Selling Family Business Interests to an Intentionally Defective Grantor Trust

An all-time high federal gift and estate tax exemption, low interest rates, and (in many cases) decreased values of family businesses resulting from the COVID-19 pandemic have created an ideal opportunity for business owners who are ready to put highly effective succession plans into action. An Intentionally Defective Grantor Trust (or “IDGT”) is a trust with a strange name and unique tax characteristics but selling stock in the family business interests to an IDGT may be the family business succession planning strategy that works best for you.

Forming the IDGT:
Before the family business owner can sell family business interests (such as stock in the family corporation or membership interests or partnership interests in the family limited liability company or partnership) to an IDGT, the business owner must form the IDGT. To do this, the business owner as the “grantor” will execute a trust agreement wherein among other things she will identify those persons whom she wishes to be the IDGT beneficiaries – usually the grantor’s children or grandchildren. The trust agreement for the IDGT will be structured in such a way so that although the grantor is treated as the owner of the IDGT assets for federal income tax purposes, the grantor is not treated as the owner of the IDGT assets for federal estate tax purposes. It is this characteristic to which the IDGT owes its strange name and is why this type of trust is said to be “intentionally defective”.

Initially Funding the IDGT:
Once the IDGT is formed the grantor will make a gift of property to the IDGT. The value of the gifted property is typically at least 10% of the value of the business interests the IDGT will subsequently purchase from the grantor and the gifting is done so that the IRS will respect the purchase and sale. So long as the value of the property gifted by the grantor to the IDGT is not greater than the grantor’s unused federal gift and estate tax exemption amount the grantor should not have any federal gift tax liability relating to the gift of the property. Currently, the federal gift and estate tax exemption is at $11.58 million per person for 2020.

Selling Business Interests to the IDGT:
After the grantor has made the described gift of property to the IDGT, the grantor and the IDGT will enter into a purchase and sale agreement pursuant to which the IDGT will purchase from the grantor the business interests specified in the purchase and sale agreement for the purchase price also specified therein. In exchange for the business interests acquired from the grantor, the IDGT will execute a promissory note with an original principal amount equal to the purchase price and made payable to the grantor. The promissory note will be secured by the business interests being purchased and sold pursuant to the terms of a security agreement executed by the IDGT and the grantor. So far this sounds like a fairly typical purchase and sale transaction except for the fact that for federal income tax purposes the grantor and the IDGT are treated as being the same person with respect to the IDGT’s assets – the business interests – and, accordingly, the grantor neither recognizes any taxable gain on the sale of the business interests to the IDGT nor recognizes any taxable income on receipt of interest paid by the IDGT pursuant to the promissory note. Further, the business interests – including any future appreciation – are removed from the value of the grantor’s estate for federal estate tax purposes and although the promissory note will be included in the value of the grantor’s estate for federal estate tax purposes, the promissory note will not appreciate and upon its eventual payment in full it will have no value.

As described, the combination of a high federal gift and estate tax exemption, potentially decreased business enterprise values, and other factors provide a unique – and perhaps once in a lifetime – opportunity to successfully implement a meaningful succession plan.

Please contact the Estate Planning, Probate & Trusts practice group to schedule a time to discuss how an IDGT might assist you in reaching your personal and business goals.

Frank L. Leffingwell is a tax attorney in the firm’s Tax Planning & Controversy, Estate Planning, Probate & Trusts, and Real Estate sections.