WHAT IS AN IDIT?
The IDIT is an estate freeze technique that allows taxpayers to remove appreciating assets from their taxable estates at
a low gift-tax cost, while providing liquidity at death to pay taxes and other estate costs.
great difficulty with placing any quantity of assets into trust is the
federal gift tax. Modest gifts can be covered
with gift tax annual exclusions and unified credits; however, once these protections have been exhausted, the affluent
are forced to pay gift tax on such transfers at a marginal rate that can equal 55%, or even 60%.
selling the assets (instead of making gifts) to a particular type of
trust - an Intentionally Defective Irrevocable
Trust ("IDIT") - in exchange for a promissory note, this gift tax cost can be reduced dramatically or eliminated
altogether. Life insurance is used to repay the note at the seller’s death, or to recover the cost of repayment if the note
was repaid during the seller’s life, to fund estate taxes, and for other estate liquidity needs.
This strategy offers the following planning advantages:
It allows an income tax-free
sale of property (reflecting appropriate valuation discounts) to an
provides that only the note is included in the seller-grantor’s estate;
all post-sale appreciation is immediately
excluded from the seller-grantor’s estate.
It offers an ideal wealth transfer mechanism for multi-generational planning.
It combines the transfer tax
leverage of several estate planning tools into a dynamic new technique.
Either individual or
survivorship insurance can be used with the IDIT technique.
Survivorship insurance can be
less costly than individual life insurance, and that is often a consideration. The insurance can be either split-dollar or
ledger (non-split-dollar), depending on trust cash flows.
Overview of the IDITŪ Strategy
High-net worth individuals
often own assets that are appreciating in value. Good estate planning
dictates that these assets be eliminated from estate taxation because as time passes, the assets will create tremendous
estate tax before they can be passed to children, grandchildren, or other beneficiaries. Also, these assets often generate
considerable income that the owner cannot or does not want to give up currently. Further, the gift tax cost of giving
those assets away may be prohibitively expensive.
The IDIT offers an excellent
solution to these problems. An individual first makes a "seed money"
gift to an IDIT,
which is an irrevocable trust for the benefit of the grantor’s family. The individual then sells appreciating assets
(reflecting any applicable valuation discounts) to the trust in return for a promissory note that pays interest only to the
seller-grantor, with a balloon principal payment due at the end of the note’s term.
Assuming the seller-grantor
dies during the term of the promissory note, only the value of the note
included in his estate. Therefore, the value of the assets sold to the trust is capped in the seller-grantor’s estate at the
value of the note, and all subsequent appreciation passes to the trust free of estate and gift tax. Because the assets sold
to the trust are "frozen" in value in the seller-grantor’s estate, the IDIT is called an estate "freeze" technique. In
addition, because the trust is a grantor trust - a "defective" trust for income tax purposes - the IRS’s current position is
that no capital gain is recognized from the sale, and the seller-grantor’s basis carries over to the trust.3 Furthermore,
interest is not taxable to the seller nor deductible by the trust. Therefore, although the IDIT is "defective" for income tax
purposes, it is "effective" for transfer tax purposes.
Almost any kind of property
can be sold to the IDIT; however, it should have the potential for
After the property is transferred to the trust in exchange for the promissory note, the IDIT purchases life insurance on
the seller-grantor’s life. (An IDIT is also an excellent life insurance purchasing vehicle, independent of its value as an
estate freezing technique.) Assuming that income-producing assets are transferred to the trust, funds are now available
in the trust to purchase life insurance. The amount of life insurance that can be purchased is thus limited by the trust’s
cash flows and underwriting limitations, and not by the face amount of the note.
On the death of the
seller-grantor, the IDIT applies the insurance proceeds that it
receives to pay the note,
assuming it was not paid off during the seller-grantor’s life. (If the note were repaid during the seller-grantor’s life, the
insurance proceeds can be used to recover the cost of the earlier repayment, which depleted trust assets.) The seller-
grantor’s estate then uses the cash that it receives from the IDIT to pay estate taxes and fund other estate liquidity
The major risk involved in
using this estate planning strategy is that, because it is relatively
new, there is little
direct legal authority for its use. However, all estate planning strategies have some risk, and the IDIT is well within the
list of respectable, accepted techniques.
