The IRS has renewed its attack on the transfer tax planning technique in which taxpayers make installment sales to intentionally defective grantor trusts (IDGTs). The latest case before the Tax Court is Woelbing v. Commissioner (No. 030261-13), and it follows similar challenges by the IRS over the past several years.

Properly structured, the installment sale IDGT planning technique is a powerful tool, but some lawmakers have made efforts to curb it. For example, the current administration has proposed amending the law to provide that the assets of most types of grantor trusts could be included in their grantors' taxable estates.

The IRS has also repeatedly challenged the strategy, but without much success. For example, the IRS argued in the 2003 Tax Court case Karmazin v. Commissioner (#002127-03) that the installment sale to the trust should be viewed as a contribution to the trust with a retained right to receive the payments called for under the installment note (effectively merging the note into the trust agreement). The IRS argued that the transaction should be taxed under Section 2702, and since the note payments did not meet the definition of "qualified payments" under Section 2702, the entire value of the assets transferred to the trust would be subject to gift tax. Before the Tax Court could render its decision, the case was settled on taxpayer-favorable terms.

The IRS is echoing these arguments in Woelbing, which is currently before the Tax Court. In addition to the Section 2702 argument, the IRS claims that the installment note is not worth its face because it carries an artificially low and commercially unreasonable interest rate. (The note carries the applicable federal rate (AFR) that was in effect for the month of the sale.)

It is important to remember that installment sales to an IDGT are not proscribed in the regulations as they are in the grantor retained annuity trust (GRAT) rules. Careful planning should go into the transactions in consideration of IRS challenges under Section 2702.

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