The current low interest rate environment provides excellent opportunities to transfer wealth to family members. One approach commonly used to accomplish this goal is to sell assets to an intentionally defective irrevocable trust (“IDIT”). An IDIT is an irrevocable trust for the benefit of someone other than the creator of the trust (the “Settlor”), perhaps Settlor’s descendants. However, the “intentionally defective” component of the IDIT means that, for income tax purposes, the assets in the trust will continue to be treated as owned by Settlor. Thus, Settlor’s sale of assets to the IDIT will not result in income tax consequences. Additionally, Settlor’s payment of income taxes on the income earned by the IDIT provides an additional means of reducing Settlor’s taxable estate, while allowing the benefits of the income earned by the IDIT to benefit Settlor’s descendants.
Typically, Settlor will take back a promissory note for the assets sold to the IDIT. To the extent that the value of the assets held in the IDIT appreciates at a rate in excess of the interest rate on the promissory note, such excess appreciation is effectively a tax-free transfer of wealth by Settlor to his descendants. This is where low interest rates provide even greater opportunity. While requiring no interest on the promissory note is not an option (if no interest is due on the promissory note, the IRS will impute interest to the transaction), the IRS provides an interest rate, known as the Applicable Federal Rate (“AFR”), which may be used as the interest rate on the promissory note. Currently, the AFR is very low. For the IDIT, the lower the interest rate on the promissory note, the lower the payments to Settlor, and the more assets the IDIT gets to keep.
For example, assume Settlor sells publicly-traded stock worth $1,000,000 to an IDIT and takes back a $1,000,000 promissory note with a repayment term just short of 9 years, at 1.63% (the current mid-term annual AFR). Assume also that the stock held in the IDIT will appreciate at an average rate of 8% per year over the nine-year repayment term. The annual interest payments on the promissory note would be $16,300, which could be paid by returning a portion of the stock to Settlor. The result in the first year is a net gain of $63,700 in the value of assets held in the IDIT ($80,000 gain in value of the stock, less the $16,300 interest payment). At the end of those nine years, the IDIT would repay the $1,000,000 principal to Settlor, and at that time, after the repayment of the principal balance, the stock held in the IDIT would be worth $795,457. In other words, Settlor would have passed $795,457 in value to his descendants, tax free. Alternatively, if the AFR was 4%, the annual interest payments would be $40,000, and the value of the stock held in the IDIT at the end of the nine-year term would be $499,502. Settlor would have passed only $499,502 to his descendants, still a great result, but a difference of $295,955, nonetheless.
IDIT’s can be great wealth transfer vehicles in nearly any interest rate environment, but the benefits are maximized when interests rates are low, or as is currently the case, historically low.