When to Use This Strategy
The IDIT planning strategy
should be considered for individuals who have highly appreciating
assets that they
want to pass on to their beneficiaries, but that, because of that appreciating character, will create a large increase in the
value of their estates subject to transfer tax. It is also a useful planning technique when a multi-generational "Dynasty"
trust is indicated (discussed below). Many professional advisors think that an IDIT is superior to a GRAT (Grantor
Retained Annuity Trust), and that it may be better than, or serve as a complement to, a QPRT (Qualified Personal
In addition to being an
outstanding estate "freezing" technique, the IDIT can serve as the
wealth replacement trust
when a charitable remainder trust (CRT) is implemented. The insurance and other assets in the IDIT that pass to the
family replace the assets that the estate owner transfers to the CRT.
The IDIT can also be a very
cost-efficient vehicle for purchasing life insurance to pay estate
taxes, in addition to
any insurance proceeds made available from repayment of the promissory note at death (or from the cost recovery
funding of the earlier repayment of the note during life). If the trust holds income-producing assets (such as S
corporation stock, partnership interests, and real estate), it can use the income to pay annual economic benefit ("P.S.
58/38") costs in a split-dollar insurance plan,6 or full premiums when split-dollar is not used. Using trust cash flows to
pay premiums eliminates the need for subsequent gifts by the estate owner for this purpose. Furthermore, trust cash
flows are enhanced because the grantor, not the trust, pays the income taxes on trust income under the grantor trust
In the context of a buy-sell arrangement, for example, in a family-owned corporation, the IDIT can serve as the
purchasing entity, instead of the child or children active in the business. This has three distinct advantages over a
typical buy-sell arrangement:
1.The purchase price is fixed
at the time of sale, rather than at the time of the selling parent’s
death, and the life-
funding costs less because the insurance does not have to fund an
escalating purchase price.
2.The problem of successively
running the purchased stock through the children’s taxable estates is
not an individual child, purchases the stock, and the trust is designed
to avoid taxation in the
estates (and the generation-skipping transfer tax (GSTT) at a child’s
active in the business can share in the estate as beneficiaries, if
desired (solving the "estate
problem), while control can be in the hands of the active children as
trustees of the IDIT.
For the estate owner
who wants to keep control of the business during his life (and most
estate owners seem to fall
in this category), the property sold to the trust can be an interest that is not entitled to vote. Examples include
nonvoting stock in a C or S corporation, or a nonvoting interest in a limited liability company or family limited
A particularly favorable
application of this technique involves a corporation (or other entity)
that ultimately plans to
sell out to a competitor or go public. If the value of the stock sold to the IDIT can be valued as a closely held corporate
interest (with appropriate minority interest and lack of marketability discounts, including a discount for the
corporation’s built-in capital gains tax allowed by the recent Davis7 decision), the value of the stock in the trust will be
much greater when the subsequent sale or public offering takes place. In this instance, all of the "instant growth" can
avoid transfer taxation via the use of an IDIT. In short, the IDIT technique is an extremely flexible estate planning
strategy that can be used to generate substantial tax savings in several estate and business-continuity planning
Example. The following example illustrates the advantages of the IDIT technique compared to other estate planning
techniques. (These comparable techniques are all non-charitable and the client may also employ charitable giving techniques
as part of a wealth transfer plan.)
