Under the right circumstances, Intentionally Defective Irrevocable Trust (IDIT) ) can be an effective property tax planning tool. These trusts are created to intentionally fail certain technical tests of tax law, but they still have IRS approval and allow individuals to transfer more assets to their heirs.
Here are a few things to consider:
An Intentionally Defective Irrevocable Trust (IDIT) is considered a separate taxable person for federal property tax purposes and general state law purposes.
However, an Intentionally Defective Irrevocable Trust (IDIT) is considered a grantor for federal income tax purposes. As such, income and deductions from the Intentionally Defective Irrevocable Trust (IDIT) belong to the grantor (the person who sets up the trust).
These trusts are confusing, but we'll explain how an Intentionally Defective Irrevocable Trust (IDIT) deal can work for your tax benefit in this article.
Intentionally Defective Irrevocable Trust (IDIT) Tax Saving Strategy
If you own sizable assets and want to get the future appreciation of your property, an intentionally bankrupt irrevocable trust may be just what you need. The strategy works as follows:
Establish the Intentionally Defective Irrevocable Trust (IDIT) as a legal entity per applicable state law and name the trust's beneficiaries (usually your children and grandchildren). Usually, you also make a gift of some sort to Intentionally Defective Irrevocable Trust (IDIT) to create immediate liquidity for the fund (this is called "initial capital" or "seed money").
Then, you sell appreciated assets to Intentionally Defective Irrevocable Trust (IDIT) in exchange for an IDIT note payable (in other words, an installment sale). Since IDIT is ignored for federal income tax purposes. The sale is unrelated to federal income tax (you are treated as if you were selling your assets, which is not a taxable transaction tax).
To pay back the note owed, Intentionally Defective Irrevocable Trust (IDIT) uses money from the seed capital, income, and profits generated by the trust asset and, where applicable, the sale of assets.
Intentionally Defective Irrevocable Trusts are sometimes referred to as intentionally defective grantor trusts. They are two names for the same arrangement.
All income, gains, and deductions related to Intentionally Defective Irrevocable Trust (IDIT) assets are reported on federal personal income tax returns because you are still considered the owner of the assets for federal tax purposes. You can pay income tax out of pocket. You don't need to dip into the trust. This enables you to leave more value in the Intentionally Defective Irrevocable Trust (IDIT) for the future benefit of the people you have designated as beneficiaries of the fund. You are allowed to donate money to cover the trust's income tax bills without causing negative tax consequences.
Ultimately, Intentionally Defective Irrevocable Trust (IDIT) will be paid the invoice due, but the trust will, in any event, have a net worth equal to the appreciation of the value of the assets deposited therein. Finally, Intentionally Defective Irrevocable Trust (IDIT) 's equity will be allocated to the named beneficiaries, and equity will not be included in equity for federal property tax purposes.
IRS says you can use Intentionally Defective Irrevocable Trust to pay income tax, but be careful
While you would generally prefer to pay income tax on Intentionally Defective Irrevocable Trust's assets (for a reason explained above), these taxes can be more than what you can afford. If so, the IRS has ruled that taxpayers can turn to an intentionally defective irrevocable trust to get the money they need without negative federal tax consequences. This favorable ruling resolved a problematic issue in a taxpayer-friendly manner. So this was good news for taxpayers and wealth planners.
Disclaimer: The Intentionally Defective Irrevocable Trust (IDIT) instrument should not require the trust to reimburse you for income taxes generated by its assets. Such a requirement would result in the trust assets being included in your taxable assets, undermining the entire strategy behind the concept of an irrevocable error-based trust.
In short: Intentionally Defective Irrevocable Trust (IDIT) is considered to exist for income tax purposes but not for income tax purposes. Therefore, it is described as "defective," but the defect is intentional. Hence the name Intentionally Defective Irrevocable Trust.
Bottom Line
While the IRS-approved Intentionally Defective Irrevocable Trust (IDIT) strategy may effectively reduce the value of your taxable property, it is a complicated arrangement that requires professional assistance. This article only covers the basics.
FOR MORE INFORMATION ON HOW DANIEL P. VIGILANTE, CPA & PROFIT CONSULTANTS CAN BEST HELP YOU WITH YOUR TAX FILING NEEDS, PLEASE CLICK THE BLUE TAB ON THIS PAGE.
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