Charlie will sell his 50% interest in ABC to an irrevocable trust. The trust, which benefits his heirs, will be treated, for income tax purposes, as a grantor trust, making it an “intentionally defective grantor trust” (IDIT). Charlie will pay income tax on all trust income but will not pay additional tax on the interest received each year. The sale will be structured as an interest-only installment sale with all principal payable by the IDIT at the end of the term (9 years in this example).

Each year, the trust receives its share ($70,000) of income from ABC. As the trust is a grantor trust, Charlie must pay income tax at his rate on all of the trust income (e.g., $70,000 of ordinary income taxable at 37% yields $25,900 in tax). Under the terms of the sale, the trust must pay Charlie the interest of $42,500 on the note, but it retains the difference of $27,500 each year. Charlie nets $16,600 of cash each year ($42,500 received less the $25,900 paid in taxes).

The value of the trust at the end of nine years (prior to the balloon payment) will vary according to the investment return—on how the annual $40,000 of net income left in the trust performs. Growing at 4%, the trust’s value is expected to be about $291,027. Growing at 6% the value would be about $316,011. In either case, Charlie will have removed a significant amount of appreciation from his estate.

While the example assumes reinvestment, the trustee might choose instead to use some of its net income to pay premiums on a permanent life insurance policy. If the net income ($27,500 in this example) were spent on premium, there would not be any investments left after the arrangement concludes, but the trust would own a life insurance policy on Charlie, with the attendant cash surrender value and death benefit.

Structured properly, the value of the note will equal the value of the property sold, so that no gift will occur because of the exchange. Further, the seller’s estate will include only the remaining balance of the note, not the actual value of the sold property.

Other Considerations

• The arrangement must use a stated interest rate, at least the applicable federal rate (AFR) for the appropriate duration.
• The principle on the promissory note is an asset in the gross estate until the note is repaid by the trust.
• This concept, unlike the grantor retained annuity trust (GRAT), does not have safe harbor parameters. A bona fide arrangement will have economic significance besides tax savings and will have terms suitable to an arms’ length transaction, including minimum debt-to-equity ratios.
• The ability to discount the sale price, though supported in various court decisions, is complex and will almost certainly be scrutinized by the IRS. Any such discount should be determined by a qualified appraiser.
• Payments on the note should not be tied to the income of the trust. If they are, the grantor might be treated as having retained an interest in the transferred property.