In a trust, a trustor transfers title of his property into the name of the trust for distribution to beneficiaries at the time of death. Many families choose this option in order to avoid the costs of probating a will, as beneficiaries receive trust property upon the trustor's death and court supervision is not required. In an irrevocable trust, once the trustor transfers his property into the trust, it cannot be changed under any circumstances. A defective irrevocable trust, also known as an intentionally defective irrevocable trust, is one way to set up a trust to lessen estate taxes upon death and reduce gift tax liability.
Understanding a Trust Instrument
A trustor or grantor sets up a trust to bequeath property -- real estate or personal property, or both -- upon death. Title to property is transferred from the grantor's name into the trust's name. The trust document names beneficiaries and includes instructions on how trust property is distributed. A trust is an alternative to a last will and testament, in which title to real and personal property is transferred after death in a court-supervised probate process.
Revocable vs. Irrevocable
A revocable trust is also known as a living trust; the grantor can change it at any time. If a grantor chooses a revocable trust, the assets transferred to the trust are still considered personal assets for estate tax purposes. At the time of the grantor's death, all assets within the trust will be treated as personal to the deceased and will be subject to estate tax.
If the grantor chooses an irrevocable trust, he cannot change it. The irrevocable trust is treated as separate and distinct from the grantor. Thus, when the grantor passes away, the real and personal property contained in the trust is not subject to estate taxes.
Intentionally Defective Irrevocable Trusts
An intentionally defective irrevocable trust is an emerging estate planning tool designed to further limit taxes at death. Often, large trusts earn income while the grantor is still living or property contained within the trust appreciates during the grantor's life, exposing him to tax liability. In an IDIT, the grantor sells his or her property to the trust in exchange for a promissory note as opposed to merely transferring the property into the trust -- which is considered a gift by the IRS and subject to gift tax. This creates an IDIT and significantly reduces federal gift taxes attaching to the trust corpus. The IDIT is particularly useful for grantors with significant wealth and appreciating assets. Another important benefit to the IDIT is that the value of the assets freeze when sold into the trust, avoiding costly capital gains taxes.
Tax Consequences
An IDIT is a savvy estate planning tool for those with significant wealth. When a person dies with valuable personal assets, the federal and, usually, state governments tax the value of the property as it transfers from the deceased to the heirs. This could leave heirs with hundreds of thousands of dollars in estate taxes to pay. The IDIT strategy removes all personal tax liability from the person and places it into the trust as a separate entity, thus protecting beneficiaries from the personal estate tax. IDITs also avoid gift tax, which can take a significant bite out of an inheritance.
