It’s Defective, Stupid
In the estate planning context, defective can be ideal. Selling property to an intentionally defective grantor trust (“IDGT”) has become one of the most popular estate planning methods available for transferring substantial wealth to heirs while avoiding the estate tax. Properly structured, the transaction generates no income or transfer tax consequences. Surprisingly case law has not meaningfully examined the sale technique, leaving practitioners guessing how to avoid and prevail against any IRS challenge, thereby avoiding potential malpractice. In a nutshell, IDGT sales work as follows: the grantor creates an irrevocable trust for the benefit of his or her descendants. The grantor funds the trust with seed capital. The grantor then sells property to the trust, which could be for example an interest in a family limited partnership (“FLP”). The trust issues a promissory note to the grantor equal to the fair market value of the purchased property. The trust will probably require a third party to guarantee payment of the note, particularly where the trust holds little cash. A common technique is to have the trust beneficiaries guarantee the note, otherwise, a third party guarantor can be engaged. The FLP continues to generate income. The income belongs to the trust since it owns the FLP. The trust then uses that income to make payments on the note held by the grantor.
When properly structured, the grantor retains just enough control over the trust so that the grantor and trust are disregarded for income tax purposes, but not estate tax purposes. In other words, the grantor reports all income tax consequences of the trust on his or her personal tax return. That is, the trust is “defective” for income tax purposes with respect to the grantor. As an added bonus, the grantor’s estate is reduced by the amount of income tax paid to the government, which some refer to as the “tax burn.”
The coup de grace of the IDGT sale: the grantor has relinquished just enough control of the trust to ensure the sold property is excluded from his or her gross estate. Obviously a properly drafted trust instrument is critical.
IDGT sales first appeared in 1995 when the IRS issued favorable rulings regarding such sales in PLR 9535026, and the IRS has been aggressively targeting IDGT sales since. The IRS has frequently challenged such sales on the bases that the promissory note was actually a retained equity interest, and not a bona fide debt. If the note was actually a disguised equity interest, Internal Revenue Code sections 2036, 2701, or 2702 would apply, an eviscerate the transaction by creating substantial taxable gifts or causing the sold assets to be included in the seller’s gross estate.
Considering the prevalence of these transactions, and the degree to which the IRS has challenged them, it is surprising little tax jurisprudence exists to guide practitioners and the IRS on proper structuring. They almost got some answers. Almost.
The Woelbing cases involved taxpayer sales of closely held stock to IDGTs, valuation disputes, defined value transfers, and IRS allegations that Code sections 2036, 2038, and 2702 applied to the sale transactions. To put things in perspective, the Notices of Deficiency issued by the IRS totaled $150,000,000. During the pendency of these cases, the estate planning world was abuzz with ecstatic practitioners eager that a court might finally provide some guidance that could shield them from malpractice should an IRS challenge result in additional tax.
But the estate representatives crushed the excitement. On January 12, 2016, the parties informed the court they had reached a tentative settlement. The settlement was confirmed recently this year. Case dismissed.
Without guidance from the Woelbing cases, estate planners will remain wary of these sales, but will no doubt continue using them as part of their planning.
But there might be hope on the horizon. The newly added IRS Priority Guidance Plan will include guidance for the valuation of promissory notes for transfer tax purposes under sections 2031, 2033, 2512, and 7872. It is possible but unlikely that such guidance will provide a safe harbor road map for engaging in IDGT sales that will avoid IRS challenge.
— By Michael S. Cooper, Esq., Barnes Law
Michael Cooper is an associate attorney with Barnes Law, and is licensed to practice law in California.
The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its clients, or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
 As with many tax strategies, a bulletproof valuation is required.
 See Estate of Marion Woelbing v. Commissioner, Dkt. No. 30260-13 (pet. filed 2013); and Estate of Donald Woelbing v. Commissioner, Dkt. No. 30261-13 (pet. filed 2013)