Assume a $1 million cash loan made in December 2023 to a child in exchange for a nine-year, 4.76% interest-only note with a balloon payment upon maturity. The cash is invested in an asset that generates a 6% pretax annual return. After nine years, the child would have $106,869.

Installment sale to an intentionally defective grantor trust (IDGT)

Before diving into the strategy, let’s understand what an “intentionally defective grantor trust” (often known simply as a grantor trust) is. An IDGT is a trust that is structured so that the grantor – not the trust – is responsible for paying tax on income earned in the trust. This allows the trust’s assets to grow effectively income-tax-free. (A non-grantor trust pays its own taxes, with highly compressed brackets.)

If a trust is a grantor trust, it also means that transactions between the trust and the grantor are ignored for income tax purposes. This means that sales by a grantor to his or her trust do not trigger capital gains tax, and interest paid on a note is neither deductible by the trust nor taxable to the grantor.

An installment sale to an IDGT functions like an intra-family loan, except that (i) the borrower is a trust, structured as a grantor trust for income tax purposes, and the lender is the donor of the trust, and (ii) the sale is often of non-cash assets. Any asset appreciation over the applicable interest rate will accrue to the trust rather than the donor. This strategy is more complex than an intra-family loan, since the lender needs to create a trust and fund it with seed capital to ensure that the trust is a creditworthy borrower – a transaction involving a loan to an undercapitalized IDGT could have negative estate tax consequences for the donor. However, the estate planning benefits of this transaction can be greater than those of an intra-family loan since the assets in the trust grow on an income-tax-free basis. These benefits can be even more significant when the sale is of a discounted asset.

Assume a sale to an IDGT in December 2023 of a partnership interest with a net asset value of $1.5 million and a discounted fair-market value of $1 million. The sale is in exchange for a $1 million, nine-year, 4.76% interest only note with a balloon payment upon maturity. The partnership interest generates a 6% pre-tax return. After paying off the note in nine years, the IDGT would have $1,156,180 of value – which is now held by the trust for its beneficiares.²

Grantor retained annuity trust (GRAT)

A GRAT is a grantor trust to which the donor transfers property and from which the donor receives an annuity payment each year for a term of years. Each annuity payment (whose value is fixed as of the date the GRAT is funded) consists of both an interest and principal portion. If any property remains in the GRAT after the final annuity payment is made (i.e., if the assets appreciate more than the applicable interest rate) and the GRAT is “zeroed-out,” the property will pass to the remainder beneficiaries (outright or in trust) free of gift tax; people who have already used up their lifetime gift tax exemptions will often use zeroed-out GRATs to transfer wealth to their beneficiaries gift-tax-free. “Zeroing out” a GRAT means that the annuity payments are calculated to result in no or a nominal residual value when the GRAT is created. In this way, a GRAT can potentially transfer value with no use of gift tax exemption and no gift tax cost, unlike a sale to an IDGT, where an initial gift is required to make the IDGT creditworthy.

Similar to an installment sale to an IDGT, the transfer of property to the trust will not trigger a capital gains tax to the donor, and the annuity payments from the trust to the donor will not be taxable. However, because the annuity payments include repayment of principal, unlike in an installment sale, the economic benefits of a GRAT may not be as favorable. As a result, individuals sometimes create a series of short-term, rolling GRATs (the donor funds a new GRAT each year with the annuity from the previous GRAT) rather than a single GRAT, to increase the wealth transfer benefits and capitalize on market volatility.³

Assume a gift to a five-year GRAT of a partnership interest with a net asset value of $1.5 million and a discounted value of $1 million, with a 5.6% IRS interest rate. The partnership interest is reinvested in an asset that generates a 6% pretax return. After five years, the remainder beneficiaries would receive $683,642.

Charitable lead annuity trust (CLAT)

A CLAT functions in the same way as a GRAT except for one key difference: the annuitant is a charity rather than the grantor. As compared to other techniques, CLATs serve to reduce a donor’s estate rather than freeze its value, since the donor does not receive any annuity payments. As a result, for individuals who (i) are philanthropic, (ii) are comfortable with losing control of, and income from, the assets with which they want to do planning, and (iii) wish to transfer asset appreciation to individual beneficiaries without paying gift tax (if they zero-out the CLAT by selecting an appropriate annuity payment), a CLAT can be an attractive solution.

Assume a cash gift of $1 million to a 20-year CLAT, with a 5% IRS interest rate. The cash is invested in an asset that generates a 6% pre-tax return. After 20 years, charity would have received a total of $1,604,853 and the remainder beneficiaries would receive $255,362.