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Using Various Types of Trusts for Asset Preservation

Using Various Types of Trusts for Asset Preservation

Using the IDGT (Intentionally Defective Grantor Trusts) to Protect Your Personal Residence.

Rocco Beatrice, CPA, MST, MBA, Managing Director, Estate Street Partners, LLC. Mr. Beatrice is an asset protection, award-winning trust and estate planning expert.

As you know if you've been reading my newsletters for any amount of time, I believe that NO estate or financial plan can be complete if they do not incorporate asset protection.

One of the most difficult assets to help our clients protect is their personal residence. It is also usually one of the most valuable assets of many clients and therefore should be protected.

Let's review the traditional personal residence protection tools before getting into the IDGT discussion.

  • Be fortunate enough to live in a state like Texas or Florida. A few states like Texas and Florida asset protect the entire value of the home from creditors through state statutes (with limitations of the new bankruptcy laws).
  • Use a Qualified Personal Residence Trust (QPRT). A QPRT is an irrevocable trust with not very favorable terms and the use of a QPRT as an asset protection tool is usually a tip off that the advisor does not know the better options for protecting the home.
  • Equity stripping (also known as Equity Harvesting). This concept can work out very well from a financial and asset protection standpoint when done right (which is rare) and especially when coupled with the 1% cash flow arm mortgage.
  • Limited Liability Companies (LLCs) (multi-member). Many undereducated advisors will read about the power of LLCs for asset protection and recommend that a client use one to protect the home.

The problem with such advice is: 1) the client loses the mortgage deduction; 2) the client could lose the $250,000 per spouse capital gains tax exemption (the client must own the house in his/her own name for 2 years out of 5 in order to use the exemption); 3) in some states the property taxes will double because the client can't claim the residence as a homestead.

Estate Street Partners recommends equity stripping/harvesting when it is a good fit for a client financially. Equity stripping/harvesting is not for every client with equity (notwithstanding what the Missed Fortune 101 followers believe). That leads us into the discussion about using an Intentionally Defective Grantor Trust (IDGT) to protect the home.

IDGTs (Intentionally Defective Grantor Trusts)

Most advisors are not aware of the power of IDGT when it comes to "advanced" estate and business transition planning. Having said that, this discussion will focus not on a capital gains, income, estate, or gift tax play with an IDGT, but instead will focus on how to use an IDGT for "asset protection."

I think the best way to explain how to use an IDGT to protect the home is simply to give readers a flow chart for how to set up and use one. For purposes of this discussion, you need to know that, as a general statement, an IDGT is a disregarded entity for tax purposes when the grantor is making the transfer to the trust.

  • The steps for using an IDGT (Intentionally Defective Grantor Trust) to protect the personal residence
  • The client's attorney setups up an IDGT (which is just an irrevocable grantor trust).
  • The client "sells" the residence to the IDGT for fair market value (FMV) in exchange for an "installment note."
  • The client enters into a lease with the IDGT to live in the residence
  • The client pays rent to the IDGT (FMV rent)
  • The IDGT pays the client annual installment payments via the installment note

What really happened? The client sold the residence to the trust and entered into a lease with the trust to live in it. The client pays X dollars to the trust as rent and the trust pays back to the client Y dollars via the installment note.

  • Frequently Asked Questions: Protecting your personal residence with the Intentionally Defective Grantor Trust (IDGT)
  • Is the rent deductible to the client? No.
  • Is the rent income to the IDGT? No.
  • Is the installment note payment to the client from the IDGT income to the client? No.
  • Can the note be accelerated? Yes. If the client ultimately would like the house sold, that can be accomplished in the IDGT and the proceeds can be paid to the client through an accelerated installment note payment.
  • What happens if the property has a mortgage? The IDGT would make the mortgage payments which would still be deductible to the client/grantor as if the house is owned individually.

Call Estate Street Partners 888-93-ULTRA (888-938-5872) and one of our advisors can help you.

Intentionally Defective Beneficiary Trusts

Author: Julius Giarmarco, Esq.

The benefits of an intentionally defective grantor trust ("IDGT") are well known.

