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Under the right circumstances, an intentionally defective irrevocable trust (IDIT) can be an effective estate tax planning tool. These trusts are set up to purposely fail certain technical tests in tax law, yet they still have the approval of the IRS and allow individuals to pass more assets on to their heirs. Here are a couple of points to keep in mind:
These trusts are confusing but in this article, we’ll explain how an IDIT arrangement can work to your tax-saving advantage.
If you own appreciating assets and want to get the future appreciation out of your estate, an intentionally defective irrevocable trust could be just what the doctor ordered. The strategy works as follows:
While you would generally like to pay any income taxes generated by the IDIT’s assets with money from your own pocket (for the reason explained in number 4 above), those taxes could wind up exceeding what you can afford. If so, the IRS stated in a ruling that taxpayers can dip into the IDIT for the needed cash without any adverse federal tax effects. This favorable ruling resolved a troubling question in a taxpayer-friendly manner. So it was good news for taxpayers and estate planners.
Warning: The IDIT instrument should not require the trust to reimburse you for income taxes generated by its assets. Such a requirement would cause the trust’s assets to be included in your taxable estate, which would ruin the whole strategy behind the intentionally defective irrevocable trust concept. (IRS Revenue Ruling 2004-64)
Bottom Line: The IDIT is considered to exist for estate tax purposes but not for income tax purposes. It is therefore described as “defective” but the defect is intentional. Thus the name intentionally defective irrevocable trust.
While the IRS-approved IDIT strategy can be effective in reducing the value of your taxable estate, it’s a complicated arrangement that requires professional assistance. This article only covers the basics. Contact your PDR estate planning advisor if you have questions or want more information.