Intentionally Defective Irrevocable Trusts; Estate Planning for Insecure Times

Article excerpt

In tumultuous economic times, intentionally defective irrevocable trusts (IDITs) offer taxpayers a powerful triple play: an estate-freeze and wealth-transfer technique, as well as an estate planning opportunity--despite terrorism, the market's vagaries and recent estate tax legislation. CPAs should become familiar with IDITs to help eligible clients preserve wealth.

WHAT IS AN IDIT?

An IDIT is an irrevocable trust; it takes advantage of a disparity between the income and estate tax treatments offered certain trusts under IRC sections 674 and 675. Because an IDIT is deemed a grantor trust for income tax purposes, the trust grantor reports the trust's income annually; however, the trust assets are not includable in the grantor's estate for estate tax purposes. A grantor can sell appreciating assets to an IDIT in exchange for a note, "freezing" the value of his or her estate and transferring wealth by converting an appreciating asset into a fixed-yield asset (for example, an interest-bearing note).

HOW DOES IT WORK?

A grantor "seeds" an IDIT with cash or property that creates a taxable gift. He or she then sells an asset to the IDIT for an installment note. Under regulations section 1.1001-2(c), example 5 (see also revenue ruling 85-13 and Madorin, 84 TC 667 (1985)), the grantor does not recognize gain or loss on a sale of an asset to the IDIT. Similarly, the grantor pays no tax on the interest payments received on the note, but pays tax on all of the trust's income. If the grantor dies during the note's term, the IRS might argue that under Madorin the gain should be recognized. However, the grantor's estate may be able to defer the gain under the section 453 installment-sale rules, until the note is fully paid off (see Sun First Nat'l Bank of Orlando, 607 F2d 1347 (Ct. …