United States: Sale To An IDIT For A Promissory Note – The Best Estate Planning Strategy (Gimmick) Going

I. Introduction.

It has been over twenty-five years since the article first discussing the sale to IDIT technique was published.¹ This article examines that technique, along with a number of variations, including a sale to an IDIT in exchange for an annuity which terminates upon the seller's death and the sale to a so-called BIDIT.

II. Structure of Sale to IDIT Transaction.

The term an Intentionally Defective Irrevocable Trust ("IDIT") describes a particular type of trust. The existence of an IDIT apart from its grantor is recognized for estate, gift and generation-skipping tax purposes, but not for income tax purposes. Any uncompensated transfer to an IDIT constitutes a gift. The assets of an IDIT are not included in the estate of its grantor at death.

The position of the Internal Revenue Service ("IRS") is that an IDIT does not exist for Federal income tax purposes.² All income of an IDIT, including capital gain, is taxed directly to its grantor. A sale of appreciate property to an IDIT causes no recognition of gain. Interest on a promissory note paid by an IDIT to its grantor is not taxed to the grantor or deductible by the IDIT. For income tax purposes, such interest is ignored. An IDIT has the option to use the social security number of its grantor as its tax identification number.³

The sale to an IDIT technique involves a grantor establishing an IDIT and selling assets to the IDIT in exchange for the IDIT's promissory note. The IRS has asserted in litigation that IRC Sec. 7872 applies to a promissory note given in a sale transaction, and that if, pursuant to IRC Sec. 7872(f), a promissory note bears interest at the applicable Federal rate under IRC Sec. 1274, it has a gift tax value equal to its face amount. This position has been accepted by the Tax Court.⁴ The sale to an IDIT is a mechanism by which equity can be converted into debt without income tax consequences.⁵

Under IRC Sec. 7872(f)(2)(A), the applicable Federal rate for a term loan is the rate in effect under IRC Sec. 1274(d) as of the date upon which the loan is made. IRC Sec. 1274(d)(2) establishes a special rule for determining the applicable Federal rate for a sale or exchange. Under IRC Sec. 1274(d)(2), the applicable Federal rate is the lowest of the interest rates for the month in which there is a binding contract for the sale or exchange, and the two immediately preceding months. Because a lower interest rate on an IDIT's promissory note reduces the value of the seller's estate, it is tempting to make use of the IRC Sec. 1274(d)(2) exception when the applicable Federal rate for one of the two months preceding the month of sale is lower than the rate for the month of sale.

IRC Sec. 1274(d) is an income tax statute. As noted in the discussion with note 2, supra, the IRS takes the position that transactions between a grantor trust and its grantor are not recognized for income tax purposes. It is conceivable that the IRS might apply this position to assert that a sale to an IDIT is not a sale or exchange for purposes of IRC Sec. 1274(d)(2). In most cases, the variation in the interest rates over the three month period described in IRC Sec. 1274(d)(2) is unlikely to be substantial. It would seem advisable not to risk challenge by the IRS and use the applicable Federal rate for the month of sale and not either of the two preceding months.⁶

In the sale of difficult to value assets to an IDIT, the sales documents might describe the quantity of an asset being sold through the use of a formula expressing that quantity as a dollar amount rather than as a number or percentage of units e.g., as $X worth if ABC, Inc. stock rather than XX number of shares of ABC, Inc. stock. Recent cases indicate that the courts might recognize the effectiveness of such a formula to eliminate any gift if the IRS successfully argues that the assets being sold to the trust have a greater per unit value than contemplated in the sale transaction.⁷ In such event, the formula operates to reduce the number or percentage of units transferred so that the dollar amount transferred remains constant. If the effectiveness of the formula is recognized, the reduction in units transferred avoids a gift.

Similar to a grantor retained annuity trust, or GRAT, the sale to an IDIT technique produces an estate tax savings if the assets sold to the IDIT produce a total return (net income plus appreciation) which exceeds the interest on the IDIT's promissory note. In such case, the excess return is trapped inside the IDIT and excluded from the seller's estate. This result is easier to produce with an IDIT than with a trust which is a separate taxpayer. With an IDIT, the grantor pays all taxes due on income and capital gain generated by the assets of the IDIT. The IDIT's return on assets is not reduced by income tax liability.