A 55-year-old grantor has
assets of $16.5 million available to commit to the plan. The grantor
establishes the IDIT
and makes a seed-money gift of $1 million to it (paying gift tax of $500,000). He then sells $15 million of business
assets, with a discounted value of $10 million (based on a qualified appraisal), to the trust in exchange for a $10
million promissory note. The note pays interest only, at the applicable federal rate (AFR),8 over its term of 15 years, with
a balloon payment of the entire principal due at that time. (If the grantor survives the term of the note, it is
contemplated that the note will be renewed so that it will remain outstanding at the grantor’s death.) Using the cash
flow generated by the seed money gift and the business assets, the trust buys a $10 million life insurance policy on the
grantor’s life, in this instance on a split-dollar basis. The beginning asset base in the IDIT, therefore, consists of the $15
million of business assets ($10 million discounted value), the $1 million in seed money, and the $10 million life
At the grantor’s death in 24
years (his normal life expectancy), the total asset base has grown to
more than $60
million, plus the $10 million in life insurance. This includes the grantor’s taxable estate reflecting interest received
over 15 years plus the balloon payment, net of estate taxes. Therefore, after taxes are deducted, the IDIT technique
provides over $70 million to the grantor’s heirs, more than any of the other comparative estate planning techniques.
When Not to Use This Strategy
the IDIT can be a valuable estate planning technique, it will not
provide the desired effect in all
circumstances. First and foremost, for the technique to work, the assets sold to an IDIT must be reasonably expected to
appreciate (in terms of both income and capital growth) at more than the AFR, which is the measure used to compute
the interest rate on the promissory note. Otherwise, neither an IDIT nor any other estate freezing technique makes
Second, although the IDIT
does generate an interest income stream back to the seller-grantor,
those persons who
will likely need all of the income from their assets for a prolonged period should consider alternative methods of
planning. The interest payments from the IDIT are generally less than the actual income stream from the assets. The
interest income stream may also end at some point, if the note is paid off during the seller-grantor’s lifetime. If the
interest income stream does end, the seller-grantor either must be able to replace the lost income, or have no need for
Third, life insurance is an
integral part of the IDIT design, and individuals who are extremely
elderly or not in
good health -and so are subject to higher premiums for coverage - should be careful to avoid having the full premiums
paid from the trust. Although the cost of life insurance increases with age or ill health, much of the negative impact of
higher premiums on an IDIT can be mitigated by using a split-dollar life insurance plan between the trust and another
entity or individual.
Fourth, if there is a risk
that the assets sold to the IDIT will not generate enough income to
make the interest
payments to the seller-grantor, this strategy may not be as effective. If insufficient income is being generated, the
trustee of the IDIT will have to return some of the trust assets to the seller-grantor to satisfy the promissory note’s
interest payment requirement. Assuming these assets are appreciating, the technique will still be advantageous, but
not as advantageous as if there were sufficient income to pay interest. The reason is that not all of the appreciating trust
assets will be required to be returned to the seller-grantor in lieu of interest payments, and thus some value will
remain in the trust. (Paying interest "in kind" is called a "leaky" freeze.)
Specifics of The Strategy
put the IDIT strategy to work, an individual first makes a "seed money"
gift to the trust, as noted above. Many
practitioners think that this gift should be at least 10% of the (discounted) sales price of the property that will be sold to
the trust. After making the gift, the grantor sells appreciating assets to the trust in return for a promissory note, which
pays interest back to the seller-grantor at the AFR, with a balloon principal payment due at the end of the term of the
note. Only the note will be included in the seller-grantor’s estate, and all post-sale appreciation will be immediately
excludable from the estate.
As stated previously, because
the trust is a grantor trust, the current IRS position is that no
capital gain is
recognized from the sale, and the seller-grantor’s basis carries over to the trust. Furthermore, interest on the note is not
taxable to the seller-grantor, nor deductible by the trust.
Although the seed-money gift
is subject to gift tax, the assets sold are not, as their sale to the
trust is assumed to be
a bona fide sale for adequate and full consideration. Gift tax annual exclusions and unified credit can be used to
exempt at least a portion of the seed money gift from gift taxes, although it may inadvisable to use annual exclusions for
the one-time gift contemplated by the IDIT technique. Assuming annual exclusions are used elsewhere, the IDIT does
not have to contain "Crummey" withdrawal powers, avoiding their complexities and uncertainties.
