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Shakespeare gives us all some friendly advice, “Neither a borrower nor a lender be/For loan oft loses both itself and friend” (Hamlet Act 1, Scene 3).  Perhaps Shakespeare is giving us all timeless advice, but maybe, if structured properly, lending money could be a good estate planning tool.

One way to lend money/stock/real estate to your family is through an installment sale to an intentionally defective grantor trust (IDGT).  This is an estate planning technique that can ‘freeze’ the value of the assets in your estate and lower your potential estate tax.  Let’s first look at what we mean by an Intentionally Defective Grantor Trust or “IDGT”.

An IDGT is an irrevocable trust with an intended flaw, and therefore makes the irrevocable trust’s income tax taxable back to you rather than to the trust.  You will be responsible for paying the taxes on all the trust income annually.  This flaw allows the assets in the trust to grow income tax-free for the trust.  For estate tax purposes, the assets held in the trust are not included in your estate upon your death.  This trust is defective for income tax purposes, but effective for estate tax purposes.

The most common defects for making the irrevocable trust defective are:

  • A power that allows the grantor to swap or substitute assets of the trust. (IRC Section 675)
  • An authorization for the independent trustee to add beneficiaries. (IRC Section 674)
  • An allowance for trust income to pay for grantor or grantor’s spouse’s life insurance. (IRC Section 677)
  • The trust permits loans to be made without adequate security. (IRC Section 672)

Once your IDGT is established, the next step is that you will want to fund the trust with some cash or assets, i.e. “seed money”.  Since the IRS will scrutinize this transaction, you want to ensure that the trust has cash available, “seed money”, to pay the interest on the note for the assets you are about to sell in exchange for a promissory note.

The general rule is to fund the trust with about 10% of the value of the assets to be sold to the trust, and the “seed money” should be liquid assets so the interest payments can be made.  Note the funding of the seed money is a taxable gift to you.

As you can imagine, the IRS strictly scrutinizes these types of transactions due to the potential estate tax savings with this IDGT strategy.  You must make sure the transaction is treated as an arm’s length transaction so the interest rate on the promissory note must not be lower than the published rates by the IRS.  With the current low interest rate environment, this strategy is even more compelling.

Now you are ready to sell appreciating assets, such as real estate, stocks, or even a portion of your closely held business, to the trust in exchange for the promissory note equal to the full value of the assets.  This value freezes at the time of the sale, locking in the value for estate tax purposes.  If, for example, an asset was valued at $1,000,000 at the time of transfer, and then appreciates to $5,000,000 at the time of your death, since your estate is holding the $1,000,000 promissory note, the value at your death is the value of the note and the entire appreciation of the assets is out of your estate for estate tax purposes.

Finally, the value of the asset sold to the trust in exchange for the promissory note must be fair and reasonable.  If you fund with publicly-traded appreciating stock, then the value is the fair market value of the stock on the date of funding.  If you fund the trust with real estate or a closely held business, you should get an appraisal of the asset to determine the fair and reasonable value for the transaction.

The installment sale to an IDGT is a very beneficial estate planning vehicle.  The value of the assets sold to the trust freezes for estate tax purposes and all appreciation of the assets are enjoyed by your beneficiaries, usually your family, when the trust is finally distributed.  The payment of the income taxes during the term of the IDGT allows the trust to grow income tax free, and your payment of the income tax is not considered a gift.  This transaction must be structured properly and is very complex and closely scrutinized by the IRS, so it is important to contact your estate planning professionals for guidance.