Expert’s Critical Analysis of His IDIOT® Trust

Michael D. Weinberg, an attorney (licensed, not practicing) with more than 30 years experience in tax law and estate and business planning, is president of The Weinberg Group, Inc., a Denver, Colorado planning firm specializing in the design and funding of estate and business continuity plans for successful families and businesses. Mr. Weinberg previously served as a tax attorney in the Office of Chief Counsel, Internal Revenue Service, New York City, before joining the private sector.

Mr. Weinberg has developed a planning technique which he refers to as the IDIOT® Trust. An IDIOT® Trust combines an Intentionally Defective Irrevocable Trust (IDIT) with an Irrevocable Life Insurance Trust (ILIT). The result is an Intentionally Defective irrevocable Outstanding Trust an IDIOT® Trust.

Mr. Weinberg is a member of the Colorado, Minnesota and New York bars and is a former Adjunct Professor at the University of Minnesota Law School. He is a former chair of the Insurance Committee of the Real Property, Probate and Trust Law Section of the American Bar Association (ABA) and served as editor of its Insurance Counselor Primer series from 1987-1995. Mr. Weinberg’s articles have been published in the CLU Journal, the Journal of Taxation, Trusts and Estates, and Probate & Property. He is the coauthor of The Insured Stock Purchase Agreement and has lectured and conducted seminars for many industry groups, including the ABA, American Law Institute, Miami Estate Planning Institute, Practicing Law Institute, Note Dame Estate Planning Institute, Southern California Tax & Estate Planning Forum, Texas Bar Association Advanced Estate Planning Course and the American Society of CLU & ChFC. IDIOT® Trust is a registered trademark of The Weinberg Group, Inc. The Interviewer is our executive editor, Myron Kove, Esq.

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Q. What is an IDIOT® Trust?

Weinberg: The IDIOT® Trust is an estate freeze technique which combines an IDIT (Intentionally Defective Irrevocable Trust) with an ILIT (Irrevocable Life Insurance Trust) to achieve significant estate planning benefits. The result is an IDIOT® Trust (Intentionally Defective Irrevocable Outstanding Trust). The Trust beneficiaries are the grantor’s children with grandchildren (or lower generation) as the remainder persons.

Q. How does the IDIOT® Trust achieve an estate freeze?

Weinherg: The grantor creates an IDIOT® which, for income tax purposes, is treated as a grantor trust so that there are no income tax consequences to the trust or the grantor. The grantor also funds the trust with a significant "seed money" gift. The grantor sells property, reflecting appropriate valuation discounts, to the IDIOT® Trust in exchange for a bona fide promissory note.

Q. What are the income tax consequences of the sale?

Weinberg: Since the IDIOT® Trust is treated as a grantor trust, there are no income tax consequences to the trust or the grantor. No gain is recognized on the sale. The trust is not entitled to an interest deduction and the grantor does not have any interest income. Also, the grantor’s basis carries over to the Trust. The grantor will be taxed on the net income of the IDIOT® Trust. The payment of the income tax reduces the value of the grantor’s estate, without there being a gift of the income tax to the Trust beneficiaries.

Q. How is the estate freeze achieved?

Weinberg: At the grantor’s death, only the unpaid balance of the note, plus accrued interest, is included in his or her estate. To the extent the property owned by the IDIOT® Trust increases in value, none of the post-sale appreciation is included in the grantor’s estate.

Q. What type of property should be sold to the IDIOT® Trust?

Weinberg: Any type of property may be sold to the IDIOT® Trust, including closely held regular C corporate stock, subchapter S stock, partnership interests, marketable securities, and real estate, so long as its appreciation potential is in excess of the interest paid on the note.

Q. What are the terms of the note?

Weinberg: The note should be for a term of years with a balloon payment of the principal at the end of the term. The note pays only interest during its term. The interest rate is fixed at the IRS Applicable Federal Rate (AFR) at the time of the transaction.

Q. Why not have installment payments of principal rather than a balloon payment?

Weinberg: The reason a balloon payment of the principal amount of the note is recommended is because the IDIOT® Trust will purchase life insurance on the life of the grantor equal to the principal amount of the note. Additionally, keeping the note outstanding until death maximizes the estate freeze. If the note is still outstanding at the grantor’s death, the death benefit will be used to pay the note so that the trust does not have to use any of the purchased assets.

Q. What if the grantor lives beyond the due date of the note?

Weinberg: There are several possibilities. The term of the note may be extended or the trust may pay the note in kind with the purchased assets or there may be a partial payment and partial extension. If the IDIOT® assets have increased in value, less than all the assets need be used to pay the note, and no capital gain is recognized because of the grantor trust rules. Further, the reacquired assets receive a date of death step-up in basis since they will be included in the grantor’s estate.

Q. Why is the interest rate the same as the AFR?

Weinberg: The purpose of the AFR is to avoid any gift tax on the transfer. Since the note will be in an amount equal to the discounted fair market value of the transferred property, the general rule is that fixing the interest rate at the AFR rate eliminates any gift since the note is deemed to have a fair market value equal to its face amount. Frazee, 98 TC 554 (1992); IRS Letter Ruling 9535026.

Q. How is the life insurance purchase structured?

Weinberg: The IDIOT® Trust will purchase life insurance on the grantor’s life which may be funded either under a split-dollar arrangement with the grantor’s company (or perhaps with the grantor or spouse under a "private" split dollar arrangement), or full premiums can be paid out of Trust assets, depending on the Trust’s cash flow.

