The benefit of the intentionally defective grantor trust is that it enables several estate freezing transactions like an installment sale to occur without causing income taxation on assets like closely held interests, which might otherwise negate planning like this because the resulting income tax would be detrimental
Another potential advantage is that it treats the grantor as the owner of the trust property for income tax purposes, but the trust property is typically excluded from the grantor’s estate for estate tax purposes. Payment of the income taxes by the grantor is, in effect, a further gift to the trust. This means the gross amount of the assets in trust can accrue to the benefit of the beneficiaries, while the tax can be paid by the grantor without gift tax implications.
If for some reason, the grantor eventually didn’t like paying the tax there is flexibility afforded by a properly designed trust to essentially have the grantor surrender the powers in the trust that made it income tax defective to him or her and finally the trust could give the trustee the discretion to reimburse the grantor for any income taxes paid.
Revenue Ruling 2004-64 provides that a trustee’s discretionary authority (whether or not exercised) to reimburse the grantor for the grantor’s income tax liability attributable to trust assets will not, by itself, cause the value of the trust’s assets to be includible in the grantor’s gross estate. The IRS cautioned, however, that estate tax inclusion may occur if applicable local law subjects the trust’s assets to the claims of the grantor’s creditors.
As a result New Jersey, Ohio and Virgina have or are about to enact legislation to provide that a trustee’s discretionary authority to pay directly or reimburse the settlor amounts for income taxes payable on trust income will not subject those amounts to the claims of the settlor’s creditors.
Hope this helps!
Jeremy P. Green CFP, CTFA, CLU, CEBS, MSFS, AEP, EA
Wealth Strategist & Expert Witness Consultant
Wealth Strategist Designs