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Powerfully Effective “Defective Trust” 

By: Matthew S. Dana, Esq. CPA, LLM in Taxation, CLU, ChFC

Over a 37-year career, you not only have the advantage of 37 years of continuous learning, but you also have the advantage of “hindsight” in seeing Estate Plans that you set up over 30 years ago accomplish huge Estate Tax savings for the families of your clients.  You see that the curse of Estate Planning is that your client, Generation One, will never actually see the benefits of the years of planning.  But, that is also the blessing of an “old war dog” Estate Planning Attorney. He gets the blessing of seeing Generation Two flourish.  As I have said many times before, “I don’t practice Estate Planning, I live it”.  

In my younger days, I used to think that using your Federal Estate Tax Exemption early was a very powerful tool.  And it is, in that it locks in your Exemption thereby preventing Congress from taking it away.  But now, with the benefit of hindsight, and seeing my clients get $40 million or $50 million or more out of their Estates without an Estate Tax, I have learned that it was getting the growth and appreciation in the value of those assets out of the Estate that was exponentially more powerful.  

As I climb the Estate Planning client ladder and work with the ultra-wealthy, I can see the value of compounding interest and the “rule of 72” in doubling one’s Estate value approximately every 10 years.  Many of my clients 30 years ago that were $15 million clients are now dying at $50+ million clients, yet we are paying zero Estate Taxes.  It becomes easy to realize that locking in a $1 million Exemption 30 years ago wasn’t the magic.  It was the significant growth and appreciation from that $1 million that is the magic.  

With the ultra-wealthy (which I define as a married couple over $50 million net worth or a single individual over $25 million), I learned that locking in the Exemption is Estate Planning 101.  Getting growth and appreciation out is Estate Planning 202.  See, the problem with the ultra-wealthy is that they still have significant wealth even after they have gifted away their Federal Gift/ Estate Tax Exemption.  So, are we finished at that point? Or is there more?  And yes – the “more” is the ability to “Freeze the Estate” and get growth and appreciation out of the Estate on all Assets, without using any Federal Estate Tax Exemption. 

So, this article will focus on how to do that, and on Estate Planning 202.  How do you get growth and appreciation in value out of your Estate on all of your Assets, and especially those Assets that are above and beyond the Federal Exemption amount?  The quick answer is the classic “Freeze Technique” which requires a Trust to be “defective” for Estate Tax Purposes.  I will explain more below, so keep reading.  

The advantages of using a “Freeze Technique”

  1. Getting growth and appreciation of Assets out of your Estate for Estate Tax purposes (getting the assets into a “Green Box” – a Trust that is exempt from paying Estate Taxes). 
  2. On Assets that are above and beyond your Federal Estate Tax Exemption. 
  3. Freezing the value of your Estate Tax Liability (into a “Red Box”- a Trust subject to Estate Taxes) by taking back a Promissory Note that is a declining asset.  
  4. And yet you keep the cash flow from the Assets that you “sold” to the Defective Trust (a Green Box). 

How to do a classic “Freeze Technique:

  1. Client creates an Irrevocable Trust, (a Green Box) for the benefit of his spouse, or his children, or possibly even his great-grandchildren.  
  2. Client makes the Trust “Defective” for Income Tax purposes (more later).
  3. Client sells appreciated assets to the Defective Trust on the Installment basis.  
  4. Client takes back a Promissory Note for the Assets sold. 
  5. Buyer of the Assets, the Defective Trust, generates income from the Assets that it receives. 
  6. The Defective Trust makes quarterly payments on the Promissory Note back to the client.  
  7. The amount of the quarterly payment replicates the income lost by the client concerning the Assets sold.  
  8. No capital gains to the client on the sale, and no tax consequences (here’s the juice, more later). 
  9. The client’s Estate (the Red Box) is now “frozen” in value tied to the Promissory Note.  
  10. The growth assets of the client are now in a “Green Box” such that all of the growth and appreciation in value of the Assets are now in a “Green Box” and not subject to Estate Taxes when the client dies and for 3 more generations.  

Effectively “Defective”

Okay, you have waited patiently for it.  Here it is.  A Trust that is “defective”, is ignored for Income Tax purposes, but fully “effective” for Estate and Gift Tax purposes.  What does this all mean?  It means that when the client sells the Assets to a “Defective Trust” the client doesn’t need to pay capital gains, and the transaction is ignored for Income Tax purposes. It’s as though the client is selling Assets to himself.   Yet, when the client dies, the Trust is respected for Estate and Gift Tax purposes, (a Green Box) such that the value of the Defective Trust is not includable in the clients’ Gross Taxable Estate for Estate Tax purposes.  Magic to the client.  Misery for the IRS.  Yet, Revenue Ruling 85-13 makes it perfectly legal and makes it an extremely valuable Estate Planning tool.  In fact, because it is so powerful it shouldn’t surprise anyone that the current tax proposals pending in Congress will repeal Rev. Rul. 85-13.  As a result, this “Freeze Technique” will be one of the hottest Estate Planning strategies for the remainder of 2021.  

