An installment sale to a grantor trust freezes the value of an asset in the estate at the note, and passes everything it earns above the interest rate to the next generation.
In a sale to an intentionally defective grantor trust (IDGT), the grantor gives the trust a seed gift, then sells it assets in exchange for a promissory note bearing interest at the applicable federal rate (AFR). The note freezes the value in the grantor's estate; the growth above the interest rate passes to the trust's beneficiaries. Illustratively, $20.0M of assets growing 7 per cent, sold for a nine-year note at 4.00 per cent, leaves the trust $18.13M after the note is repaid.
Worked in full in The Family Office Professional by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The structure works because the trust is treated differently by two taxes. For income tax it is "defective": under the grantor trust rules of sections 671 to 679 the grantor is treated as its owner, so under Rev. Rul. 85-13 the sale is a transaction with oneself, with no gain recognised and no tax on the note interest. For estate and gift tax it is a completed transfer: what the trust owns is outside the estate. Family offices use it most often for operating company shares and family partnership interests, where expected growth is high and a valuation discount may apply. All figures below are illustrative and this is not tax advice; the structure needs specialist counsel.
| Input | Value |
|---|---|
| Underlying assets held in a family LLC | $20.0M |
| Discount for lack of control and marketability on the LLC interests | 30% |
| Fair market value of all the interests | $14.0M |
| Seed gift, share of the interests | 10% |
| Note: interest only, balloon at maturity, rate (illustrative AFR) | 4.00% |
| Term | 9 years |
| Total return on the underlying assets, a year | 7% |
| Estate tax rate | 40% |
Seed gift = FMV × 10%; note = FMV − seed gift
Trust assetst = assetst−1 × (1 + g) − note × AFR
Passed to heirs = assetsT − note
In Excel: =FV(g,T,Note*AFR,-Assets)-Note
The grantor's estate holds the note and the interest received; the trust holds $18.13M, 13.0 times the seed gift. Without the sale, the grantor's estate would hold the whole $36.77M. Treating the $1.40M seed as the only use of exemption, the $16.73M moved out beyond it would have cost about $6.69M of estate tax at 40 per cent. The figure is understated in one respect: because the trust is a grantor trust, the grantor pays income tax on the trust's earnings for nine years, which shrinks the estate further and lets the trust compound untaxed; under Rev. Rul. 2004-64 that payment is not a further gift. It is overstated in another: assets sold to the trust keep the grantor's income tax basis and do not receive a step-up at death, so a low-basis asset carries a deferred capital gains cost that the estate tax figure ignores.
Two of the three sources of value are visible in the arithmetic. Growth above the AFR is the economic one. The valuation discount is the other: the note is priced on $14.0M but the trust receives $20.0M of underlying value. Without the discount the trust would keep $10.15M, so the discount accounts for $7.99M of the $18.13M.
| Growth a year | 30% discount | Estate tax saved | No discount |
|---|---|---|---|
| 3% | 8.38 | 2.79 | 0.78 |
| 5% | 12.87 | 4.59 | 5.09 |
| 7% | 18.13 | 6.69 | 10.15 |
| 9% | 24.28 | 9.15 | 16.06 |
Without a discount, the sale passes more than the seed gift only if the assets grow faster than about 3.60 per cent, just under the 4.00 per cent note rate. With the discount, even flat assets leave $2.86M in the trust, which is exactly why discounts are the part of the structure most often challenged. The note rate moves the result less: at a 3.00 per cent AFR the trust keeps $19.64M, at 5.00 per cent $16.62M.
The common mistake is to count the whole remainder as a gain without asking whether the discount will survive. If the 30 per cent discount is reduced on examination, the note was too small, the difference becomes a gift, and the transfer can exceed the exemption the family planned to use. Well-drafted sales include a defined value or price adjustment clause for this reason. The second mistake is to forget the grantor's income tax: it is a benefit to the heirs, but it is a cash cost to the grantor every year, and a family office must make sure the grantor's liquidity can carry it. The third is to compare the sale with a GRAT on the transfer alone; the GRAT needs no gift and carries no note risk, while the sale uses a lower rate, a longer term and can be allocated generation-skipping exemption.
A sale to an IDGT passes the growth on an asset above the AFR, plus any valuation discount, for the price of a seed gift. On these illustrative figures that is $18.13M after nine years from a $1.40M gift. The free workbook for this book prices the office that would run this plan; whether the family can afford to preserve wealth per heir is the question the transfer serves.
A GRAT returns the assets to the grantor through an annuity at the 7520 rate and needs no gift; a sale to an IDGT uses a seed gift, typically around 10 per cent, and an interest-only note at the lower AFR, which can run for many years and allows generation-skipping planning. In the illustrative case a $12.60M note at 4.00 per cent costs only $0.504M a year in interest.
It is a practitioner convention, not a rule in the tax code: a trust with its own equity of about 10 per cent of the assets looks like a credible buyer able to pay the note. Here the gift is $1.40M against a $12.60M note. A thinner seed raises the risk that the sale is recharacterised as a retained interest, pulling the assets back into the estate.
Less passes, and the trust may struggle to repay. Without a valuation discount, assets growing 3 per cent leave only $0.78M after repaying the note, less than the $2.00M seed; transfer beyond the seed needs growth above about 3.60 per cent. With a 30 per cent discount, even flat assets leave $2.86M, but that result depends on the discount surviving review.
This article is one calculation from The Family Office Professional. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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