GRAT or IDGT

Perry M. Schroeder, CPA Managing Director  Baden, Gage & Schroeder, LLC 260-969-2525 pschroeder@badencpa.com

How Are These Trusts Used?

Clients create GRATs by transferring assets to a trust in exchange for annuity payments for a specified term, anticipating that the assets will likely earn more than the Internal Revenue Service's minimum section 7520 rate, which is 4.2% for September 2008.  At the end of the specified term, the beneficiaries receive the appreciated assets often without any gift or estate tax.

Clients fund IDGTs by transferring assets by gift and installment sale.  The grantor would gift a minimum of 10% of the combined transfer value before the sale, which will consume some of the grantor's annual and lifetime gift exemptions.  The balance of the assets would be transferred to the trust by an installment sale.  The terms of the installment contract are flexible with the exception of the interest rate.  Each month, IRS determines the minimum interest rate for this type of transaction; for September the minimum rate is 3.5% for 3 to 9 year contracts.

Once the trusts are funded the rates are fixed; now is a good time to lock in the relatively low current interest rates of either type of trust.  Because of the lower rate, IDGTs have the advantage of lower future cash flow requirements.

What Assets Are Appropriate to Fund the Trusts?

Because of closely held business valuation multiples and discounting considerations in determining the current fair value of a minority interest, using stock of an S Corporation or a limited liability company can be very beneficial in maximizing the value transferred via either type of trust.  Assets, including real estate, that produce enough cash flow to support the debt service or assets that are likely to appreciate in value are ideal.

Because both types of trusts are grantor trusts, no gain is recognized on the transfer or sale of assets to the trust.  The basis of the asset in the trust will be the same as the basis of the grantor.

What Happens if the Grantor Dies During the Term of the Trust?

The grantor specifies a term of existence for both a GRAT and IDGT.  If the grantor survives that term, the remaining assets are distributed to the beneficiaries, the trust terminates and all of the transferred assets are excluded from the grantor's estate.  If the grantor dies during the term of the trust all or a portion of the assets are included in the estate of the grantor. 

In the case of a GRAT all of the then current value of the assets is included in the estate of the grantor.  There are techniques using "Laddered GRATs" that can be used to minimize the effect of including all of the appreciated asset value in the grantor's estate.

In the case of an IDGT only the remaining balance of the installment note is included in the grantor's estate.  All of the appreciation of the transferred assets will be excluded from the grantor's estate.

Cash Flow Flexibility

The annuity payments required by the GRAT and the installment payments required by the IDGT should both be treated as arms-length transactions.  Any disregard of the required payments could jeopardize the status of the trust.  If cash flow is not sufficient to make the scheduled GRAT annuity payments, a portion of the assets may need to be returned to the grantor as the annuity payment.

However, the installment payments owed by the IDGT may be more flexible if cash flow does not permit the scheduled payments, since interest accrues on the unpaid balance of the installment contract.  It is possible to have an interest only installment contract with a balloon payment at maturity.

Other Factors to Consider

GRATs are supported by IRS regulations, if you follow the regulations there is more assurance that your transaction will be accepted by IRS as intended.  IDGTs have little regulatory or case law supporting them, drafting of the terms and documents are based on related sections of IRS regulations.

If the grantor wants to skip generations, the GRAT cannot accomplish it without an additional step – selling the remainder interest in the GRAT.  The IDGT can operate as a generation-skipping trust.

The advantages or disadvantages of a GRAT over an IDGT differ from one case to another.  Each client's set of facts and circumstances should be evaluated to determine which trust is right for the given situation.  We will be glad to discuss those with you and help you evaluate the best solution for your case.  Contact Perry Schroeder , CPA, at (260) 969-2525 or pschroeder@badencpa.com.