How To Create a “Defective Trust”  

The answer is simple, you make it a “Grantor Trust “as defined in Internal Revenue Code Sections 671 thru 678.  The nuts and bolts of doing this are too technical to put in this article.  Suffice it to say that a competent “high-end Estate Tax Attorney” can do it fairly simply.  It is merely a series of provisions that can be inserted in any Irrevocable Trust, whether or not created for the benefit of the spouse, the kids, or the grandkids.  In most of our Defective Trust, we insert a clause that “intentionally” violates IRC 675 by allowing the client to substitute Assets of equal value into the Trust in comparison to the value of the Assets withdrawn from the Trust.  Then, add in Revenue Ruling 85-13 which makes it crystal clear that a Trust that violates one of these code sections is ignored for any and all Income Tax purposes, but yet has validity to escape Estate Taxes when the client dies.  Many national Estate Tax Attorneys, including me, believe this Revenue Ruling to be the most significant impact on wealthier clients.  

There is not just one “Defective Trust”.  In reality, it means that you add “Grantor Trust Provisions” in any Irrevocable Trust.  That Trust could be:

  1. Spousal Gift Trust you create for your Spouse. 
  2. Irrevocable Gift Trust you create for your Children. 
  3. Irrevocable Grandchildren’s Trust.  

Creating a Cash Flow back to the Client 

There is a second benefit to this “Installment Sale to an Intentionally Defective Trust” (IDGT).  Generally, to remove assets from ones’ Taxable Estate (move assets from a Red Box to a Green Box) the client cannot retain any “use and enjoyment” or “economic benefit” from the recipient Trust.   So, here’s the juice.  The Installment Payments back to the client as repayment of the Promissory Note doesn’t violate the IRS rules on keeping an “economic benefit”.  This is true even though the payment on the Note back to the client can replicate the income lost by the client is the fact that the Assets were sold to an Irrevocable Trust.  Keep in mind that the client is not a beneficiary of the Trust.  Wow, talk about having your cake and eating it too.  

Adding a Self-Canceling Provision in the Promissory Note

You want more juice?  How about forgiveness of the Promissory Note at the client’s death so that the value of the Note is not included in the client’s Estate (Red Box) for Estate Tax purposes!  I will drink that juice.  Having this feature not only gets growth and appreciation in value out, but it also makes it look like a “gift” in that nothing is left in the client’s Estate when the client dies, and yet the client didn’t need to use any of his or her Estate Tax Exemption.  Wow, let me hear the drum roll and let the band begin to play.  But of course, the Defective Trust must pay a “premium” back to the client to get the “self-canceling feature”.  Not a problem, in that the client can maximize the stream of payments back to him or her by not only collecting on the Promissory Note but also the Premium.  

What are the Downsides to the Client? 

  1. Loss of “stepped-up basis” – when the client does pass away, and the Assets pass to Generation Two, they don’t get a “stepped-up cost basis”.  Remember IRC 1014 that generally gives Generation Two a new basis equal to the fair market value of the Asset at death?  That section is believed to only apply to Assets that are subject to Estate Taxes.  But the loss of stepped-up basis can be controlled, and capital gains taxes are significantly lower than Estate Taxes.  
  1. Because the client didn’t have to pay Capital Gains Taxes when the Assets were sold, and because the client doesn’t pay any income taxes on the payments from the Promissory Note, the client must instead pay all Income Taxes on the Defective Trust even though the client is not a beneficiary of the Trust.  However, this is a good thing as well.  The IRS has also ruled that the payment of Income Taxes with respect to income in a “Grantor Trust” for the benefit of your children or grandchildren is not treated as a gift for Gift Tax Purposes.  In essence, it allows the client to shrink his or her “Red Box” without using any further Estate/ Gift Exemption.  
  1. Complexity – this strategy is a “high performance” airplane.  It isn’t something you buy and put in a drawer.  It is something that needs at least annual monitoring by the Estate Planning Team (the Lawyer, CPA, and Financial Advisor).

Conclusion – Who Should be Doing Defective Trusts 

In this article, we have used some very high numbers.  And clearly, clients with a net worth now that already exceeds the Federal Estate Tax Exemption of $11,700,000 should be using this technique – the Freeze Technique.  But, in addition to those clients, clients that are married and over $10 million should use this technique to “freeze the Red Box” and get further growth and appreciation into a Green Box.  

Remember two bad things from an Estate Tax standpoint happen over time.  The Assets appreciate in value and the Estate Tax Exemption is always at risk of being reduced.  As explained in this article, the client really does not have anything to lose and everything to gain.  The client still has access to the economic benefit for the Assets sold to a Green Box thru the Promissory Note payments back to the client.  And, if the client is married, his or her spouse can be the beneficiary of the Green Box (see the Article on Spousal Gift Trusts).  So, all growth and appreciation going forward escape Estate Taxes, yet the client and his or her Spouse retain the economic benefit.  

If you do this strategy and the Exemption does not go down, or the Estate Tax is eliminated, the worse thing that happens is that Generation Two loses the Stepped-Up Cost Basis.  But, if you are wrong and do not do this and your Exemption goes down and your Assets go up, then Generation Two will have to pay 40% Estate Taxes on everything above the existing Exemption.   This is a far worse outcome than losing Stepped Up Basis.  As discussed above, Stepped-Up Basis may also be lost in the pending proposed Tax Bills.  And, even if you do lose Basis, you can control that with additional planning going forward in simply not triggering the Capital Gain and by not selling the assets.  

Matt Dana

Matt Dana

The Dana name has become the symbol of a quality Estate Plan in Arizona. It has taken over 34 years to develop and continues to strive for excellence in the Estate Planning community. At its core is Estate Planning lawyer Matt Dana. [Learn more about Matt]

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