Q. If the Trust has adequate assets to purchase the note, why is there a need for life insurance?

Weinberg: Under the grantor trust rules, there is a basis canyover on the assets sold to the IDIOT® Trust. The Trust will not want to sell assets since it has a iow basis and will incur substantial capital gain on any sale. Further, the Trust assets may include a family business which the Trust will want to retain. One of the benefits of the IDIOT® Trust is to provide a succession plan for younger family members to take over the family business.

     The use of life insurance avoids the need to sell Trust assets, while at the same time providing a source to pay principal on the note and liquidity for the estate to pay estate settlement costs (estate taxes, administration expenses and debts), and preserving the family business for the family.

Q. What is the purpose of the "seed money" gift?

Weinberg: The seed money contribution to the Trust is designed to avoid any estate tax problems.

Q. What estate tax problems are you concerned about?

Weinberg: The concern is that if the sold assets are the only source for paying the note, then it might be argued that the grantor made a transfer with a retained life interest. Such a transfer is included in the grantor’s estate under Code Sec. 2036. By contributing seed money to the Trust, the debt to equity ratio is improved so that it is less likely that the creditor/debtor relationship will be ignored. There is a similar issue under Code Sec. 2702.

Q. Is there any rule of thumb as to the amount of seed money that is required?

Weinberg: We recommend to clients that the seed money equal at least ten percent of the discounted value of the assets sold to the Trust. If the discounted value of the sold assets is $1 million, then the seed money should be $100,000.

Q. Are there any gift tax consequences related to the transfer of the seed money?

Weinberg: The transfer of the seed money to the Trust is a gift to the Trust beneficiaries subject to gift tax, except to the extent of any available unified credit. If any gift tax is actually due on the transfer, payment of the tax reduces the grantor’s estate, assuming the grantor lives for more than three years following the gift.

Q. Are there any generation-skipping transfer benefits using an IDIOT® Trust?

Weinberg: Clients may achieve significant leverage by structuring the IDIOT® Trust as a generation-skipping transfer (GST) trust, assuming the grantor has sufficient GST exemptions available to cover the seed money gift. Once the IDIOT® Trust is exempt from GST tax, then none of the trust assets, including the life insurance death benefit and the sold assets, will be subject to GST tax even though skip persons, the grandchildren, are the remainder persons.

Q. How does this treatment compare to a GRAT (grantor retained annuity trust) or GRUT (grantor retained unitrust)?

Weinberg: With a GRAT or GRUT, the grantor retains an interest in the trust. If the grantor dies during the term, the trust property is included in the grantor’s estate. The GST exemption cannot be allocated during this period, known as the estate tax inclusion period (ETIP). Therefore, the GST exemption is not available to a GRAT or GRUT until after the trust term. With the IDIOT® note, there is no ETIP, and the GST exemption can be allocated to the Trust after it is funded with the seed money. This will protect all future appreciation in the Trust assets from any GST tax.

Q. Do you have an example showing how the IDIOT® Trust compares to other planning strategies, such as GRATs or ILITs?

Weinberg: I have prepared a chart (Death At Projected Life Expectancy) which summarizes the relative performance of the IDIOT® Trust as compared to six other strategies.

Q. What are the assumptions used in the chart?

Weinberg: We are assuming that a 55 year old grantor has assets of $16,500,000 available for the plan. The grantor sells $15 million of business assets, with a discounted value of $10,000,000, based on a qualified appraisal, in exchange for a $10 million balloon note due in 15 years. The note pays interest only, at the AFR rate. The grantor also makes a seed money gift to the IDIOT’® of $1 million on which a gift tax of $500,000 is paid. The IDIOT® purchases a $10 million life insurance policy on the life of the grantor. The chart assumes that the grantor will live a normal life expectancy of 24 years and reflects the financial results of the various planning strategies at the grantor’s death at that time.

Q. What are the assumptions for the other strategies?

Weinberg: The starting asset base for each strategy is the same so we have an apples-to-apples comparison. Each strategy involves a different approach because of the nature of the strategy. For example, the IDIT is similar to the IDIOT® in that it involves a sale of assets in exchange for a note, but there is no life insurance, while the WIT is funded only with life insurance. The "do nothing" strategy means that the grantor’s estate will pay estate tax on the entire value of the estate in view of the absence of any planning. A direct gift means that the grantor will pay gift tax on the value of the transfer, while a GRAT involves payment of gift tax on only the remainder interest. The private annuity involves the payment of an annuity in exchange for the property and, if properly structured, should be gift tax free

Q. What do the values in the chart reflect?

Weinberg: The chart shows the value of the starting asset base, plus earnings and appreciation. For example, with the IDIOT’ Trust, the starting asset base is the $10 million (discounted) property sold to the IDIOT,"’ plus $1 million of seed money, plus the $500,000 used to pay taxes. At the end of 24 years the asset base has grown in value to $60 million, plus $10 million of life insurance death benefit. Included is the grantor’s net taxable estate since he or she has received interest payments during the 15 year note term, plus the balloon payment in the fifteenth year. After deducting estate taxes, the IDIOT® Trust reflects a net amount to the heirs, after 24 years, of almost $70 million.

Q. The chart shows that the IDIOT® Trust performs beter than any of the other strategies.

Weinberg: That’s correct. The reason is because of the leverage achieved with funding the trust with life insurance. Funding the IDIOT® Trust with life insurance combines the transfer tax leverage of each of its constituent trusts (the IDIT and ILIT) into a dynamic estate planning technique.

 

Disclaimer: Nothing contained in this interview is to be considered as the giving of investment, legal or tax advice. Each person is responsible for consulting his or her own investment advisors, lawyers and accountants concerning the plan or plans and the ideas and techniques discussed.