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Tax Break with Intentionally Defective Trust (IDIT)

December 29, 2014

Do you own appreciating assets and want to minimize future appreciation of your taxable estate? An Intentionally Defective and Irrevocable Trust could be the solution!

An Intentionally Defective Irrevocable Trust (IDIT), or an Intentionally Defective Grantor Trust (IDGT) is a useful estate tax planning instrument if arranged properly. It is set up to deliberately fail certain technical tests in the tax law, but still be approved by the IRS. For individuals looking to pass more assets on to their children and grandchildren, an IDIT could be the answer.

IDIT Tips

Although an IDIT is considered a separate taxable entity (for federal estate tax and customary state law purposes), it is considered to be a grantor trust for federal income tax purposes, making the person who sets up the trust the owner of the IDIT’s income and deduction items.

Since the nature of these trusts is confusing, it is helpful to understand some important tips in starting the process:

  1. It is important to establish the IDIT as a legal entity under applicable state law and indicate the beneficiaries of the trust. It is generally effective to gift some cash to the IDIT in order to establish some immediate liquidity (the “seed money”)
  2. In exchange for a note payable from the IDIT, or an installment sale, sell appreciating assets to the IDIT. This is not considered a taxable transaction since the IDIT is ignored for federal income tax purposes and you are essentially treated as selling the assets to yourself. The IDIT will use cash from your seed money, income, and gains from the trust’s assets to reimburse the note owed to you.
  3. Since you are still considered to own the assets for federal income tax purposes, any income, gain, and deduction items related to the IDIT’s assets will be accounted on your personal federal income tax returns. It is not necessary to tap into the trust to pay the income taxes- you can pay out of pocket. This prevents any unfavorable tax consequences and allows you to leave more value in the IDIT for future benefits. If these taxes end up surpassing what you can afford, an IRS ruling states that you can tap into the IDIT without any negative tax effects.
  4. Though the IDIT will have paid off the note you are owed, the trust will still have a net balance equivalent to the appreciation in the value of the assets you contributed to it. The overall net worth of the IDIT will eventually go to your designated beneficiaries, and, for federal estate tax reasons, the net worth will not be incorporated in your estate.

Successful implementation of an IDIT depends on a rather complicated arrangement. Contact us to make sure you are effectively using the method to reduce the value of your taxable estate.

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