In addition, the $1 million
generation-skipping transfer tax (GSTT) exemption can be used to exempt
the trust from
generation-skipping transfer tax for gifts up to this amount. Again, the GSTT exemption need be allocated only against
the seed-money gift. This allows the trust to be multi-generational (a "Dynasty" trust).
Gift-splitting is also
allowed. This means that married couples can apply both spouses’
applicable gift tax annual
exclusions (if used), unified credits, and GSTT exemptions to the gift, effectively doubling the amount of the tax-free
The property sold to the IDIT
can be almost any kind of property, including S corporation, C
publicly traded stock, a partnership or limited liability company interest, and real estate. A key characteristic of the
property is that it should have the potential for future appreciation, in excess of the note interest, which will be frozen
out of the seller-grantor’s estate.
The IDIT then purchases
individual life insurance on the seller-grantor’s life (or survivorship
insurance on the
lives of the seller-grantor and spouse). Further transfer tax "leverage" can be achieved by using a split-dollar life
insurance plan. However, the insurance can also be ledger (or non-split-dollar), depending on trust cash flows.
At the seller-grantor’s
death, only the note (plus any accumulated interest) will be included
in his estate, and all
post-sale property appreciation will be excluded from the estate. In addition, the seller-grantor’s payment of income
taxes on the IDIT income (which is permissible without being subject to gift tax because the trust is a grantor trust)
further reduces his estate.
The IDIT then applies the
insurance proceeds that it receives to repay the note, if it is not
paid off during the seller-
grantor’s life. (If the note is paid off during the seller-grantor’s life, the insurance proceeds can be used to replace, or
"cost recover," the trust assets expended to repay the note, plus perhaps cost of money or appreciation forgone on those
assets.) Using the insurance proceeds allows the trust to pay off the note without having to sell assets to generate the
necessary cash. This is an important factor, because the trust assets are typically low-basis - resulting from the
carryover of the seller-grantor’s basis to the trust - and will have appreciated substantially in value. Thus, the
insurance not only funds payment of the note, but it also avoids triggering taxation of the built-in gains had the trust
assets been sold to pay the note. Any additional insurance proceeds can be injected into the estate in the usual way, by
the trust purchasing assets from the estate or making loans to it. The estate then uses the cash that it receives from the
IDIT to pay estate taxes and to fund other estate liquidity needs.
In addition, payment of the
note can be deferred until the death of the seller-grantor’s surviving
spouse, if desired.
This allows for funding the note payment with less costly survivorship life insurance, either split-dollar or ledger.
Furthermore, the note is an excellent asset to transfer to a marital trust for the benefit of the surviving spouse because
it provides the surviving spouse with a lifetime income, without appreciating in his estate.
Although life insurance is
central to the IDIT technique, some of the same estate planning
advantages can be
achieved through the use of an Intentionally Defective Irrevocable Trust (IDIT), which is an uninsured IDIT. The author
feels, however, that combining either individual or survivorship life insurance with this technique maximizes the
transfer tax leverage.
Income Tax Considerations During the Life of the Seller-Grantor
The IDIT is a "grantor" trust
under the Internal Revenue Code.12 A grantor trust is one in which
exist that cause all of the income of the trust to be taxable to the seller-grantor, rather than to the trust itself. It is
therefore possible for a seller-grantor to be taxed on income, including capital gain income, that he never receives.
While it is usually not the
best idea to be taxed on income that one does not receive, there are
estate and gift tax
advantages to this result. When the seller-grantor pays the income tax on trust income, he is effectively making a gift of
the tax paid to the trust beneficiaries, and lowering his own taxable estate, without suffering any gift or estate tax
Example. Trust income is $100 and the resulting income tax is $40. If the grantor pays this $40 tax, in effect he has made a
gift of the $40 to the trust beneficiaries (the trust income remains at $100) and reduced his estate by the same amount. The
is that the seller-grantor’s estate is reduced by the amount of income
taxes paid on trust income, but the seller-grantor
is not treated as having made a gift of these amounts.
