THE ASSET PROTECTION GUIDE: A STATE OF THE ART APPROACH TO INTEGRATED ESTATE PLANNING (CCH, 2001).

Gammill. Estate Planning Changes in the 2001 Tax Act-More Than You Can Count, CUTTING-EDGE CURRENT.

Giordani and Osborne. Stateside Asset Protection Trusts: Will They Work?, CLARK BOARDMAN CALLAGHAN'S ESTATE & PERSONAL FINANCIAL PLANNING (Nov., 1997).

Hall. Bank Sarasin: Principles of Offshore and International Investing: Private Banking and Europe, PESI FIFTH ANNUAL OFFSHORE PRACTICE & PROCEDURE CONFERENCE (Sept. 14-15, 2000, Las Vegas).

Hamilton. Using Beneficiary Guarantees in Defective Grantor Trusts, CUTTING-EDGE CURRENT.

Harrington, McCaffrey, Plaine, and Schneider. Generation-Skipping Transfer Tax Planning After the 2001 Act: Mostly Good News, 95 J. TAXATION 143 (Sept. 2001).

Kelley. Comparing the GRAT to the Installment Sale to a Defective Trust, and Who's Afraid of the Exhaustion Test?, CUTTING-EDGE CURRENT.

Lockwood. Alaska, Delaware, and Other U.S. Domestic Trusts as Planning Tools, 1 ASSET PROTECTION J. 3, Summer 1999, at 29.

Mintz and Hanslits. The Impact of Investment Volatility on Wealth Transfer Strategies, CUTTING-EDGE CURRENT.

Rothschild, Rubin, and Blattmachr. Self-Settled Trusts: Should a Few Bad Apples Spoil the Bunch?, 32 VANDERBILT J. TRANSNATIONAL L. 763-778 (1999).

Tillman. Sales to Grantor Trusts: Exponential Leverage Using Multiple Installment Sales, CUTTING-EDGE CURRENT.

Whittenberg. Freeze Interests in Family Limited Partnerships by using GRAT together with Sale of Retained Annuity Rights to IDGT, CUTTING-EDGE CURRENT.

Zaritsky. Grantor Trusts: Sections 671-679, 858-2ND TAX MGMT. (BNA).