By Robert S. Keebler, CPA, MST, AEP (Distinguished) | Volume 2, Issue 4 (April 2014)
Sales to intentionally defective grantor trusts (“IDGT sales”) are one of the most popular estate planning strategies for transferring large amounts of wealth to heirs. Planners must be very careful about how the sale is structured though.
IDGT sales date back to 1995 when the IRS issued favorable rulings regarding such sales in PLR 9535026. The favorable rulings were contingent, however, on the notes being bona fide debt rather than a retained income (equity) interest. If the note was really equity, Internal Revenue Code sections 2701, 2702 or 2036 would apply, creating a large taxable gift or causing the transferred assets to be included in the seller’s gross estate.
In 2001, the IRS returned to this caveat in Karmazin,taking the position that IDGT notes were really equity interests subject to Code Sections 2701 and 2702. Code Section 2036(a) did not apply because the seller was still alive. Karmazin was settled on terms very favorable to the taxpayer and the IRS did not challenge IDGT sales on the debt/equity issue again for 12 years. Then in 2013, the IRS resurrected the Karmazin arguments in Woelbing, a case currently before the Tax Court. This article explains the IDGT sale strategy and the favorable tax consequences it can produce, summarizes the Karmazin arguments and the highly unfavorable tax consequences that would result if the arguments succeed, outlines the current Woelbingcase, and concludes with suggestions on how to structure IDGT sales to avoid the debt/equity issue raised inKarmazin and Woelbing.
Overview of the IDGT Strategy
An IDGT sale is structured to produce a completed gift for transfer tax purposes with no income tax consequences. A summary of the basic mechanics of the sale is as follows:
(1) The grantor creates an irrevocable grantor trust for the benefit of his or her descendants.
(2) The grantor retains enough control over the trust to make it a grantor trust for income tax purposes, but not so much control that the trust assets are included in the grantor’s gross estate.
(3) The grantor sells assets to the trust and takes back a note.
(4) The interest rate on the note is set at the lowest rate allowable under the tax law (AFR).
(5) The assets sold to the trust are expected to produce a total return substantially in excess of the Code Section 7520 rate.
(6) The sale price is set equal to the FMV of the assets sold so there is no taxable gift.
(7) The assets sold to the IDGT are typically assets that qualify for valuation discounts, like FLP interests.
(8) If the purchaser is a dynasty trust, the grantor allocates generation-skipping transfer tax exemption to the trust to cover the amount of the seed money gift.
Wealth Transfer Tax Benefits
The value of the assets transferred by the grantor exceeds the value of the assets returning to the grantor’s estate, producing important estate planning benefits.
(1) If the total return on the assets sold to the trust exceeds the interest rate on the note, assets are transferred tax-free to the trust beneficiaries.
(2) Payment of the trust’s income tax liability by the grantor increases the amount of the tax-free transfer.
(3) The transfer tax benefit is further increased by valuation discounts.
(4) If the trust is properly structured, none of the assets are included in the grantor’s gross estate.
Income Tax Benefits
Because the buyer is a grantor trust, the IRS treats the seller and the trust as the same taxpayer for income tax purposes. As a result of grantor trust status, the grantor:
(1) Recognizes no gain or loss on the sale;
(2) Is not taxed on the interest payments received from the trust; 
(3) Recognizes no capital gain if note payments are made in kind;  and
(4) Makes the trust an eligible S corporation shareholder.
As noted above, the most compelling planning issue is avoiding Sections 2701, 2702, and 2036(a). If the IRS succeeds in applying any of these statutory provisions to the sale, the tax results could be devastating.
Section 2701: Special valuation rules in case of transfers of certain interests in corporations or partnerships.
Section 2701 applies to transfers by individuals of certain junior interests in a corporation or partnership to a family member if the transferor or an applicable family member holds an “applicable retained interest” in the corporation or partnership immediately after the transfer. An “applicable retained interest” cannot be a creditor interest in bona fide debt. If the note is a retained equity interest, Section 2701 would apply.
