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Funding Strategies

How to Fund an IDIT: A Step-by-Step Guide to Installment Sales

Key Takeaways:

  • The "Seed" is Crucial: Always seed the trust with at least 10% of the sale value to establish economic substance and avoid IRS scrutiny.
  • Use the AFR: The promissory note must charge interest at the Applicable Federal Rate (AFR) to avoid gift tax issues.
  • Don't Rush: Separate the funding gift and the sale transaction by at least 30 days to avoid the "step transaction" doctrine.

Setting up the legal structure of an Intentionally Defective Irrevocable Trust (IDIT) is only half the battle. The real magic happens during the funding phase, where you transfer high-growth assets out of your taxable estate for U.S. federal tax purposes.

If done incorrectly, the IRS may argue that the transfer was a retained interest gift rather than a bona fide sale, potentially pulling the assets back into your estate.

Here is a step-by-step guide on how to properly fund an IDIT using the "sale to a defective grantor trust" technique.

Step 1: The "Seed" Gift

Before you can sell anything to the trust, the trust must have some economic substance of its own. If a trust has zero assets and signs a multi-million dollar promissory note, the IRS may view the transaction as a sham.

  • The Rule of Thumb: Most practitioners recommend a "seed gift" equal to 10% of the value of the assets to be sold.
  • Example: If you plan to sell $10 million of stock to the IDIT, you should first gift $1 million in cash or other assets to the trust.
  • Tax Implication: This gift uses a portion of your lifetime gift tax exemption.

Step 2: The Installment Sale

Once the seed money is in the account, the "sale" can proceed. You (the Grantor) sell your appreciating assets (e.g., business interests, real estate, pre-IPO stock) to the IDIT.

In exchange, the IDIT gives you a Promissory Note.

The Promissory Note Terms

  • Principal: The face value of the note equals the fair market value of the assets sold.
  • Interest Rate: The note must charge interest at least equal to the Applicable Federal Rate (AFR) for the month of the sale. This is crucial. If the rate is too low, the IRS will deem part of the sale a gift.
  • Term: Notes are typically structured as interest-only "balloon" notes for 9 years, though terms vary.

Step 3: Paying the Interest

The IDIT is now the owner of the asset. As the asset generates income (dividends, rent, distributions), the trust uses that cash flow to pay the interest on the promissory note back to you.

  • Income Tax "Defect": Because the trust is "defective" (grantor trust), you pay the income tax on the trust's earnings. This is actually a benefit. It allows the trust's assets to grow tax-free, while your tax payments further reduce your taxable estate.
  • Burn Rate: Ideally, the asset's cash flow covers the interest payments. If the asset is illiquid (like raw land or pre-revenue stock), the trust may use the "seed" money to service the debt.

Step 4: The "Spread" (The Wealth Transfer)

This is where the IDIT creates value.

  • Scenario: You sell an asset expected to grow at 10% per year.
  • Hurdle: The AFR (interest rate on the note) is only 4%.
  • Result: The 6% "spread" stays in the trust. Over 10-20 years, this compounded growth creates millions of dollars of wealth outside your estate, free of estate taxes.

Common Funding Pitfalls to Avoid

  1. Step Transaction: Do not gift the seed money and execute the sale on the same day. Allow some time (e.g., 30 days) to pass so the steps are distinct.
  2. Valuation Issues: If you are selling a "hard-to-value" asset (like a private business), get a qualified appraisal. An undervaluation can trigger a massive unexpected gift tax liability.
  3. Ignoring Cash Flow: Ensure the trust has a plan to pay the interest. If you constantly forgive interest payments, the IRS may treat the note as a disguised gift.

Automating Compliance with IDIT.ai

Managing the flow of funds—seed gifts, note payments, and interest calculations—can be complex. IDIT.ai helps automate the administration of your trust. Our platform tracks payment schedules, alerts you to AFR changes, and ensures your documentation supports the economic reality of the sale.

Ready to fund your legacy? Contact us to see if an IDIT is the right vehicle for your assets.