A Grantor Deemed Owner Trust (GDOT) is an irrevocable trust that is treated differently for federal income tax purposes than for federal estate tax purposes. For estate tax purposes, any gifts you make to the GDOT will be treated as completed gifts, meaning the gifts are excluded from your taxable estate (just like the ILIT). However, for income tax purposes, you are treated as the owner of the GDOT assets. As a result, you are responsible for the income taxes. Paying the income taxes on assets that you gift to the GDOT is the equivalent of making additional tax free gifts to the beneficiaries of the GDOT. This is because the GDOT funds will not be depleted by payment of income taxes generated by the income of the GDOT .As a result, the beneficiaries will receive more assets in trust than if the GDOT was required to pay its own income taxes. This additional gift does not count against your lifetime gift tax exemption or the annual exclusion for gift tax.

A common planning technique is to sell your assets to the GDOT. The sale may be in exchange for a promissory note payable to you. For income tax purposes, the sale is not recognized (since you are treated as the owner of the GDOT assets for income tax purposes) and there will be no taxable gain on sale, thus avoiding income or capital gains tax. However, for estate tax purposes, any assets sold to the GDOT would be excluded from your estate.

Your estate will own the promissory note and receive periodic payments of interest and principal as provided in the note. Although the promissory note is included in your taxable estate at your death, the value of the note is fixed at the time of the sale. Therefore, if the assets sold appreciate in value from the time of sale to your date of death, the appreciation is excluded from your taxable estate. The assets of the GDOT, including all of the appreciation, will pass estate tax free to the GDOT’s beneficiaries, according to the GDOT’s terms.

For this strategy to work, the transaction must be a commercially reasonable transaction .The mechanics are as follows:

• You establish the GDOT and name a Trustee other than yourself or a beneficiary of the GDOT.
• You make a gift of cash or property to the GDOT (called “seed money”).
• The amount of the seed money must be commercially reasonable, say, for example, ten percent of the assets to be sold. The seed money must be sufficient to assure that the GDOT will have enough funds to pay off the note. That’s what makes it commercially reasonable.
• The note must bear an adequate rate of interest. Many times the note requires the payment of annual interest with a balloon payment of principal at a later point in time.
• The GDOT Trustee will then negotiate for the purchase of the assets from you.
• You enter into an agreement for the sale and purchase of the assets with the Trustee.
• You should sell income-producing assets that are expected to appreciate in value to the GDOT. This way, the GDOT will have sufficient funds to pay off the note. The Trustee will use the income produced by the assets sold to the GDOT to pay the note’s interest.
• When the note matures, a final balloon payment will be made to you (or your estate) and the assets that are sold, including all of the appreciation in value will be distributed or held in the GDOT for the benefit of the beneficiaries.