Sale To An IDIT For A Promissory Note ' The Best Estate Planning Strategy (Gimmick) Going

• Published date: 13 January 2023
• Subject Matter: Family and Matrimonial, Wills/ Intestacy/ Estate Planning
• Law Firm: Lewis Rice
• Author: Michael D. Mulligan

I. Introduction.

It has been over twenty-five years since the article first discussing the sale to IDIT technique was published.¹ This article examines that technique, along with a number of variations, including a sale to an IDIT in exchange for an annuity which terminates upon the seller's death and the sale to a so-called BIDIT.

II. Structure of Sale to IDIT Transaction.

The term an Intentionally Defective Irrevocable Trust ("IDIT") describes a particular type of trust. The existence of an IDIT apart from its grantor is recognized for estate, gift and generation-skipping tax purposes, but not for income tax purposes. Any uncompensated transfer to an IDIT constitutes a gift. The assets of an IDIT are not included in the estate of its grantor at death.

The position of the Internal Revenue Service ("IRS") is that an IDIT does not exist for Federal income tax purposes.² All income of an IDIT, including capital gain, is taxed directly to its grantor. A sale of appreciate property to an IDIT causes no recognition of gain. Interest on a promissory note paid by an IDIT to its grantor is not taxed to the grantor or deductible by the IDIT. For income tax purposes, such interest is ignored. An IDIT has the option to use the social security number of its grantor as its tax identification number.³

The sale to an IDIT technique involves a grantor establishing an IDIT and selling assets to the IDIT in exchange for the IDIT's promissory note. The IRS has asserted in litigation that IRC Sec. 7872 applies to a promissory note given in a sale transaction, and that if, pursuant to IRC Sec. 7872(f), a promissory note bears interest at the applicable Federal rate under IRC Sec. 1274, it has a gift tax value equal to its face amount. This position has been accepted by the Tax Court.⁴ The sale to an IDIT is a mechanism by which equity can be converted into debt without income tax consequences.⁵

Under IRC Sec. 7872(f)(2)(A), the applicable Federal rate for a term loan is the rate in effect under IRC Sec. 1274(d) as of the date upon which the loan is made. IRC Sec. 1274(d)(2) establishes a special rule for determining the applicable Federal rate for a sale or exchange. Under IRC Sec. 1274(d)(2), the applicable Federal rate is the lowest of the interest rates for the month in which there is a binding contract for the sale or exchange, and the two immediately preceding months. Because a lower interest rate on an IDIT's promissory note reduces the value of the seller's estate, it...