While the economy and stock market have made marked improvement this year, opportunities still abound. With the recent tax proposals and potentially drastic changes to common planning techniques, now is an optimal time to review your estate plan. A perfect trifecta—historically low interest rates, proposed tax changes, and a temporary increase in the estate and gift tax threshold—have converged to provide an opportunity that allows you to maximize your gifting.
So, if now is the right time to take advantage of the three timely events outlined above, how do you gift your assets appropriately? Perhaps you don’t want to give a large sum of money directly to your children and you worry about possible life events such as divorce, bankruptcy, or a bad business deal impacting where and how your gift is spent.
An Intentionally Defective Grantor Trust (IDGT) provides valuable protection, as well as income, gift, and estate tax benefits. With an IDGT, you create an irrevocable trust for the benefit of your loved ones or beneficiaries. Generally, an IDGT allows the trustee to make annual discretionary distributions, or standard income distributions, to your beneficiaries. Placing your assets in this type of trust allows your loved ones to benefit from the assets without giving them outright access.
An IDGT also offers an income tax benefit by allowing the trust assets to grow tax free. Although you’re responsible for paying the income tax on your assets going into the trust, the assets are removed from your estate for gift and estate tax purposes. As a result, the trust grows tax free, and all that growth takes place outside your estate.
You can fund an IDGT by selling assets to the IDGT in exchange for a promissory note. You will then have a note that will be paid back over time, with the IDGT holding the assets. This is referred to as an “estate freeze technique” because it transfers an asset out of your estate at today’s value (sometimes less than fair market value) without using any of your gift and estate tax exemption. All future growth of the assets occurs in the trust, which is outside of your estate. For example, if the assets sold to the IDGT produce a total return (income and appreciation) in excess of the interest rate on the promissory note, substantial wealth can be removed from your gross estate—both gift and estate. Based on today’s interest rates, that annual growth would only need to be between 0.82%-1.4%, depending on the loan terms.
Let’s take for example a mother who wants to gift her three children $6 million in company stock, but wants to make sure they don’t receive the entire amount all at once. The company is growing rapidly and is expected to exceed future estate taxes if the stock remains in her estate. Her estate lawyer sets up the IDGT and creates the promissory note. The IDGT is funded with the stock, and in exchange, the IDGT gives the mother back a note in the amount of $6 million, payable over 20 years. She retains her entire estate tax exemption amount, which is $11.7 million in 2021, because this transfer is not a gift due to the use of the note that will be paid off by the IDGT over 20 years.
Due to the way the IDGT is structured, there are no taxes on this transaction, not even capital gains, because the stock is still considered owned by the mother for income tax purposes. The business pays dividends, which is enough to cover the note payments which are much lower than a commercial note, at only 1.15%. When the mother dies, her brother, the trustee, doles out income to the beneficiaries. Of course, the growth of the $6 million dollars, which has now turned to $25 million over 20 years, passes free of estate tax because it is outside the mother’s estate when she dies. This is important because this allows the mother’s estate to remain below the estate tax exemption amount, thereby avoiding estate tax altogether.
An IDGT is just one of many options that can be used to take advantage of today’s ideal gifting environment. If you’re able to gift and would like to take advantage of this opportune time, contact your wealth advisor to discuss your options and learn about other trusts. Utilizing various gifting strategies can help you both transfer your wealth and protect it for generations to come.
Mercer Advisors Inc. is the parent company of Mercer Global Advisors Inc. and is not involved with investment services. Mercer Global Advisors Inc. (“Mercer Advisors”) is registered as an investment advisor with the SEC. The firm only transacts business in states where it is properly registered or is excluded or exempted from registration requirements.
All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Some of the research and ratings shown in this presentation come from third parties that are not affiliated with Mercer Advisors. The information is believed to be accurate but is not guaranteed or warranted by Mercer Advisors. Content, research, tools and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. For financial planning advice specific to your circumstances, talk to a qualified professional at Mercer Advisors.
Hypothetical examples are subject to uncertainty and contingencies outside Mercer Advisors’ control.