Although the grantor's payment of taxes on an IDIT's income can be viewed as an indirect transfer increasing the value of an IDIT, the IRS ruled in Rev.Rul. 2004-64⁸ that such payment does not constitute a transfer subject to gift tax. Rev.Rul 2004-64 permits a grantor to pay taxes on income which is not in the grantor's estate without having such payment being treated as a gift.

The sale technique is particularly powerful when interests in a partnership, limited liability company or S corporation are sold to the IDIT. There is no income tax imposed upon such an entity. Rather, tax is imposed upon its owners. The seller of an interest in such an entity to an IDIT continues to be taxed on the portion of the entity's income attributable to that interest. If the entity makes a distribution to its owners for the payment of income taxes, that distribution is received by the IDIT. The IDIT can move funds to the seller by making payments on the promissory note, which has the effect of reducing, not just freezing, the value of the seller's estate.

The sale to an IDIT technique also produces favorable generation-skipping tax results. These favorable results can be illustrated by an example. A grantor may make a gift of $5,000.00 in cash to an IDIT, and then sell assets having a fair market value of $50 million to the IDIT in exchange for this IDIT's $50 million promissory note. The grantor/seller need only allocate $5,000.00 in GST exemption to the IDIT for the IDIT to have an inclusion ratio of zero. With that allocation, all of the excess return excluded from the grantor/seller's estate for Federal estate tax purposes is also insulated from generation-skipping tax. The significant point is this insulation is achieved without allocation of any additional GST exemption.

III. Avoiding IRC Secs. 2702 and 2036(a)(1).

Two statutes to be avoided in a sale to an IDIT are IRC Secs. 2702 and 2036(a)(1). Each of these statutes produces an unfavorable tax result for certain retained interests in transferred property.

A. The Fidelity-Philadelphia Trust Co. Case.

IRC Sec. 2702 provides that, for purposes of valuing a transfer to a trust for the benefit of a member of the transferor's family, any interest in the trust retained by the transferor is valued at zero unless it is a qualified interest defined in IRC Sec. 2702(b). IRC Sec. 2702 is the statutory basis for the GRAT.

A promissory note received in a sale to an IDIT would rarely, if ever, satisfy the requirements of IRC 2702 and the regulations issued under that statute. If the promissory note were deemed to be an interest in the IDIT, its value would be zero for gift tax purposes and the seller would be deemed to have made a gift to the IDIT equal to the fair market value of the property transferred to the IDIT in the sale transaction, unreduced by the amount due under the promissory note.

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Footnotes

1. Mulligan, Sale to a Defective Trust: An Alternative to a GRAT, 23 Est. Plan. No. 1, 3 (1996).

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

3. Treas.Reg.Secs. 671-4(b)(2)(i)(A) and 301.6109-1(a)(2)(i)(B).

4. Frazee v. Commissioner, 98 T.C. 554 (1992); Estate of True v. Commissioner, 82 T.C.M 27 (2001), aff'd on other grounds, 390 F.3d 1210 (10th Cir. 2004). See also Ltr. Ruls. 9408018 and 9535026.

5. For an article advocating abolition of the grantor trust rules to foreclose this kind of planning see Rics, I Dig It, But Congress Shouldn't Let Me: Closing the IDGT Loophole, 36 ACTEC L.J. 641 (2010).

6 For a different point of view, see Hesch, Gassman and Denicolo, Interesting Interest Questions: Interest Rates for Intra-Family Transactions, 36 T.M.Est., Gifts and Tr. J. No. 2, 128 (2011).

7. Succession of McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006); Estate of Christiansen v. Commissioner, 130 T.C. 1 (2008); aff'd 586 F.3d 1061 (8th Cir. 2009); Petter v. Commissioner, 98 T.C.M. 534 (2009), aff'd 653 F.3d 1012 (9th Cir. 2011); Hendrix v. Commissioner, T.C.M. 2011-133 (2011); Wandry v. Commissioner, 103 T.C.M. 1472 (2012).

8. 2004-2 C.B. 7.

Originally published by Orange County Branch of the Society of Trust and Estate Practitioners

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.