Tax attorneys work daily to create income tax schemes that wind up being incomprehensible to most people. Along with this, accountants devise incomprehensible rules and regulations regarding the gift and estate tax.
Luckily, the inconsistencies between income tax rules (one part of the Internal Revenue Code) and the gift and estate tax rules (a different part) allow us to create an exceptional estate and gift-tax-saving device known as an Intentionally Defective Irrevocable Trust (IDIT)-often referred to as the “Dynasty Trust”.
To understand this concept, think about the tax consequences of “selling something to yourself.” Very simply, there are none. We most often see this when we transfer a client’s assets into the name of a revocable trust. The IRS deems a revocable trust to be a non-entity for tax purposes. This means the transfer of assets to a revocable trust is not a “taxable event” for income tax purposes, and is a “non-event” for estate and gift tax purposes.
Of course, an IDIT is by definition an irrevocable trust, but it is a special one. An IDIT is a trust in which the creator of the trust (the grantor) retains sufficient power over the transferred assets so that those assets, even though titled in the trust, are deemed to be the grantor’s assets for income tax purposes. But an IDIT is also a trust in which the grantor releases enough control so that the assets are no longer considered to be owned by the grantor for estate tax purposes. Because the IDIT has both of these features, a transfer to an IDIT removes the assets from the taxable estate with no income tax consequences. Additionally, because future income earned by the transferred assets will be taxed to the grantor, the assets will appreciate outside of the taxable estate without reduction for any income taxes generated during the grantor’s lifetime.
The IRS has ruled that a grantor trust will be ignored for federal income tax purposes, and all of the income, deductions and credits of the trust will be taxed to the grantor. This ruling has encouraged many clients to use this Trust to transfer assets with a future income or appreciation with little or no gift or estate tax cost.