An Installment Sale to a Grantor Trust (ISGT) is a combination of a number of estate planning strategies. These include the implementation of a grantor trust, a gift to that grantor trust and a sale of additional assets to the grantor trust using a promissory note and a pledge of trust assets as collateral. Used together, these strategies can have very advantageous tax consequences.
The client who creates a grantor trust is treated as the owner of the trust for Federal income tax purposes, but not for Federal estate tax purposes due to certain powers retained by the client. The client then selects a pool of assets to transfer to the trust. There are actually two transfers to the trust taking place – one in the form of a gift and one as a sale.
In order to enter into the sales transaction, the trust must have some financial resources in order to have collateral to pledge. As a result, a gift is made to the trust prior to the completion of the sales transaction. The amount of this gift must be carefully considered as it may become an indicator of the reasonable nature of the transaction if it is reviewed by the Internal Revenue Service. Further, the size of the gift may be dependent upon the amount of the gift tax exemption available to the client.
After the gift is made, the client and the trust enter into a Purchase and Sale Agreement with the trust agreeing to purchase from the client another portion of the assets that the client wants to transfer to the trust. The sale is made in exchange for a promissory note and the transaction is treated as an installment sale. In order to secure the client’s right to receive payments under the note, the trust enters into a Pledge Agreement pledging the assets that it received by gift and the assets received pursuant to the sale as collateral for the note. If the trust defaults on the note payments, the client will have the right to take possession of the collateral pledged by the trust. The payments due the client on the note which secure for the client cash flow on the assets.
In light of the fact that the client is treated as the owner of the trust for Federal income tax purposes, no capital gains are realized due to the sales transaction. Further, the payments of interest on the promissory note are not treated as taxable income due to the grantor trust treatment of the trust. Because the client and the trust are treated as the same person for income tax purposes, there is no gain recognized on the sales transaction due to the fact that a person cannot sell themselves assets.
Further, a person cannot pay themselves interest and thus, there is no recognition of income upon the receipt of the interest payments by the client. The assets gifted by the client to the trust are frozen at that value for later estate tax computation purposes. The assets sold to the trust are eliminated from the client’s taxable estate and replaced by the value of the promissory note. The value of the promissory note will decline in value over time if payments of principal are made on the note. The benefit of this transaction is the shifting of future appreciation on assets out of the client’s estate for the use of family members. For estate tax purposes, a portion of the client’s estate is thereby frozen.