The so-called “Intentionally Defective Grantor Trust” (“IDGT”) has become a very popular estate planning technique. An IDGT is a trust that does not contain any provision that would cause the assets of the trust to be included in the taxable estate of the person who created and funded the trust. However, the trust does contain a provision that makes it a “grantor” trust for income tax purposes. An income tax grantor trust is essentially ignored and all its income and deductions are reported on its grantor’s income tax returns.

If an appreciating asset is sold to an IDGT for its current fair market value (usually for consideration including a substantial promissory note), no gift tax results. The seller also does not recognize any income tax gain from the sale or any interest income from the note payments, since the trust and hence the sale itself are disregarded for income tax purposes. If the asset appreciates before the death of the seller/grantor, that appreciation has been removed from his taxable estate at no tax cost whatsoever since the trust assets are not included in his taxable estate. The IDGT can present an attractive way for parents to transfer appreciating assets to their children.

Only a few trust provisions make a trust a grantor trust for income tax purposes yet do not require its assets to be included in the grantor’s taxable estate for estate tax purposes. One such commonly used provision is the power to take assets that the grantor had contributed out of the trust and replace them with assets of equivalent value. This is commonly referred to as a “power of substitution.” While this provision has been in common use, there had been a lingering concern that the IRS might take the position that a power of substitution did cause the trust assets to be includible in the grantor’s estate under IRC Section 2036, which includes assets that a decedent had transferred but over which he had retained some degree of control.

In Rev. Rul. 2008-22 (April 17, 2008), the IRS significantly alleviated this concern. The ruling holds that such a power of substitution will not result in Section 2036 inclusion provided: i) the trustee of the trust has a fiduciary obligation to ensure the grantor’s compliance with the terms of the power by satisfying itself that the asset withdrawn and the asset transferred to replace it are in fact of equivalent value; and ii) the power of substitution cannot be exercised in a manner that can shift benefits among trust beneficiaries. This ruling should ensure the continued popularity of these trusts for wealth transfer planning; however, in the ruling, the IRS described the power in a somewhat different manner than it is described in the statute. Extreme care should be taken in drafting these provisions. It may be appropriate to include a second power that would make the trust a grantor trust without causing the trust assets to be includible in the grantor’s taxable estate. We have made appropriate modifications to the forms we use for these trusts.