Shortly before his passing, Benjamin Franklin uttered one of his more infamous quotes, “In this world, nothing is certain except death and taxes.” With the certainty of death implicitly comes another: everyone will transfer his or her wealth, whether in life or after death. How a person transfers wealth will affect how the other certainty, taxes, comes into play.
Generally, if a person transfers assets upon his or her death, the recipient will avoid income tax on the appreciation of such assets during the decedent’s lifetime.[1] On the other hand, if a person transfers assets during his or her lifetime, the recipient will not receive such favorable income tax treatment, but the person will avoid transfer tax on any appreciation of the asset following the gift.
To illustrate, see the following (extremely) simplified example:
John Doe purchased stock in XYZ Corp twenty years ago for $1.6 million. XYZ Corp subsequently exploded in value, and the shares John purchased are now worth $12 million. John’s only other assets consist of real property which he recently acquired for $12 million.
Scenario 1: John bequeaths the XYZ stock and real property to his son, Jim, in his Will. Jim receives the stock with a $12 million basis. John can now sell the stock for $12 million with no income tax consequences. John’s estate, however, will be taxed on the $24 million of value of the stock and real property which is included in John’s gross estate for a total estate tax based on the current $13.61 million exemption of approximately $4.2 million. Given the current 20% top capital gains rate, without considering the 3.8% net investment income tax, the adjustment to cost basis of the stock from $1.6 million to $12 million saved approximately $2.1 million in capital gains.
Scenario 2: The day after John purchased the XYZ stock, he gifted it to young Jim outright. Jim’s basis in the stock is $1.6 million[2], and if Jim sells the stock today, he would be taxed on the $10.4 million in appreciation as long term capital gain for a total tax of approximately $2.1 million. John’s estate, however, will avoid tax on this appreciation, as such would pass outside John’s estate, which would consist of the $1.6 value of the stock on the date of transfer[3], as well as the $12 million in real property resulting in no federal estate tax. As John’s estate tax base is conveniently equal to the basic exclusion amount, his estate will not be subject to estate tax.
As you can see, in these scenarios, when the decedent’s gross estate exceeds the basic exclusion amount, imposition of tax is certain. John can decide which tax is to be imposed; the estate tax, if John transfers upon his death, or income tax, if John gifts during his lifetime. While one manner of transfer may prove more beneficial than the other when considering a number of factors, what if there was a way to avoid both; to have the proverbial cake and eat it, too? Enter, the Intentionally Defective Grantor Trust (“IDGT”).
IDGTs, Generally
IDGTs, as previously written about by my colleague[4], are the product of discrepancies between Chapters 11 and 12 of the Internal Revenue Code, dealing with estate and gift tax, respectively (“Transfer Tax”), and Chapter 1, which deals with income tax. Generally, the aforementioned Chapters of the Internal Revenue Code are compatible, and if a taxpayer retains certain control over transferred property that violates the grantor trust rules[5] (and thus is treated as owning the property for income tax purposes), the same property will also be treated as owned at death by the taxpayer for estate tax purposes. The utility of IDGTs, however, derive from a few exceptions where certain powers are retained that violate the grantor trust rules (and thus the taxpayer will be treated as owning the transferred property for income tax purposes) but do not trigger inclusion in the taxpayer’s gross estate (thus avoiding imposition of estate tax on such property).[6]
The Swap Power
The most widely utilized retained power that will cause the transferred assets to be treated as owned by the taxpayer for income tax purposes, but will not trigger inclusion in the taxpayer’s gross estate, is the retained power to reacquire trust principal by substituting other property of equivalent value (“Swap Power”).[7] While there are a few other powers that will cause the same result, the Swap Power, as illustrated below, provides flexibility which allows taxpayers to best utilize the discrepancy between the income tax and Transfer Tax regimes.[8]
Suppose a taxpayer transfers property to an IDGT containing a Swap Power, and that property appreciates in value following the transfer. For Transfer Tax purposes, the property will be valued as of the date of transfer to the IDGT.[9] For income tax purposes, however, the transfer is disregarded, and the taxpayer is treated as still owning such property. If left here, when considering only the tax effects, this in and of itself may not prove materially beneficial, as the beneficiaries of the IDGT would not receive a step up in basis of the transferred property and would thus be subject to income tax on any appreciation. Herein lies the beauty of the Swap Power. By exercising the Swap Power, the taxpayer can later swap high-basis property into the IDGT in exchange for the originally transferred low-basis property, which will then pass through the taxpayer’s estate and receive a step up in basis.[10]
To illustrate, let’s see how John Doe could effectively utilize an IDGT containing a Swap Power.
