Business Planning Tools: An Intentionally Defective Trust


Case Three: The Norton Family
Family Business Planning Tools of an Intentionally Defective Trust and Practical Ideas for the Acquisition of Business Real Estate.

Tom Norton was already a very successful business consultant to the property and casualty insurance industry when he was alerted in 1989 to an opportunity in Jackson, New Hampshire to purchase a ‘distressed’ resort, the Hawk Mountain Lodge. A client of Tom’s had told him that the property, now in the hands of its creditors, would be auctioned off unless a quick private deal could be had in the next 30 days.

Most of Tom’s friends and family members thought he was nuts to get into the hospitality business at all, especially now that he was approaching the age of 50 and had some health issues. His fiancé, Joanne however, was very supportive as her background in real estate marketing helped her to see the potential for the property as a real estate investment, if not as a resort. The property consisted of 400 acres with 1,000 feet of frontage (most of it a beach) on a crystal clear mountain lake. The eighteen hole golf course, in disrepair, was strategically positioned so that many of the holes abutted the lake and all looked to the surrounding mountains. The location was superb but the resort business in 1989 was suffering along with most of the commercial real estate industry.

Tom, Joanne, and Tom’s friend and accountant, David Reed of Portland Maine examined the property, the previous management’s financial statements, and the resort’s records of previous guests, which revealed some problems. There was a lot of deferred maintenance and even though all the personal property was to be included in the purchase it would be expensive to have all items cleaned and some kitchen items replaced. The dining areas, lounges, guests’ cabins, and main lodge rooms were in pretty good shape. Tom, Joanne, and David decided that with careful planning at least some income tax benefits could be obtained. Together with the help of Jack Richardson, Tom’s lawyer, they structured the purchase and sale agreement to have some special features. The bank wanted out, so they were not concerned with the details of the deal.

An S Corporation was formed to purchase the operating assets. An LLC was formed to purchase the real estate, with Tom owning 100% of each entity. The plan was to keep the real estate ownership separate from the operating company which is always a good idea for a family as it can shield the real estate from operating liabilities and allows for a sale or gifts of the entity owning the real estate without involving the operating company. The real estate entity’s purchase also included the golf course and the subdivision approvals that were in place from the previous ownership. The Town was happy to leave those rights in place as it was seen to be to their advantage to have the resort. For both parts of the acquisition, detailed schedules were prepared to delineate the assets being purchased along with a careful allocation of the purchase price to these assets. These schedules were incorporated into the purchase and sale agreement and thus agreed to by the seller (great evidence in case of an IRS review). David knew to allocate as much as possible to the personal property as it had shorter depreciation lives and less to the structures themselves. David also knew that the portion of the purchase price allocated to the golf course could be considered part of the sale of the lots in the subdivision as a basis to gain a further tax advantage that is not usually available for land. For the “subdivision” land the allocation was weighted more heavily to the lots most likely to be sold first to minimize the tax results for the early sales.

Tom knew he had to use all his business and marketing skills to make the resort profitable. The tax planning was just a small piece of the puzzle. He used his business contacts to bring in business groups during the week and supplemented the weekday business with special packages for bus tour groups on weekends. He knew that consistent and high occupancy was the key to a successful hospitality business. He hired a great chef and did not try to limit the food budget too much. He knew that the first impression of new guests was crucial as word of mouth is fast in the resort business. Early on he contacted AAA to ask how soon he could have a rating and be published in their marketing materials. It took AAA a year to do, but his first rating was a three diamond rating, quite good for an older resort. In the second year AAA Northern New England brought its Board of Directors to the resort for their annual meeting. Tom made sure that he received a lot of press for this occasion.

“The tax planning was just a small piece of the puzzle”

Tom opened up special memberships for residents of Jackson, such as golf privileges, beach access, and dining discounts in the shoulder seasons. The town manager was the first to sign up. Tom had the touch. Single family homes and condo sales on the property were very profitable, and the cash was used to pay off all the debt. The new property owners, especially the condo owners, allowed the resort to rent their properties when they were not on the premises, giving Tom commission revenue, as there was now more people to play golf and to use the dining room. When Tom originally sold the lots he used a ground lease for the land, which preserved an ongoing revenue stream. He also specified that any future re- sale would entitle the resort to a sales fee of 3% of the sale price, creating another income stream. His creativity was working like magic.

By 2007 the Hawk Mountain Lodge had gained a great reputation, was consistently profitable, and had significant business from repeat customers. It was in the fall of that year Tom and Joanne sat down with David Reed to review his estate plan since it had been a while since the last review. David was retired from public accounting but still did a few family consultations a year.

Tom and Joanne had married several years earlier. Tom had three adult children from his first marriage, two of whom helped in the business but also had other full time jobs. Joanne also had three children from her prior marriage, one of whom worked full time in the business. Both Tom and Joanne had substantial assets including real estate and investment portfolios, and purposefully kept their assets separate. Tom wanted to slow down, but the family wanted to keep the business, maybe to the benefit of grandchildren. The resort had a great non –family manager who made most of the operating decisions.

“Tom wanted to slow down, but the family wanted to keep the business”

After much discussion, Tom and Joanne decided they wanted the three children involved in the business to own it and the related real estate. They further decided that they would use other assets, if needed, for the other children so that all could be equal. Tom wanted to make sure the three children who would eventually receive the business had to work for it. Tom also wanted to be careful about his and Joanne’s future financial position. He wanted to make sure he had more than enough assets to protect him, so that he would never have to ask the children for any financial help.

