Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Neither Udell Associates nor Pendragon Financial Services are affiliated with Kestra IS or Kestra AS. This site is published for residents of the United States only. Registered Representatives of Kestra Investment Services, LLC and Investment Advisor Representatives of Kestra Advisory Services, LLC, may only conduct business with Imageresidents of the states and jurisdictions in which they are properly registered. Therefore, a response to a request for information may be delayed. Not all of the products and services referenced on this site are available in every state and through every representative or advisor listed. For additional information, please contact our Compliance department at 512-697-6000.

Estate Planning Life Insurance Charitable Gift Annuity Risk Management Deferred Annuities


Leveraging the $5 million tax exemption

An installment sale to a defective trust is a powerful strategy

For affluent families, the $5 million gift and estate tax exemptions – which are scheduled to drop to $1 million after 2012 provide an opportunity to transfer a great amount of wealth tax-free. It’s possible Congress will extend the current exemptions into 2013 and beyond, but there are no guarantees. So now is a good time to explore strategies for making the most of this opportunity.

One strategy to consider is a combination of two effective estate planning vehicles: the installment sale and the intentionally defective grantor trust (IDGT). Ideal for assets expected to appreciate significantly, such as an interest in a closely held business, an installment sale to an IDGT has the potential to transfer substantial value at little or no tax cost. And because this technique requires a gift of “seed money,” it’s most effective when the gift tax exemption is high.

Designing the trust

Here’s how the strategy works: You set up a trust to purchase the property, and you name your children or others as beneficiaries. The trust is “defective” because it’s designed so that contributions are completed gifts for transfer tax purposes but it's still treated as a “grantor trust” for income tax purposes. To accomplish this, you reserve certain powers – such as the right to substitute trust property with property of equal value – that cause the trust to be a grantor trust without pulling the trust assets back into your estate.

After the trust has been established, you contribute funds to “seed” the trust. This is important because, to ensure that the IRS will recognize an installment sale, the trust must have economic substance apart from the property you sell to it. Generally, seed money equal to at least 10% of the property's value is considered sufficient. Ideally, your gift tax exemption will allow you to avoid tax on the seed money contribution. The higher the exemption, the more property you can transfer tax-free, which is why now is a good time to consider this strategy.

Next, you transfer business interests or other property to the trust in exchange for a promissory note. To avoid being deemed a partial gift, this installment sale should have terms that are commercially reasonable. Among other things, the interest rate should be at least as high as the applicable federal rate (AFR).

The key to transferring wealth tax-free is for the value of the property sold to the trust to grow faster than the AFR. That way, at the end of the trust term, the value your beneficiaries have received will exceed what the trust paid back to you in the form of installment payments. That’s why this strategy is most effective for property expected to appreciate rapidly.

An IDGT is “defective” because it's designed so that contributions are completed gifts for transfer tax purposes but it’s still treated as a “grantor trust” for income tax purposes.

Selling to your alter ego

Grantor trust status is important for two reasons. First, as grantor, you're required to pay taxes on trust income. This is beneficial because it allows the trust assets to grow without being eroded by taxes. Essentially, your tax payments are additional tax-free gifts to the trust beneficiaries.

Second, a grantor trust is treated as your “alter ego” for tax purposes. Selling property to a grantor trust is the equivalent of selling it to yourself, so you won’t owe any taxes on the installment payments you receive. This is an advantage over a straight installment sale, which generates a combination of capital gains and ordinary income taxes with each payment.

Now’s the time

An installment sale to an IDGT can be an effective estate planning tool anytime, but it’s particularly powerful now. With the gift tax exemption at $5 million, you can transfer larger amounts of property – which require larger contributions of seed money – without triggering gift taxes.

back to top back to Insights


We are a wealth management and estate planning firm specializing in estate
and trust planning, income tax planning, philanthropy and asset management.