In 1731 the satirist Jonathan Swift completed the work Polite Conversations, a purported reference guide for use in developing conversational skills. In fact, it was a farce making fun of the “perceived banality of talk among the upper classes.”
But despite Swift’s high-handed tone, the work is not completely without usefulness, as when one character, Lady Answerall, complains of another that “she cannot eat her cake and have her cake.” Or as the Danes say, “You cannot both blow and have flour in your mouth!” Or as is well known in Eastern Europe, “It is impossible that a Hungary goat has enough to eat and the cabbage remains as well.”
Simply put, you can’t have it both ways. And that has been the President’s attitude concerning the taxation of irrevocable defective, or grantor, trusts.
There are good non-tax reasons for an irrevocable trust. They allow for direction of the use of property beyond the grave of the grantor. They can provide adequate protection of assets from creditors as well as misuse by spendthrift beneficiaries.
But where they really show their stuff are in planning situations where grantors have size-able potential estate tax liability. Consider the advantages of a properly drafted and managed IDIT:
- Income taxation – All income generated in the trust is reportable to and the responsibility of the grantor. Not only does this simplify administration of the trust, but it allows the grantor to benefit the trust (by paying its income tax) without having to use annual gift tax exclusions or the lifetime exemption.
- Capital gains taxation – Appreciated property can be bought from or sold to the trust without recognition of gain on the transaction. Note, too, that the grantor can gift annuities to the trust without triggering tax on the gain – that is big!
- Transfer taxation – Property in the trust at the grantor’s death is not includible in the taxable estate. Even better, if the grantor is married a lifetime interest in the trust can be given to the spouse with broad trustee discretion to make distributions back to the spouse giving the grantor vicarious access to the trust assets so long as the spouse is alive.
All this is too good to believe and too much for the current administration. This year for the eighth time it has been proposed in the Green Book containing the President’s budget proposals that IDITs can either have their cake or eat it, but not have the best of both worlds.
In a nutshell, assets which are treated as belonging to the grantor for income tax purposes would be includible in the grantor’s estate. Those that are not (resulting in taxation to the trust) would not be subject to estate tax. The proposal grandfathers all trusts in force before any enactment into law.
In those eight years the IDIT proposals have never been seriously considered by Congress. But eyes in other branches of the government haven’t lost sight of how remarkable a planning tool is the intentionally defective irrevocable trust and how it allows a taxpayer to, as they say in Germany, “Dance at two weddings at the same time.” You shouldn’t lose sight of it either. Call us to discuss those situations where an IDIT might fit your client’s situation.