The Need for an Intentionally Defective Grantor Trust

An installment sale to a grantor trust in exchange for a note is a popular and powerful wealth shifting strategy often recommended by estate planners.  In the typical transaction, the trust is “seeded” and then a sale is made to the trust in return for a note.  Under the “Intentionally Defective Grantor Trust” (IDGT) version of note sale, the client ordinarily transfers assets to a trust that is defective for income tax purposes and subsequently sells assets to the trust.  Often in practice, the initial funding is designed to establish the “creditworthiness” of the IDGT.  A newer strategy is for a third party to “seed” the trust, whereby a beneficiary is given a lapsing power of withdrawal which results in income tax grantor status to the power-holder under Section 678.  This variation has been referred to as a “Beneficiary Defective Inheritor’s Trust” (BDIT) or “Beneficiary Grantor Trust” (BGT), which is ordinarily the recipient of an initial capitalization of $5,000. 

There is a popular belief or “rule of thumb” that the initial funding of an IDGT should be 10% (a ratio of 9:1) in order to give the sales transaction “economic substance.”  Thus, $1 million will support a sale of $9 million to the trust because that theoretically will provide economic validity to the transaction.   In other words, subscribers to the 10% test contend that a rational seller in the “real world” would not sell his/her assets to a buyer who does not own the 10% minimal amount to protect against the downside risks of the sale.  

The real test is – Will the note be expected to be paid in accordance with its terms.  That test was derived from several USSC cases on the reality of sale in the income tax area, such as Clay Brown.

See Jerry Hesch, Dick Oshins & Jim Magner, Note Sales, Economic Substance and “The 10% Myth,” Steve Leimberg’s Estate Planning Email Newsletter, May 9, 2016.