Intentionally Defective Grantor Trusts

While day-to-day activities of a business usually consume most of a business owner’s time, planning for how the business will be passed on is also important. With good planning and proper structuring, business succession can be accomplished, while simultaneously providing benefits to both business owners and the individuals receiving the business. A common way of passing assets, including a business, is through the use of a trust.

“Defective” Trust

Trusts can either be revocable or irrevocable and are either funded during the lifetime of the grantor (called an inter vivos trust) or upon the death of the grantor (called a testamentary trust). One type of trust that can be used to plan for business succession is known as an intentionally defective grantor trust (IDGT). In relation to IDGTs, two characteristics of trusts are important to be aware of. An irrevocable trust (which is one that cannot be altered) shelters assets from estate taxes when the grantor dies. An inter vivos trust can remove the value of a business from the taxable estate.

An IDGT is an irrevocable trust that is used for estate tax and inheritance purposes. IDGTs have become beneficial for closely-held businesses that are structured as partnerships and S-corporations. They are called “defective” because they contain an intentional flaw in that the business owner (the grantor) gifts his or her ownership interests to the beneficiary or successor of the business through the trust, but retains control over the assets (the ownership interests). As a result, the grantor continues to pay tax on the ownership interests. By doing this, the beneficiary is protected from potentially having to pay a significant tax burden.

The grantor’s payment of taxes also allows the owner to remove money from his or her estate. This can be beneficial when the tax rate of the grantor is higher than the tax rate of the beneficiary, which is often true. Additionally, the value of the grantor’s estate is reduced by the amount of assets that are transferred to the trust.

The transfer involved in an IDGT is technically considered a sale, so a gift does not exist for federal gift tax purposes. The sale is not recognized for federal income tax purposes, however, which means no capital gain is triggered. The transfer involves a “sale” of assets to the trust by the grantor in exchange for a promissory note. The note is for some specified amount of time (like 10 or 15 years) and pays a certain level of interest to the grantor. The assets the beneficiary receives are allowed to grow free from any reductions due to income taxes because that tax is paid for by the grantor.

Get the Help You Need

Your business means a lot to you and ensuring it ends up in the right hands after you step away is important. For more information about business succession, speak with an experienced business and tax law attorney today. At the Royse Law Firm, we provide representation for business owners located in the San Francisco, Los Angeles, and Palo Alto areas. We look forward to hearing from you and discussing how we can help.

Disclaimer: This blog and website are public sources of general information concerning our firm and its lawyers, as well as the information presented. They are intended, but not promised or guaranteed, to be correct, complete, and up-to-date as of the date posted. This blog and website are not intended to be, and are not, sources of legal opinion or advice. The materials, information, and communications on this blog and website do not apply to any particular person, entity, or situation, and do not apply to you or to your specific situation. You will need to consult with an attorney and/or other appropriate professional about your specific situation. Thank you.
Roger Royse
rroyse@rroyselaw.com

Roger Royse, the founder of the Royse Law Firm, works with companies ranging from newly formed tech startups to publicly traded multinationals in a variety of industries. Roger regularly advises on complex tax structuring, high stakes business negotiations and large international financial transactions. Practicing business and tax law since 1984, Roger’s background includes work with prominent San Francisco Bay area law firms, as well as Milbank, Tweed, Hadley and McCloy in New York City.
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