While some may see the discovery and use of tax loopholes as a triumph of human ingenuity, others see their exploitation as an abuse of the tax code. The concepts developed here are complex but worth understanding if you want to use them for your clients or participate in the public discourse about related tax law reforms.
When anticipating significant appreciation of an asset, affluent taxpayers typically have two options: 1. transfer the property now (as a gift) to avoid estate taxes on future appreciation, or 2. transfer the property upon death to avoid income taxes on the appreciation. For each of these options, there is good news and bad news:
If the taxpayer gifts the property today, its value is fixed for transfer tax purposes as of the gift date per IRC Sec. 2512. This avoids transfer taxes on any future appreciation. However, the donee inherits the donor’s basis, often low, under IRC Sec. 1015 and will pay income tax on the appreciation when selling the property.
If the property is transferred at death, its value is determined at the date of death under Sec. 2031, capturing all appreciation for transfer tax purposes. The donee receives a stepped-up basis under IRC Sec. 1014, eliminating income tax on the appreciation that occurred before the donor’s death. However, the property is subject to the estate tax at its current fair market value.
In addition to the above, we need to mention an intermediate situation, the incomplete gift. An incomplete gift occurs when the donor retains certain powers or interests over the transferred property, which prevents the gift from being considered complete for tax purposes. This can have various implications, including the deferral of gift tax liability and the potential inclusion of the property in the donor’s estate.
Tax Planning Conundrum: Wouldn’t it be nice if a taxpayer who has an estate large enough to be subject to estate taxes could do both: avoid capital gains taxes and avoid additions to the taxable estate due to appreciation? In other words, could one obtain a stepped-up basis for income tax purposes while also “freezing” the value of the wealth for transfer tax purposes?
Let’s hold that thought and review the Grantor Trust Rules. They determine when a trust is a grantor trust and when it is not, which in turn determines who pays income taxes. This will be important to solving the tax planning conundrum posed above.
Grantor Trust Rules
The distinction between a grantor trust and a non-grantor trust depends on whether the settlor (grantor) retains any incidents of ownership over the trust. If they do, it is a grantor trust; if they don’t, it’s a non-grantor trust. Incidents of ownership can be any number of things by which control over the trust is exerted, for example, the right to change beneficiaries (Table 1).
As stated, in a grantor trust, the grantor maintains a certain degree of control over the trust’s assets or income. In contrast, non-grantor trusts include irrevocable trusts in which the grantor has relinquished control over the trust assets and does not retain any powers that would cause the trust to be treated as a grantor trust.
Table 1: The most important grantor trust rules
The distinction between grantor and non-grantor trusts was made to determine who has to pay income taxes on the trust’s income. In a grantor trust, it’s the grantor; in a non-grantor trust, it’s the trust.
The transfer tax and income tax regimes are closely aligned. When a grantor retains control over transferred property in a trust, they have a grantor trust. This property is generally considered owned by the grantor at death for estate tax purposes. For instance, if a grantor has the power to revoke a trust, Section 676 treats the grantor as owning the property for income tax purposes, and Section 2038 treats it as owned by the grantor at death for estate tax purposes. However, there is a loophole.
The Loophole – The Intentionally Defective Grantor Trust
An Intentionally Defective Grantor Trust (IDGT) is a type of trust designed to be treated as owned by the grantor for income tax purposes but not for estate tax purposes. This means that the income generated by the trust is taxable to the grantor, but the trust’s assets are not included in the grantor’s estate for estate tax purposes. To draft an IDGT, certain provisions must be included to ensure that the trust is considered defective for income tax purposes. These provisions typically involve intentionally violating one of the above grantor rules so that the trust is taxed on the trust’s income.
A more descriptive name for an Intentionally Defective Grantor Trust (IDGT) could be “Swap Power Grantor Trust”. The swap power is a common feature in the drafting of an Intentionally Defective Grantor Trust (IDGT). It allows the grantor to reacquire trust property by substituting other property of equivalent value. This power is crucial because it helps ensure that the trust is considered a grantor trust for income tax purposes while not causing the trust property to be included in the grantor’s estate for estate tax purposes.
The “Swap Power” in Action:
Income Tax Implications:
Section 675: The swap power causes the grantor to be treated as owning the property for income tax purposes.
No Corresponding Estate Tax Rule: There is no rule that includes this property in the grantor’s estate for transfer tax purposes. Thus, the value of the property for transfer tax purposes is fixed at the time of the gift (Section 2512).
Transferring Property to the Trust:
Initial Transfer:
When the grantor transfers property to a trust with a swap power, the property is valued for gift and estate tax purposes as of the date of the gift, which freezes its value.
Appreciation:
Inside the trust, after the transfer, the property may enjoy unlimited appreciation; however, its value for estate tax purposes remains “frozen” at the time of the gift.
Income Tax Treatment of Transactions with the Trust:
Disregarded Transactions:
Under Section 675, transactions between the grantor and the trust (due to the swap power) are disregarded for income tax purposes.
Exercise of Swap Power:
When the grantor exercises the swap power (exchanging property within the trust), it is seen as moving assets between the grantor’s own “pockets,” so there are no income tax consequences.
Basis and Tax Implications:
Carryover Basis Rule (Section 1015):
Normally, the basis of the gifted property carries over to the donee, meaning any appreciation is subject to income tax when the property is sold.
Stepped-Up Basis (Section 1014):
By using the swap power, the grantor can transfer appreciated low-basis property out of the trust and high-basis property of the same value into the trust.
The appreciated property is back in the grantor’s hands. When the grantor dies, it gets a stepped-up basis to its fair market value at death.
This eliminates the capital gains tax on the appreciation of the property that occurred before the grantor’s death.
In addition, estate taxes are at a lower level because the valuation for estate tax purposes was frozen before appreciation in the trust.
Derren works with International Entrepreneurs, Expats and Investors who are exposed to multiple jurisdictions. Tax optimization. Asset Protection. Compliance Obligations. Strategies include second citizenships, second residencies, trusts, foundations, insurance wrappers and other offshore structures.
Skip to content 
