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Popular Estate Planning Tool May Now Be Subject to Tax

For years estate planning practitioners used a sale to an intentionally defective grantor trust (“IDGT”) to freeze the value of property from the taxable estate of a client. Although not codified in the Internal Revenue Code or regulations as an acceptable estate planning tool, sales to IDGTs have withstood IRS scrutiny.

Here’s how an IDGT works. A client has a beach house worth five million dollars and other assets valued in excess of ten million dollars. The client is willing to transfer his house out of his name in order to reduce his estate tax liability and to try to preserve the beach property for generations to come. To achieve this, the client establishes an irrevocable trust appointing his daughter as Trustee. To take advantage of the differences between the estate tax and the income tax regimes, the trust is designed to qualify as a grantor trust under Internal Revenue Code 671-679 because typically the grantor retains an administrative power under 675, such as the power to substitute assets in the trust with assets of equivalent value. These powers do not cause the trust assets to be included in the grantor’s estate and are what make the trust a grantor trust, also known as a “defective” trust. As a grantor trust, all income tax consequences that occur in the trust are taxed to the grantor. For income tax purposes the trust is a pass through entity, but for estate tax purposes the trust is respected as a separate entity. New York State adopts the federal definition of grantor trust and as such requires that income, credits and deductions of the trust be reported on the grantor’s income tax return.

The trustee of the trust purchases the beach house from the client at fair market value through an installment sale and issues a note for the payment of the purchase price. The notes can be structured in many different ways depending upon the income generated by the trust assets or the income needs of the grantor. Typically, the assets being purchased by the trust are structured in such a way that discounts can be taken to arrive at fair market value.

In order to add validity to the purchase, the trust, in most circumstances, must show that it has sufficient assets to make payments on the note. The private letter rulings on this suggest the trust should initially be funded with 10 percent or more of the value of the note. This 10 percent should come into the trust prior to the purchase as a gift from the Grantor.

Many benefits are derived from the IDGT. The structure has accomplished a sale of property, thus the property is out of the grantor’s taxable estate, generally at a discount. All future appreciation on the trust assets is removed from the grantor’s estate. For income tax purposes, the sale is essentially to the grantor himself (as a grantor trust) thus, there is no gain recognition on the sale, nor income recognition on the interest on the note. The trust will typically not require generation skipping transfer tax exemption allocation (except to the assets transferred by gift for the seed money). Since the grantor is required to pay the income tax annually, the grantor continues to spend down his estate assets. The balance of the note will be an asset of the grantor’s taxable estate if the grantor dies before the note is paid off.

So why the case for alarm? Recently, New York State Division of Taxation and Finance ruled in a private administrative ruling, that the sales of real property to an IDGT are subject to the real estate transfer tax.

Why is New York Department of Taxation and Finance requiring real estate transfer tax (RETT) be paid on transfer that is technically to one’s self? Well they haven’t quite yet, but they did issue an advisory opinion, TSB-A-14 (2) R, which can lead us to conclude that a transfer of real property to an IDGT will also be subject to RETT. Although an advisory opinion is binding only upon the person who requested it and is based on the facts and circumstances specific to the particular situation, as a tax practitioner, we can glean the position of the department from these opinions. In TSB-A-14 (2) R, a grantor of a IDGT funded the IDGT with cash shortly before the tax laws in effect in December of 2012 were set to expire, thereby making a gift to the trust of the cash. In effort to add more effect to the IDGT later, the grantor wished to exercise her power to exchange property in the trust for property of equivalent value, namely an apartment in New York City. The Commissioner of Taxation and Finance ruled that the exchange of property from the grantor to the trust is a “conveyance” triggering RETT under New York Tax Law Section 1402 (a) (a tax rate of $2 for every $500 conveyed). The commissioner went on to say that in order to be exempt from RETT as a gift, there must not be any consideration for the conveyance. This sentence leads us to conclude that the transfer of property to IDGT in exchange for a note will also cause RETT to be due.

If New York is going to be requiring transfer tax on sales to IDGTs, then the practitioners should exercise caution when transferring real property to IDGTs. Other options exist such as first transferring the property to an LLC. The transfer of real property to an LLC, which the grantor wholly owns, is not subject to RETT. Once the LLC is funded, transfer the LLC interest to the IDGT, which is NOT a transfer of real property subject to RETT. With careful planning, use of the IDGT can serve as a very valuable estate planning tool and not cause real estate transfer tax.

Note: Laura I. Dunathan is partner of the firm, Twomey, Latham, Shea, Kelley Dubin & Quartararo, LLP in the estate planning department. Ms. Dunathan’s primary areas of practice are estate planning, estate and trust administration, elder law, taxation and the representation of non-profit organizations. Her personalized service and attention to individual circumstances is a hallmark of her practice.