  • First, the grantor's payment of the trust's income taxes is essentially a tax-free gift to the beneficiaries of the trust. Rev. Rul. 2004-64. Thus, the assets in the trust grow "tax free".
  • Second, by paying the income taxes, the grantor is reducing his/her estate by the taxes paid and any future appreciation that would otherwise have been generated on the funds used to pay income taxes.
  • Third, the grantor can sell assets to an IDGT (on installments) without any gain or loss recognition. Sales between a grantor and a grantor trust are disregarded for income tax purposes. Rev. Rul. 85-13.
  • Fourth, a sale to an IDGT of a life insurance policy on the grantor's life can avoid both the three-year rule and the transfer-for-value rule. Rev. Rul. 2007-13.
  • Fifth, an IDGT qualifies as an eligible S corporation shareholder. IRC Section 1361(c)(2)(A)(i). But, at such time as the IDGT is no longer a grantor trust, the trust must then "convert" to a Qualified Subchapter S Trust ("QSST") or an Electing Small Business Trust ("ESBT").
  • Finally, with proper design and drafting, grantor trust status can be "toggled" on and off for maximum flexibility.

The powers that are typically used to trigger grantor trust status for income tax purposes, but without causing inclusion of the trust's assets in the grantor's estate, are the following:

  • The power to substitute trust property with other property of equivalent value. IRC Section 675(4)(c).
  • The power in a non-adverse party to add charitable beneficiaries. IRC Section 674(b)(4).
  • The power to distribute income to the grantor's spouse. IRC Section 677(a)(1) and (2).
  • The power to use trust income to pay premiums on policies of insurance on the life of the grantor or grantor's spouse. IRC Section 677(a)(3).
  • The power of the grantor to borrow trust assets without adequate security. IRC Section 675(3).

That said, consider turning the tables and drafting the trust so that the beneficiary - and not the grantor - is taxed on the trust income. With an IDGT, the grantor cannot be a beneficiary or a trustee of the trust without adverse estate tax consequences (under IRC Sections 2036 and 2038). But, with an intentionally defective beneficiary trust ("IDBT"), the beneficiary can be both the primary beneficiary and the trustee of the trust. The reason is that the beneficiary is not the grantor of the trust. Instead, the grantor is usually the beneficiary's parent or grandparent.

Although it may not be cited as precedent, PLR 200949012 provides planners with a road map on how to properly design an IDBT. Following are the facts in PLR 200949012:

The grantor proposes to create a trust for the benefit of beneficiary;

  • The beneficiary will be a co-trustee of the trust (along with two independent co-trustees);
  • The beneficiary will have the unilateral power to withdraw all contributions made to the trust. However, this power will lapse each calendar year in an amount equal to the greater of $5,000 or 5% of the value of the trust.
  • The beneficiary will also have the power, during his lifetime, to direct the net income and/or principal of the trust to be paid over or applied for his health, education, maintenance and support ("HEMS"), and this power will not lapse;
  • The beneficiary will have a testamentary limited (non-general) power of appointment to "re-write" the disposition of the trust assets upon his death;
  • The trust provides that neither the grantor nor the grantor's spouse may act as a trustee, and that no more than one-half of the trustees may be related or subordinate to the grantor within the meaning of IRC Section 672(c); and
  • The trust contains various provisions assuring that the grantor will not be treated as the owner of the trust for income tax purposes under IRC Sections 671 - 679.

The IRS ruled that the trust did not contain any provisions that would cause the grantor to be considered the owner of the trust for income tax purposes. Instead, the IRS ruled that the beneficiary will be treated as the owner of the trust for income tax purposes - before and after the lapse of the beneficiary's withdrawal rights. The IRS analysis was as follows:

  • The trust did not contain any grantor trust "triggers" under IRC Sections 673 (reversionary interests); 674 (power to control beneficial enjoyment); 675 (administrative powers); 676 (power to revoke); 677 (income for benefit of grantor); or 679 (foreign trusts).
  • Under IRC Section 678, the beneficiary will be treated as the owner because the beneficiary had the right exercisable solely by the beneficiary to vest trust principal or income in himself.

In order for a beneficiary to be deemed the owner of a trust (for income tax purposes) under IRC Section 678, the beneficiary must be given the unilateral right to withdraw all income or corpus from the trust and, if such power is "partially released", after the release the beneficiary retains such an interest in the trust that it would be a grantor trust with respect to the real grantor (if the real grantor had retained such interest). But, when the power gradually lapses in its entirety (by $5,000 / 5% per year), is IRC Section 678 status lost? According to PLR 200949012, the answer is "no". The ruling apparently treats a "lapse" as a "release" so that even if the unilateral right to withdraw eventually disappears (by $5,000 / 5% per year), the lapse would be partial only because the power to withdraw for HEMS remains. And the HEMS standard - if available to the grantor - would be a grantor trust trigger under IRC Section 677. Thus, under IRC Section 678, the beneficiary continues to be treated as the owner of the trust.

