What are Intentionally Defective Grantor Trusts?

Considering differences between grantor and non-grantor trusts often leads estate planners in the direction of examining the comparative tax savings under the different forms of trust. An intentionally defective grantor trust (IDGT), contrary to the name, is not the product of a mistake, rather from the perspective of the IRS it is intentionally defective so as to reduce tax liability.

From an estate planning perspective “intentionally defective” in this sense may be one of the few circumstances something defective under the law is a good thing. A defective grantor trust is viewed as a complete transfer to a trust for transfer tax purposes but an incomplete, or “defective,” transfer for income tax purposes.

Like a non-grantor trust, an IDGT is irrevocable for estate and gift purposes; as such, the grantor does not retain any authority over trust management that would trigger estate tax inclusion. However, there are some minor differences when comparing an IDGT to a non-grantor trust, in that the grantor retains a minimal level of authority.  Further the future value transferred assets is not included in the grantor’s estate on the date the trust was funded.

Under a defective grantor trust, the grantor retains certain other powers over the trust limited by the fact that the trust cannot be revoked and amended under limited conditions. Although irrevocable, an IDGT is considered a grantor trust for income tax purposes.

As a result, the grantor, although not a beneficiary, incurs a tax liability on income the trust generates, even though the grantor is not entitled to any trust distributions. This type of format enables the grantor the ability to control the trust in a limited manner while still avoiding a significant amount of tax burden that the grantor would experience under other forms of trusts.  

IDGT Benefits

One of the primary benefits of the IDGT is the clear distinction between who owns the trust assets under gift and estate tax calculations (the trust) and who the assets are attributed to (the grantor). Accordingly, under an IDGT the grantor is still responsible for paying income tax generated from trust assets that the grantor does not receive. As, such an IDGT can be used to augment what heirs will inherit.

This strategy can achieve significant benefits when attempting to generate greater asset value in a trust by avoiding some the significant tax burdens found in other trusts.  

Another benefit found in the IDGT format is found in its ability to facilitate estate planning while reducing long term tax liability from estate taxes. The strategy of paying income tax on income received can accomplish some significant estate planning objectives. Firstly, it allows trust assets to accumulate without being depleted by income taxes. Secondly, the grantor’s estate is exhausted by paying income tax on trust earnings, thus reducing future estate tax liability. Lastly, paying tax on income from trust earnings rather than the trust serves as a tax-free proxy gift to the trust each time you pay a tax that would otherwise be paid by the trust itself.

A properly structured IDGT will receive the gross income generated from the trust’s assets, which will benefit the trust’s beneficiaries. The trust also allows the grantor the ability to withdraw future appreciation from the grantor’s estate while maintaining control over the assets. In the long-term, this provides a bonus that is two-fold, in that trust assets can grow uninhibited while also avoiding a significant amount of estate tax liability that can erase benefits gained from an appreciation of trust assets.

As a grantor, an IDGT can also be used to freeze the value of assets likely to appreciate and increase estate tax liability through an installment sale. By transferring the asset to the IDGT, a stream of income for the grantor is created while passing the appreciation on to trust beneficiaries without future tax liability.

The interest rate for the installment sale is calculated by the IRS, which is usually lower than market rates. The grantor/seller realizes no income when the trust pays interest and, therefore, no taxable gain on the sale.

Rather, the grantor’s tax liability on any income or capital gains the trust receives is avoided. Additionally, the transaction avoids gift taxes if the sale is made for the asset’s full value. If the grantor dies while the promissory note on the sale is outstanding, only the unpaid balance is included in the grantor’s estate.

An intentionally defective grantor trust attorney can provide an evaluation as to whether this structure is an appropriate asset management vehicle. Counsel experienced in trusts can also provide advice regarding the tax implications and financial impact of this form of trust. Given the amount of trust arrangements available discussing these options with counsel experienced in wealth management and asset protection is an important first step in this decision-making process.