Why are the seller-grantor’s
income tax payments not taxable as gifts? Because the seller-grantor is
complying with the terms of the income tax law, i.e., he is not paying tax on income taxable to the trust or its
beneficiaries, but satisfying his own legal tax obligation. The IRS purportedly does not like this result. However, most
tax professionals agree that despite IRS reluctance to accept this concept, the law is clear that no gift is made when the
grantor pays income tax on grantor trust income.
In the context of the IDIT
technique, grantor trust status is crucial because of the current IRS
position that no gain
is recognized by a grantor who sells property to a grantor trust. The rationale for this position is that the seller-grantor
is in effect selling to himself, which is not a taxable event. While the IDIT is "defective" for income tax purposes, it is
"effective" for estate tax purposes, with the result that all post-sale appreciation in the value of the property sold to the
trust is excluded from the seller’s estate. It is these features that make the IDIT work so effectively.
The grantor-trust nature of
the IDIT also offers another potential advantage. The trust can be
drafted to allow the
seller-grantor to "buy back" the assets held in trust at any time, although the seller should have no legal right to
repurchase these assets because that could result in adverse estate tax consequences.
Example. A seller-grantor would like to make a sale or gift of income-producing real estate to the trust, but would like
the opportunity, prior to the expiration of the trust’s term, to buy the property back at its then-fair market value. When
the buy-back occurs, even if the purchase price is in excess of the trust’s basis in the property, there is no taxable gain
The reason for nonrecognition
of gain is that under the grantor trust rules, the seller-grantor is
considered to be
buying back the property back from himself. As in the sale to the trust, one does not have to pay income taxes when
buying something from (or selling something to) oneself. Thus, a seller-grantor can sell or give property to a grantor
trust for a period of time and buy it back (at current fair market value) with no income tax consequence.
An advantage of such a
buy-back is that the repurchased property will receive a step-up in
basis at the seller-
grantor’s death because it will be included in his estate. However, once the assets are back in the seller-grantor’s
estate, they will continue to appreciate and add to that estate for estate tax purposes. This creates a "leaky" freeze, and
wholly or partially defeats the purpose of the IDIT transaction in the first place.
Income Tax Considerations at the Death of the Seller-Grantor
One of the inherent risks in
using an IDIT is that the seller-grantor may die during the term of the
note. In fact, the estate freeze effect will be maximized if the note is outstanding at death and the seller is not repaid
during his or her lifetime.
If death occurs while the
note is outstanding, an argument can be made when the trust
subsequently pays the
balloon principal payment to the seller-grantor’s estate that this payment creates income in respect of a decedent (IRD).
The result is that the payment is both income and estate taxable, with an offsetting deduction for the estate tax against
the income tax. There are also respectable arguments that this payment is not IRD.
Even if IRD, the amount in
question is confined to the face amount of the promissory note, and all
of the post-sale
appreciation escapes taxation in the seller-grantor’s estate. Moreover, the trust may receive a step-up in basis for the
assets purchased, and the insurance proceeds received by the estate on payment of the note can also be applied to pay
any income tax generated, as well as the estate tax on the note. This is another advantage of using life insurance with
the IDIT technique.
To avoid estate tax problems,
the seller-grantor should not serve as a trustee of an IDIT, nor should
he have the
right to appoint and remove trustees. In a properly drafted IDIT, anyone other than the grantor can act as trustee, as
long as he is not a minor or otherwise legally incapacitated. This includes the grantor’s child or children, or spouse
(assuming the spouse is not also a grantor of the trust). In order for a seller-grantor to preserve control of a business
entity, he should transfer a nonvoting interest in the entity to the trust, rather than act as trustee.