As to the beneficiary's estate tax consequences, the power to withdraw trust assets for HEMS does not create a general power of appointment and, therefore, does not result in estate tax inclusion. IRC Section 2041(b)(1). But, the unilateral right to withdraw principal is a general power of appointment that will cause the trust assets to be taxed in the beneficiary's estate (but only to the extent the power has not lapsed under the $5,000 / 5% rule). IRC Section 2041(b)(2). For example, if the grantor contributed $1 million to the IDBT, the unilateral power of withdrawal would lapse in 20 years (i.e., 5% x $1 million = $50,000), or even sooner if the trust assets grew in value.

An IDBT works particularly well where the beneficiary has a new business opportunity, but would like to keep the business out of his or her estate. The beneficiary convinces his/her parents or grandparents to give him/her an "advance" on his/her inheritance by making a gift to the IDBT. This will allow the beneficiary to operate the business (as the trustee of the IDBT). The beneficiary will also have access to the cash flow of the business, without inclusion in his/her estate (except to the extent the beneficiary's unilateral withdrawal right has not yet lapsed under the 5% / $5,000 power). The beneficiary can also sell assets to the IDBT without any gain or loss recognition. Finally, the beneficiary's payment of the IDBT's income taxes reduces his/her estate and is a "tax-free" gift to the remaindermen of the IDBT (i.e., the beneficiary's descendants).

In summary, an IDBT allows the beneficiary to achieve virtually all of his/her tax and non-tax planning objectives. When advising clients on estate planning matters, the planner should advise them to consider establishing IDBTs for their children and grandchildren, and/or advise them to ask their parents and grandparents to establish an IDBT for themselves.

Julius Giarmarco, J.D., LL.M, is an estate planning attorney and chairs the Trusts and Estates Practice Group of Giarmarco, Mullins & Horton, P.C., in Troy, Michigan.

For more articles on estate and business succession planning, please visit the author's website,, and click on "Advisor Resources". Article Source:

Grantor Trusts and Capital Gains with Medicaid Planning

The best example of a person who needs an irrevocable trust is a patient who needs a personal attendant while living in an assisted living facility or in a nursing home. Medicaid will not pay for companion care. The strategy here would be to make a gift so that the assets are not counted in determining the patient's eligibility for Medicaid.

The patient can make this kind of a gift without a trust. One of the drawbacks to plain, ordinary gifting is that the amounts gifted become vulnerable. Here are some of the risks to which they are vulnerable:

  • Child's creditors attach the gift, in which case the gift benefits neither the child, nor the elder.
  • Child's spouse makes claims against the gift in a divorce, in which case the gift benefits neither the child, nor the elder.
  • Child becomes disabled and the gift becomes mired in the child's conservatorship, in which case the gift benefits neither the child, nor the elder.
  • Child dies, and none of the gifted funds can be used to help the elder because they transferred to child's heirs on death.

A grantor irrevocable trust addresses these risks. The elder creates this trust. The elder funds this trust with any kind of asset, including his house, cash or securities. If the elder is presently using the cash and securities for income, that income can continue to flow to the elder. The elder can even be trustee of this trust.

The trust has a spendthrift clause which specifies that the trust principal is unavailable to the child's creditors. The trust may hold the assets for the child for a period of time even after the elder dies.

When the elder makes a gift to this irrevocable trust, the elder may incur a Medicaid eligibility penalty, depending upon how much is transferred to the trust. Very often, the elder is not in immediate need of Medicaid benefits, and depending upon the size of the gift, the penalty may expire before the elder actually needs the Medicaid benefits. No penalty will result when a gift to a trust is made more than 5 years before applying for Medicaid.

The trust specifies that the elder is not entitled to receive principal distributions from the trust. So the elder is effectively severing his or her ties with all assets that are gifted to this trust. However, the elder may continue to receive the income from those gifts, even though principal may not be touched.

A transfer of a house or other appreciated capital assets to the irrevocable grantor trust can be very advantageous. If the elder transfers his house outright to the child, the child will lose the step-up in tax basis that ordinarily occurs upon the death of the elder. Provided that the grantor irrevocable trust can return its income to the elder, the tax basis of all appreciated capital assets owned by the trust will be adjusted upwards upon the elder's death. This means that all of the capital gains tax that had built up in the house or other asset during the lifetime of the elder is effectively wiped out upon the elder's death, provided that the trust owns the property.

The irrevocable grantor trust allows the elder to maintain his or her estate plan for passing assets at death.

The trust can provide that principal distributions can be made, in the discretion of the trustee, to persons other than the elder. This person, who must be trusted, can make payments to the elder for necessary expenses, like companion care.

If the irrevocable trust triggers the grantor trust rules as to the trust principal, such as by the reservation of a special power of appointment, the grantor can maintain use of the $250,000.00 capital gains exclusion for the principal residence that was transferred into the trust upon a sale by the trust.