The IRS sees the IDGT and the grantor as the same income taxpayer while the grantor is living. If the grantor makes a loan to an IDGT, it is as if the grantor is loaning money to herself. For income tax purposes, she’s just moving money from the right pocket to the left. The interest paid by the trust is therefore not taxable income to the grantor.
Although the IRS ignores it, the flow of money between the grantor and the trust is very real. The trust will need cash flow to fund the interest and principal payments due on the loan. One option for this would be to buy income producing property from the grantor in exchange for a note.
Because the trust is an IDGT, the sale is disregarded for income tax purposes. The grantor does not recognize capital gain on the transaction. The property produces income, which the trust uses to pay the note. The grantor does not pay income tax on the interest received. However, the grantor does pay income tax on the income produced by the property held in the trust. The taxes due on the trust’s income may likely exceed the interest received so the grantor should be prepared to pay out of pocket for the excess liability.
As long as the sale of the property is for full and adequate consideration, the sale transaction is not a gift. If the note is bona fide, has the proper interest rate and all payments are made on time, the note does not have gift tax consequences. The grantor’s payment of the trust’s income tax liability is also not a gift. If everything is structured properly, there are no gifts involved in this transaction. (Note, if the trust is empty to start, it is recommended that the grantor “seed” the trust with an initial gift. This adds legitimacy to the transaction.)
A properly drafted IDGT will keep the property outside of the grantor’s estate. If the property appreciates over time, that appreciation has passed on to the trust’s beneficiaries free of estate tax. Income that accumulates within the trust is also outside of the grantor’s estate.
What remains in the grantor’s estate is the value of the note. When the transaction is first executed, the value of the note is equal to the value of the sold property. While the property will appreciate over time, the note will decrease in value as principal is repaid. Therefore, the value of the property has been “frozen” in the grantor’s estate.
Interest payments on the loan will also become part of the grantor’s estate. The interest rate can be set as low as the AFR so the payments will be modest. Even if the income from the property is just enough to pay the note’s principal and interest, the transaction will still be effective for wealth transfer because, once the note is repaid, the property and its future incomes will be entirely in the trust.
Finally the grantor will be paying income tax on the income generated by the property within the trust from his personal funds. This “tax burn” further reduces the grantor’s estate and preserves the value of assets inside the trust.
One Step Further
Suppose the trust pays off the note or that the property creates enough income that there is money left over after the principal and interest payments are made. The trust could use the surplus cash flow to purchase life insurance on the grantor (This could also be an exit strategy for split-dollar policies or policies with premium financing – I’ll save those for another post). When the grantor dies, the proceeds, which are income tax-free, would be outside of the grantor’s estate. This is especially attractive if the grantor has an estate tax liability as the proceeds would make the grantor’s heirs whole after payment of estate taxes.
Intra-family loans are a useful tool in their most basic form but the benefits can be amplified when combined with other estate planning techniques. This blog is meant only to let you know that complex techniques exist and could potentially be beneficial to you. To determine if you should execute such a strategy, you’ll need a team of experts involved – namely a financial planner, an accountant, and an attorney. With the top federal estate tax bracket at 40%, it’s a strategy worth the professional fees.