John Doe purchased stock in XYZ Corp twenty years ago for $1.6 million. Having consulted with his attorney before making such purchase, John transferred the stock to an IDGT containing a Swap Power the same day. Under the terms of the IDGT, Jim, the only beneficiary, is to receive the assets outright upon John’s death. Today, the stock John purchased is valued at $12 million. John’s only other asset is real property which he recently purchased for $12 million.
Scenario 3: John Dies without Exercising Swap Power:
The value of John’s estate tax base will be equal to $13.6 million, composed of the $1.6 million of stock, valued on the date he transferred such to the IDGT, and the $12 million of real property. Conveniently equal to the current basic exclusion amount, John’s estate will owe no Transfer Tax. Jim, as beneficiary of the IDGT, will receive a basis in the stock of $1.6 million, and assuming he sells the stock for $12 million, will be subject to income tax on the $10.4 million of appreciation when he disposes of the stock. Note: this is the same result as Scenario 2.
Scenario 4: John Exercises the Swap Power
After consulting with his attorney, shortly after acquiring the real property, John exercises the Swap Power contained in the IDGT, transferring the real property, with a basis and value of $12 million, to the IDGT while pulling out the XYZ stock, with a basis of $1.6 million and a value of $12 million. John dies shortly thereafter.
In this scenario, the value of John’s gross estate will again be equal to $13.6 million. Here, however, this value is comprised of the $1.6 million of the value of the stock on the date of transfer to the IDGT, and the value of the $12 million of stock John received via exercise of his Swap Power. Here again, the value of John’s estate is equal to the basic exclusion amount, and John’s estate will not be subject to Transfer Tax.
As the XYZ stock was included in John’s gross estate, Jim will receive the stock at a stepped up basis of $12 million. Again assuming Jim sells the stock for $12 million, there will be no income tax consequences to him on such sale. And while Jim will take John’s basis in the real property (which was not included in John’s gross estate as it was transferred to the IDGT) the real property has not appreciated, and Jim can dispose of it, too, without any income tax consequences. Thus, by prudently utilizing an IDGT with a Swap Power, John has, in fact, avoided both Transfer and income tax.
Conclusion
As illustrated above, IDGTs containing a Swap Power can prove an invaluable tool to mitigate future tax consequences when a person owns property subject to significant appreciation. In essence, an IDGT via Swap Power provides for the flexibility to shift appreciated property into a taxpayer’s gross estate, thereby giving the taxpayer’s beneficiaries a stepped-up basis in the property, which mitigates the income tax consequences to such beneficiaries. Similarly, it allows the taxpayer to choose high basis property (with inherently less income tax liability and where a stepped-up basis would prove less beneficial) to pass outside his or her estate. While extremely simplified in this article, an IDGT is worth considering if you find yourself holding significantly appreciated property, and you should consult your trusted tax professional if one could benefit you.
[1] The assets will receive a “step up” (or potentially a “step down”) to date of death value under I.R.C. § 1014.
[2] Jim took John’s basis in the stock under I.R.C. § 1015.
[3] [3] Included in John’s estate tax base as an adjusted taxable gift under I.R.C. § 2001(b).
[4] https://esapllc.com/cja-stepupplanning-2019/; https://www.esapllc.com/inclusion-planning/; https://esapllc.com/sge-heckerling-2019/ ; https://esapllc.com/irs-reverses-position-on-modifying-irrevocable-grantor-trusts-2024/; https://esapllc.com/interest-rates-rise-act-wait/
[5] The grantor trust rules are found in I.R.C. §§ 671-678.
[6] Note, however, Rev. Rul. 2023-2, where the IRS took the position that I.R.C. § 1014 would not apply to assets in an irrevocable trust where the grantor retains a power that causes such grantor to be treated as the owner for income tax purposes but does not cause inclusion in the grantor’s gross estate.
[7] I.R.C. § 675(4)(C).
[8] In Rev. Rul. 2011-28, the IRS ruled that a swap power over a life insurance policy will not be viewed as the retention of an “incident of ownership” in the policy under I.R.C. § 2042.
[9] I.R.C. § 2512.
[10] There are other nuanced way to accomplish this. For example, the grantor may borrow funds to purchase appreciated property from the IDGT to ensure the purchased assets are included in the taxable estate for purposes of I.R.C. § 1014. By purchasing the property with debt, the grantor avoids the loss of at least some of step-up of assets that would otherwise be swapped into the IDGT.
