An intentionally defective grantor (IDGT) trust is an estate-planning tool used to freeze certain assets of an individual for estate tax purposes, but not for income tax purposes. The intentionally defective trust is created as a grantor trust with a loophole that allows the grantor to receive income from certain trust assets.

The grantor pays income tax on any generated income, but the estate does not incur any estate taxes when the grantor dies.

Understanding Intentionally Defective Grantor Trusts 

Grantor trust rules outline certain conditions when an irrevocable trust can receive some of the same treatments as a revocable trust by the Internal Revenue Service (IRS). These situations sometimes lead to the creation of what are known as intentionally defective grantor trusts.

In these cases, a grantor is responsible for paying taxes on the trust’s income, but trust assets are not counted toward the owner’s estate. However, such assets would apply to a grantor’s estate if the individual ran a revocable trust because the individual would effectively still own the property.

Estate Taxes

For estate tax purposes, the value of the grantor’s estate is reduced by the amount of the asset transfer. The individual will “sell” assets to the trust in exchange for a promissory note—also called an installment note—of some length, such as 10 or 15 years.

The note will pay enough interest to classify the trust as above-market, but the underlying assets are expected to appreciate at a faster rate.

Beneficiaries

The beneficiaries of IDGTs are typically children or grandchildren who will receive assets that have been able to grow without reductions for income taxes, which the grantor has paid.

The IDGT can be an effective estate-planning tool if appropriately structured, allowing a person to lower their taxable estate while gifting assets to beneficiaries at a locked-in value.

The trust’s grantor can also reduce their taxable estate by paying income taxes on the trust assets, essentially gifting extra wealth to beneficiaries.

Selling Assets to an Intentionally Defective Grantor Trust

The structure of an IDGT allows the grantor to transfer assets to the trust either by gift or sale. Gifting an asset to an IDGT could trigger a gift tax, so the better alternative would be to sell the asset to the trust. When assets are sold to an IDGT, there is no recognition of a capital gain, which means no taxes are owed.

This is ideal for removing highly appreciated assets from the estate. In most cases, the transaction is structured as a sale to the trust, to be paid for in the form of an installment note, payable over several years. The grantor receiving the loan payments can charge a low rate of interest, which is not recognized as taxable interest income.

However, the grantor is liable for any income the IDGT earns. If the asset sold to the trust is income-producing, such as a rental property or a business, the income generated inside the trust is taxable to the grantor.

Frequently Asked Questions

What Makes a Grantor Trust Intentionally Defective?

Intentionally defective refers to the fact that the grantor no longer owns the assets in the trust—they are removed from the estate—but still pays income taxes on any income earned from the assets in the trust.

How Are Intentionally Defective Grantor Trusts Taxed?

IDGTs are not taxed when assets are sold into them or if they appreciate because there is no recognition of capital gains. However, the grantor pays income taxes if there is income from the IDGT.

KEY TAKEAWAYS

  • An intentionally defective grantor trust (IDGT) allows a person to isolate certain trust assets to segregate income tax from estate tax treatment.
  • It is effectively a grantor trust with a purposeful flaw that ensures the individual continues to pay income taxes.
  • IDGTs are most often utilized when the trust beneficiaries are children or grandchildren where the grantor has paid income tax on the growth of assets they will inherit.