David suggested that Tom sell the operating company to the three children involved in the business (all sons) in a transaction designed to be free of income tax, estate tax, and gift tax. At first Tom did not think that could be done, as it was not a well known technique. He had recently been talking with a colleague in the resort business who just sold his resort to his children using a traditional, taxable, installment sale. That friend did not tell Tom that in a such a sale the government, not the family, is the big winner (1). David was able to convince Tom that the tax road less traveled was the much better road.

A tax free plan for transferring the resort was designed. First, the business was professionally valued and the land was appraised. Then the operating company, an S Corp. , was re-capitalized to have 10,000 shares of common stock, 100 voting, and 9,900 non-voting. Tom formed an irrevocable, intentionally defective trust (grantor trust) (2) with the three boys as the beneficiaries. Tom then gave 10% of the stock (all in non-voting stock) to the trust (to protect against an IRS argument that the trust did not have substance). That gift, using a combination of appropriate discounting of the value of the stock due to its non-marketable and minority status and a modest amount of their transfer tax exemptions, was tax free. Tom then sold the remaining non-voting shares to the trust. The sale due to the trust’s “defect” had no income tax effect as Tom made the sale to himself for income tax purposes. However, the trust legally and for estate tax purposes became the owner of the stock. The trust executed a promissory note having a 15 year term and a low federally approved interest rate to Tom. The boys personally guaranteed the note as the transaction had to be a marketplace transaction and Tom wanted them to feel the pressure of ownership. A shareholders’ agreement was carefully prepared to protect the business and its owners with provisions appropriate to settle disputes, such as an early death or a divorce. A lease was executed between the real estate LLC, still owned by Tom, and the S corp. so that Tom would have a source of cash from the business. The lease gave the boys a fixed price option to purchase the real estate at any time. The price was the current value to protect the boys, but also provide a ceiling in Tom’s estate for the value of the LLC. In addition, Tom and Joanne executed a consulting agreement with the S Corp. providing for a monthly cash payment and requiring them when in Jackson to stay in their main lodge suite as a condition of their employment. The agreement provided that it would continue for Joanne if Tom predeceased her.

“David was able to convince Tom that the tax road less traveled was the much better road”

Tom decided to keep the real estate LLC to see how the boys did with their new ownership and related responsibilities. The older son was elected to chair the Board of Directors and met the expectation of holding regular and meaningful meetings.

Tom and David watch carefully how Congress handles the Federal estate tax exemptions. The exemptions at this time are $5 million per person, which protects the assets still owned by Tom and Joanne. If the assets increase to a value which exceeds the exempt amounts Tom and Joanne will revisit their estate plans.

David Reed first used such a trust in the early 1980’s in a very unusual circumstance. An attorney who helped a New England Indian tribe win a $100 million land claim settlement came to David’s firm to discuss the tax ramifications of the award. The attorney discussed the plans of the tribe to use part of the settlement to make per capita distributions to each tribal member. The tribe had established complicated rules for what determined a person to qualify as a tribe member –generally they had to be of one eighth tribal blood. Once a person was determined to qualify they would be given a distribution. One significant concern of the tribal council was that many of the tribal members were children and the council feared that if the distributions were made directly to the child or to the child’s parents that the money might never benefit the minor child. David and one of his partners quickly discovered that the initial distribution to the tribe was not taxable, as Indian tribes are exempt from income taxes. In addition, it was discovered that per capita distributions to tribal members were also not taxable. However, if the minor’s funds were distributed to some entity for the benefit of the minor the initial distribution might be considered taxable and definitely the future income of that entity would be taxable.

David suggested that an intentionally defective trust be formed for each minor child with the Tribe being the grantor. The tax result was that neither the initial distribution nor any future income to the trusts was ever taxed. The grantor, the Tribe, which would normally be taxed, was now tax exempt by law and was therefore not taxed. This was a wonderful result for these children.


(1) It is not unusual ( but not wise ) for families to transfer the ownership of a family business by means of an installment sale. For instance, if Tom had sold stock in his business worth, say $10 million to the three boys in a 10 year installment sale, the boys would have to earn about $16 million and pay $6 million in income taxes to have $10 million left to pay off the note. Tom would have to pay about $1. 5 million in capital gains tax on the sale having only $8. 5 million left. Tom receives $8. 5 million and the government gets $7. 5 million– not a good result.

(2) Congress years ago created a set of rules governing trust taxation. Many of the rules were designed to prevent grantors from using trusts to gain an income tax advantage by shifting taxable income to beneficiaries in lower income tax brackets where grantors retained control over the trust, or some of the decisions a trust could make. However, tax planners have learned to use those rules to the favor of taxpayers. Tax professionals structure trusts to be grantor trusts usually using Section 675(4) of the internal revenue code which involves the power to substitute assets of equal value for assets in the trust. A grantor who retains this power continues to be the owner of the trust for income tax purposes but not for estate tax purposes, which is what Tom did. The use of intentionally defective trusts is complicated and necessitates retaining professionals who have experience with this planning tool.

Leave a Reply

David Hawkes (aka David Reed) is a tax, financial planning, family & small business consulting expert. He has worked with thousands of clients and saved them millions of dollars in taxes over the course of his career. David is also a former minority shareholder of the Boston Red Sox.