Secure Your Child’s Inheritance

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If you have high-net-worth assets, you’re probably starting to decide how to pass on these assets to your heirs. Besides the who gets what, there are the tax ramifications for your heirs. Depending on your estate’s worth and when you die, these taxes can cripple your children. Your hard-earned dollars could go to the government.

The “government” means state and federal. And both could have their fingers in the pie. Is there a way to protect significant assets? And how long can you protect your wealth for future generations?

Current and Future Estate Tax Laws

As a result of the Tax Cuts and Jobs Act, the lifetime estate and gift tax exemption was doubled and indexed for inflation. Currently, it sits at $12.92 million for individuals and $25.84 million for married couples.

But in 2026, that figure will be reduced. The inflation-adjusted exemption will return to $7 million for individuals and $14 million for married couples. The current exemption amount will sunset unless there is congressional action.

To make matters worse, in 2026, the gift and estate tax rate will increase. It’s slated to go from the current 40 percent rate to 45 percent.

If you want to protect your assets for your heirs, preparing for this tax change is imperative. Irrevocable trusts like an intentionally defective grantor trust (IDGT) may be the answer.

Intentionally Defective Grantor Trusts

An IDGT is an irrevocable trust that is used to freeze assets for estate tax purposes. It doesn’t freeze it for income tax purposes.

The grantor pays the income tax on any income generated by the trust assets, but the estate doesn’t incur any taxes when the grantor passes. This means the heirs will not have to pay the capital gains tax if the assets increase in value while in the trust.

The value of the grantor’s estate is reduced by the amount of assets placed in the IDGT. This eliminates the 40 percent and, in the future, 45 percent estate tax levied against the beneficiaries.

Why Is an IDGT Called Defective?

The “intentionally defective” name refers to the paid income taxes. The grantor no longer owns the assets, yet must pay the income taxes on any appreciating assets in the IDGT while alive. This is because although the grantor doesn’t own the assets, they own the trust.

Paying taxes on what you don’t own may seem a little convoluted, but it benefits the beneficiaries. Because the trust won’t have to pay income taxes on increasing profits, the trust is allowed to grow unencumbered. This provides a bigger nest egg for heirs and a smaller estate for the grantor.

Funding an IDGT

There are two ways to fund an IDGT. The first involves gifting the assets to the trust. The grantor decides what assets to place in the trust and then makes an irrevocable gift.

Gifting the trust is beneficial for appreciating assets. It allows a grantor to pay income taxes on assets over the years, and additional taxes in the trust are avoided when the assets appreciate.

But the grantor may have to pay gift taxes if they exceed the annual exclusion amount. The annual gift exclusion amount in 2023 is $17,000 per individual, up to $12.92 million over a lifetime. In 2026 the lifetime amount decreases to $6.2 million.

Another way to fund the IDGT is with an installment sale. The grantor sells assets to themselves by selling the assets to the trust. In exchange, the grantor receives an interest-bearing promissory note payable from the trust to the grantor.

Any gains from the sale are tax-free. This is just a synopsis of funding possibilities; you’ll want to discuss funding an IDGT with a qualified estate attorney.

Protect Assets From Third Parties

An IDGT places assets out of the reach of potential creditors. It provides meaningful protection from creditors or other parties’ claims on your estate. This is referred to as the “spendthrift” clause.

The protection only applies to transfers that were not meant as an effort to defraud a creditor.

Swapping Assets With IDGTs

When the assets remain in the grantor’s estate (not the trust), they are stepped up to fair market value when the grantor dies. This is different with an IDGT. The grantor can swap assets with assets held inside the trust. The swapped assets must be of equal value and are often cash.

Swapping assets allows the grantor to achieve a step-up in basis of an IDGT’s assets.

A step-up in basis adjusts the value of an inherited asset for income purposes. It allows the tax code to raise the cost basis to the higher price of the asset on the date of the decedent’s death. It minimizes capital gains taxes.

Perpetual Trusts Depend on States

Perpetuities are trusts that are designed to last for multiple generations. They are not subject to estate tax upon the death of the beneficiary.

But most states have a rule against them. The rule usually terminates the trust no later than 21 years after the grantor’s death.

Fortunately, several states have abolished this rule. Some states that allow perpetual trusts include Alaska, Delaware, Michigan, South Dakota, and others.

Check with a qualified estate attorney to inquire if your state allows perpetual trusts.

Can Family S Corps Use an IDGT?

S corporations are popular with many family-owned businesses. They are used to protect personal assets from business-related liabilities.

Since there are shares in the S corps, these are considered part of an estate and, therefore, taxable. Family members can transfer shares to an IDGT. This means that shares can transfer to the grantor’s heirs tax-free.

If the business grows between establishing the trust and your death, there are no tax implications.

What Happens When Grantor Dies

What happens when the grantor dies and still receives installments from selling their assets to the trust? In that scenario, the trust must pay out the rest of what it owes the grantor to their estate. It would, therefore, be taxable.

But this can be avoided. The IDGT should be set up with a self-canceling installment note (SCIN). This automatically cancels the trust’s obligation to pay installments upon the grantor’s death. It keeps the value in the trust while not adding to the taxable estate.

IDGTs Are Effective, but Complicated

The IDGT is a great tool to protect and maximize assets for the next generation. It’s a way to ensure that assets stay in the family. This is especially true if you set up an IDGT in a state that allows perpetuity.

It’s imperative to have a qualified estate attorney set up an IDGT. Not having it set up correctly could run afoul of IRS regulations and defeat the IDGT’s purpose.

The Epoch Times Copyright © 2023 The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.