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Colorado Court of Appeals decision limits trust substitutions

The decision specifically affects an estate-planning tool called an intentionally defective irrevocable trust (IDIT). This trust allows an individual to exclude trust assets from his or her estate for estate tax purposes. The creator of this type of trust (grantor) may also pay income taxes, which can increase the value of the trust gift tax-free.

A trust can be an effective way of transferring appreciated assets to your children. An IDIT trust also can provide flexibility by allowing the grantor to substitute other property of an “equivalent value.” A recent Colorado Court of Appeals decision however narrowed this “swap power.” In this post, we will describe how the appellate court limited the use of promissory notes.

In the case, an individual funded a trust with a diversified portfolio of securities to benefit his son. Then he tried to reacquire the assets with a promissory note that had the same face value and paid interest. The trustee refused to accept the promissory note arguing that it was not of an equivalent value since the promissory note was unsecured, not liquid and at a low interest rate.

The District Court agreed that the trustee could reject the substitution. The Court of Appeals agreed and analogized the transaction to a loan looking at four questions:

  • Is the relationship that of debtor and creditor
  • Was there a promissory note
  • Would interest be paid
  • Did the parties agree that the amount would be repaid

Following this decision, it will likely be difficult to use promissory notes to withdraw assets from a trust with a promissory note. Trustees will also probably scrutinize the tax value and fair market value of substitutions more closely.

An attorney can explain in more detail the benefits and drawbacks of an IDIT as you structure gift transfers to children and other loved ones.

Source: National Law Review, “Colorado Court of Appeals Limits Settlor’s Ability to Exercise Retained Power of Substitution,” Helen Rogers, Aug. 17, 2015

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