Ownership and Management Succession – Transfers to Intentionally Defective Grantor Trusts

There are various methods for an owner of a family or other closely held business to transfer ownership of that business. One method to accomplish this transfer of ownership would be through the use of an “intentionally defective grantor trust” or “IDGT”.

An IDGT is a trust that is structured so that any transfer into the trust is excluded from the grantor’s estate for estate tax purposes because the transfer is treated as a completed gift. The owner is able to pass ownership of the business to his or her children (and/or grandchildren) while, at the time of the transfer, “freezing” the value of the ownership interest that transferred and passing it outside of his or her estate for estate tax purposes. The grantor is treated as the “owner” of the trust so all the income of that trust is included in the income of the grantor for income tax purposes. The payments received by the trust owner for the ownership interest are not subject to income tax. However, all earnings of the trust are included in the owner’s income for income tax purposes.

The IDGT holds the ownership interest in the business in trust according to the terms of the trust instrument for the benefit of the designated beneficiaries. The beneficiaries are usually the children and sometimes the grandchildren of the grantor. Generally the grantor makes an initial transfer of some cash or marketable securities to the trust. Then the IDGT and the grantor enter into an agreement through which the grantor sells all or a portion of the ownership of the family business to the IDGT. with the remainder of the payments evidenced by a promissory note given to the grantor. Since the grantor is treated as the owner of the trust for income tax purposes, all payments received by the grantor from the trust are not subject to income tax.

Preferably the family business is an “S” corporation although it could be a limited liability company or other “pass-through” entity, i.e., an entity in which all the income is passed though to the owners for purposes of income taxes. All of the income generated by the family business is allocated to the owners of the family business. The IDGT will be allocated its share of the income which is be included in the income of the grantor for income tax purposes. Thus, all dividend or distribution payments from the family business to the IDGT will be “free of income tax consequences” to the trust beneficiaries and these payments can then be used by the IDGT to pay the its obligations to the grantor pursuant to the promissory note.

An IDGT can be very attractive to an owner of a family business but it may not for everyone. Business valuations are required to substantiate the purchase price for gift tax purposes. Also, the use of an IDGT assumes that payments from dividends and distributions will be sufficient to pay the amounts due to the grantor under the promissory note. Therefore, if the business falls on hard times or if the value of the business does down, then it is possible that the trust could not afford to make the note payments.

If you would like to determine if an IDGT might be appropriate for you and your family, please call us and ask to speak with one of our partners in the business succession practice.

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