The Intentionally Defective Irrevocable Trust (IDIT) is gaining popularity as a valuable estate-planning tool. The IDIT is an attractive method for estate freezing of appreciating assets. The attractive feature of an IDIT is that while the income it generates while the grantor is alive is included on their personal income tax return, any appreciation is not included in their taxable estate.

Without proper estate planning, appreciating assets can, over time, lead to a large estate tax problem for heirs. Gifting is not an effective solution as the gift tax, which may be 55 percent or higher, can be cost prohibitive. In addition, the grantor may wish to retain appreciating assets during their lifetime so they can continue to receive the income they generate. Gift taxes are greatly reduced when using an IDIT as the assets are sold to the trust in exchange for a promissory note.

The IDIT involves several key transactions:

The grantor makes a seed money gift to an IDIT Trust. Many estate planners advise that the gift be a minimum of ten percent of the discounted sale price of the assets that will be sold to the trust. The seed money gift is subject to gift tax however the assets sold to it are not. Sometimes gift tax exclusions can exempt part of this gift tax.

Next the grantor sells appreciating assets to the trust in return for a promissory note that pays interest to the grantor with a balloon payment at the end of the term. Almost any kind of property can be sold to the IDIT including an S corporation, C corporation, a partnership, interest in a limited liability company, real estate or publicly traded stock.

If the grantor dies during the term of the promissory note, only the value of the note plus any accumulated interest will be included in the estate. Any appreciation on the underlying assets passes to the trust estate and gift tax-free.

Individual or survivorship insurance is often used in conjunction with an IDIT. After property is transferred to the IDIT trust the income producing assets of the trust purchase life insurance on the grantor's life. When the grantor dies, the trust uses the insurance benefits to pay the note. This keeps beneficiaries from having to sell assets to generate the necessary funds. If the note was repaid during the grantor's life the insurance proceeds can be applied to recover the cost of the earlier repayment, pay estate taxes or fund other estate liquidity needs.

Tax and legal professionals should be consulted for situations when an IDIT may work effectively. The number one criterion is that the assets that are sold to the trust are expected to appreciate considerably. Some are wary of the newness of the IDIT but it quickly has gained a reputation as a respectable estate-planning tool.

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