Under Section 2701, the amount of the taxable gift is the value of the property transferred minus the value of any qualified interests retained by the transferor. If the IDGT note had a fixed maturity date and payments were made at least annually, the payments would be a qualified retained interest and could be valued. Because the required return for a preferred partnership interest is ordinarily far higher than the AFR, however, there would generally be a substantial taxable gift. If the note deferred both interest and principal payments, there would be no qualified retained interest at all and the taxable gift would be the full value of the property sold.
Section 2702: Special valuation rules in case of transfers of interests in trusts.
Section 2702 applies when a donor transfers property in trust for the benefit of certain family members and retains an interest in the trust—typically the lead interest. To prevent overvaluation, the lead interest in a split-interest trust is valued at zero unless:
(1) the transfer is to a personal residence trust or a qualified personal residence trust;
(2) the trust qualifies as a grantor retained annuity trust (“GRAT”); or
(3) the trust qualifies as a grantor retained unitrust (“GRUT”).
Any other lead interest is valued at zero, resulting in a taxable gift of the full value of the property sold.
Section 2702 applies if a seller, in effect, transfers a remainder interest in assets to a trust while retaining a term equity interest in the income. Thus, the Section 2702 issue turns on the same debt versus equity analysis as the Section 2701 issue.
If the retained interest is equity, the tax results would be similar to those under Code Section 2701. If the note called for annual or more frequent payments over a stated term, the note might be treated as a qualified annuity interest (i.e., as a GRAT) and might reduce the amount of the taxable gift. If the note payments were not a qualified retained interest, however, there would be a taxable gift of the full fair market value of the assets sold to the trust. For example, if the sale involved an interest only note with a balloon payment at the end of the note term, the payment stream would not be a qualified annuity interest because the last payment would represent an increase of more than 120% over the amount of the previous payments.
Section 2036(a): Transfers with a retained life estate.
Section 2036(a) provides that if a taxpayer transfers property during life for less than adequate and full consideration in money or money’s worth, such property is included in the transferor’s estate at death if the transferor “retained for his life or for any period which does not in fact end before his death—(1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.”
Whether Code Section 2036(a) applies also turns on whether the note represents bona fide debt. If the seller is treated as transferring a remainder interest in the property while retaining the income, there would be a 2036(a) transfer. If the note was respected as bona fide debt, however, there would be no retained interest in the transferred property and no estate inclusion.
If Code Section 2036(a)(1) applied, the property transferred to the IDGT would be included in the seller’s gross estate at its full date of death value, eliminating any transfer tax benefit of the sale. All post-transfer appreciation on the assets would be pulled back into the seller’s estate and the effect of Code Section 2036(a) would be to treat the seller as if he or she had done no planning and kept the assets until death.
The Service’s Current Attack on IDGT Sales: Woelbing
The Service is again raising the IDGT debt/equity issues in Estate of Donald Woelbing et al., v. Commissioner of Internal Revenue. The Service is arguing that Section 2702 applies to the taxpayer’s sale of stock to the IDGT. The Service’s reasoning is similar to what it raised in Karmazin:
(1) that the notes were a retained income interest in the trust rather than a bona fide debt; and
(2) that the payments were not qualified annuity payments (e.g., a GRAT) so the value of the retained interest in the notes is $0 and the full value of the stock transferred is a taxable gift.
Further, pursuant to Section 2036 (and/or Section 2038), the Service is arguing that the value of the stock should be included in the gross estate because the taxpayer retained a life estate (i.e., income interest) in the stock. Again, arguing that the note was a retained equity interest rather than bona fide debt. A favorable ruling for the Service would result in devastating tax consequences for the taxpayer.
Although the Woelbing IDGT sale appeared to be very well planned, the results of the case remain to be seen. In the final section of the article we offer suggestions on how to structure an IDGT to make the note bona fide debt and withstand IRS challenges like that in Woelbing.
The following is an executive summary of suggestions for minimizing the risk that notes will be reclassified as equity for gift or estate tax purposes:
- Treat the sale as if it were to an unrelated party–observe all debt formalities, including security interests and perhaps guarantees.