Protection from Creditors
Assets that are sold or given
to an IDIT have been irrevocably parted with; even though a
seller-grantor owns the
trust’s promissory note, he no longer owns the assets transferred. If, after the sale or gift is made, the seller-grantor has
creditor problems, the assets that he sold or gave to the trust cannot, absent fraud, be taken by creditors. However,
creditors can reach the note itself.
With respect to the beneficiaries of an IDIT, generally, so long as the assets remain in trust, the beneficiaries have
creditor protection (assuming an adequate spendthrift provision in the trust document). However, income or principal
that is actually paid out of the trust to the beneficiaries is subject to the claims of their creditors.
The IDIT is an excellent
candidate for use of the GSTT exemption. The law allows a
seller-grantor to immediately
allocate, to the seed money gift only, his $1 million GSTT exemption ($2 million for spouses who gift-split). All of the
assets subsequently sold to the trust are not subject to the GSTT because they are the product of a bona fide sale for
adequate and full consideration. Thus, the entire trust can be exempted from the GSTT at the outset, assuming
sufficient GSTT exemptions to allocate to the seed money gift. This characteristic of the IDIT is what makes it so suited
to multigenerational, Dynasty trust planning.
Planning Risks and Detriments
An estate tax risk occurs in
using an IDIT if the seller-grantor dies during the term of the
promissory note. The IRS
could argue that the sale of the property to the trust was in effect the retention of an income interest in the property
transferred to the trust. This argument, if successful, would result in inclusion of the trust property (not just the note)
in the seller-grantor’s estate at his death. It could also result in a taxable gift at the time of the sale.
A proposed solution to this
problem is to ensure that (1) payment of the note interest is not in
any way tied to or
dependent on trust income (the appreciating trust assets themselves can be used to pay interest in kind, if necessary);
and (2) the seed money gift is substantial in relation to the sales price, generally at least 10% of the sales price. These
steps should rebut the argument that the seller is relying only on the property sold for his interest income payments
and therefore has retained an income interest in that property. Of course, the trust’s promissory note should be bona
fide, and interest should be paid at the AFR in accordance with the terms of the note. In addition, a qualified appraiser
should value the property to be sold so that the purchase price equals the property’s fair market value.
As stated above, the trust’s
payment of the balloon principal payment to the seller-grantor’s estate
at his death may
be both income and estate taxable as IRD. However, even if it is IRD, the insurance proceeds received by the seller’s
estate in payment of the note can be applied to these taxes.
A further danger is that the
assets held in the IDIT may not produce sufficient income to support
payments. If this occurs, the interest can be paid in kind from the appreciating trust assets themselves. This is not as
effective an estate freeze as having trust income adequate to pay interest. Any assets that are returned to the seller-
grantor immediately begin to appreciate in his estate, again inflating the estate tax value. However, as long as the
assets remaining in the trust are appreciating in value, payment of interest in kind will not exhaust trust assets. Even
such a partial or leaky freeze will save some estate taxes.
Yet another problem can occur
if the IDIT produces income in excess of the required interest payment
and the seller-grantor reports this phantom income on his income tax return. While this result is good from an estate
planning perspective - the trust beneficiaries will get more assets and the seller-grantor’s estate will be reduced at no
gift tax cost - it may present an obstacle to some clients. There are measures for dealing with this issue if the grantor
does not want to pay the income tax on trust income.
Those who are older or not in
good health should carefully consider whether to use this strategy
insurance is an integral part of this plan, and the cost of life insurance increases with age or ill health. However, much
of the negative impact of higher premiums on the IDIT technique can be mitigated through the use of a split-dollar life
While the IDIT estate
planning technique, like other planning strategies, is not effective
for all situations, it should
be seriously considered by individuals with highly appreciating assets that they want to pass on to their beneficiaries
without incurring large gift or estate tax liabilities. By using insurance, the IDIT technique also provides the trust with
funds to repay the note (or to recover the cost of repayment) and the grantor’s estate with liquidity to pay taxes and other
estate costs that arise at the grantor’s death.