- Provide seed money equal to at least 1/9 of the value of the assets sold.
- Alternatively, have beneficiaries guarantee at least 1/9 of the amount due under the note.
- Don’t peg the amount or timing of the note payments to the expected returns on the assets sold to the IDGT.
- Make payments according to the payment schedule in the note.
- Do not increase payments whenever trust income is higher than expected.
- Do not delay payments when trust income is lower than expected—instead make payments in kind.
- Make the note payable from the entire corpus of the trust (including the seed money) and not just from the purchased assets.
- If possible, set the amount of the note payments significantly below the rate of income expected to be produced by the trust.
- Do not allow the grantor to retain strings over the property sold to the trust.
- Do not set the term of the note at more than 15-20 years—the longer the note the more it looks like a retained equity interest.
- Consider structuring the note so that payments would be a qualified annuity interest so the lead interest could be valued even if it is treated as a retained equity interest.
- Finally, have the CPAs for the trustee run projections to assure the trustee that the acquisition is feasible.
By following the above guidelines, practitioners may increase the likelihood of a favorable outcome when property is sold to an IDGT.
As noted above, the crucial issue under all three sections (i.e., Sections 2701, 2702 and 2036) is whether the transferor has made a bona fide sale and taken back only debt obligations on the one hand, or whether the transferor has retained an equity interest or life estate in the property on the other hand. If the note is really debt, it cannot be an applicable retained interest subject to Section 2701. Similarly, a debt instrument would not be a term interest within the meaning of Section 2702. And, lastly, if the note is really debt, Section 2036(a) would not apply because the taxpayer would no longer have any interest in the transferred property.
 May 31, 1995.
 See Karmazin v. Commissioner, Unagreed Report of Sharon Karmazin, TC Doc 2003-7941.
 Estate of Donald Woelbing et al., v. Commissioner of Internal Revenue, Tax Court Docket No. 030261-13.
 Rev. Rul. 85-13, 1985-1 CB 184.
 Section 1361(c)(2)(A)(i).
 Section 2701(a)(1) and Reg. Section 25.2701-1(b)(2)(i)(B)(2).
 Sections 2701(a)(3)(A) and 2701(c)(3).
 Section 2702(a)(3)(A)(ii).
 Section 2702(b)(1).
 Section 2702(b)(2).
 See Hatcher, Jr. and Manigault, “Using Beneficiary Guarantees in Defective Grantor Trusts,” 92 J. Tax’n 152 (Mar. 2000).
 See, supra, note 3.
 Note that guarantor must have the resources to make good on the guarantee if called upon to do so.
 See Covey, Practical Drafting at 4365-4370.
 See generally, Akers, Update of Transfer Planning Issues, ALI-ABA conference on Estate Planning for the Family Business Owner, at Chapter 9 (7/21/04—7/23/04), for an excellent discussion of how to avoid tax problems on IDGT sales.
Join us on Wednesday, April 9th for a 90-minute teleconference entitled, “Sales to Grantor Trusts – – Revisited”, where Robert S. Keebler will take you through the planning strategies for IDGT Sales so that you and your clients don’t come under attack. For more information and to register, click here.
ABOUT THE AUTHOR
Robert S. Keebler is a partner with Keebler & Associates, LLP. He has received the prestigious Accredited Estate Planners (Distinguished) award from the National Association of Estate Planning Counsels and has been named by CPA Magazine as one of the Top 100 Most Influential Practitioners in the United States. Mr. Keebler is the past Editor-in-Chief of CCH’s magazine, Journal of Retirement Planning, and a member of CCH’s Financial and Estate Planning Advisory Board. Mr. Keebler frequently represents clients before the National Office of the Internal Revenue Service (IRS) in the private letter ruling process and has received over 150 favorable private letter rulings. Mr. Keebler is nationally recognized as an expert in family wealth transfer and preservation planning, charitable giving, retirement distribution planning and estate administration and works collaboratively with other professionals on academic reviews and papers, as well as client matters. He can be reached at (920)593-1701 or at firstname.lastname@example.org.