Intentionally defective grantor trusts (IDGT) are designed to be tax-inefficient for the grantor but tax-efficient for the trust’s beneficiaries.
They can be an excellent estate planning tool for minimizing estate taxes and maximizing accounts and property that is passed to your beneficiaries.
The grantor of the trust, not the trust itself, retains certain powers over the assets in the trust and, therefore, is liable for trust income taxes.
Since the trust is not paying annual income taxes directly, more money and property remain in the trust for the beneficiaries.
In addition to retaining value for the beneficiaries, when a grantor shifts incoming producing assets to the trust, it excludes the appreciation of these accounts and property from the grantor’s taxable estate.
The Benefits of an Intentionally Defective Grantor Trust (IDGT)
Wealthy families typically use IDGTs to preserve intergenerational wealth. They fund their trust with real estate and securities that are likely to appreciate.
These assets are:
- Outside the grantor’s estate for gift and estate tax purposes.
- Treated as owned by the grantor for federal income tax purposes. The grantor pays income tax on the appreciation of the assets in the trust.
- The appreciation of the trust assets is excluded from the grantor’s estate, which functions like a tax-free gift to the estate.
Using an IDGT, grantors keep any appreciation outside their estate because the trust assets are essentially frozen in value.
What is defective about an IDGT?
An IDGT is defective because the grantor retains certain powers over the assets, which results in the grantor being treated as the trust owner from an income tax standpoint, even though the IDGT is a type of irrevocable trust.
These powers are found in §§ 671–679 of the Internal Revenue Code and include the following:
- The right to reacquire assets already placed in the trust and substitute them for other assets
- The right to take loans from the trust
- The right to change the beneficiary of the trust
For example, suppose a grantor funds an IDGT with $10 million in assets that earn 5% annually to benefit their children.
Over the next 30 years, the $10 million initial investment would grow to $43 million.
If this grantor had used a nongrantor trust, the $10 million initial investment would only grow to $24 million because the trust would need to pay income taxes on the assets.
By using an IDGT, the grantor increases the value of the trust by $20 million.
When the grantor dies and the trust is transferred to the beneficiaries, only the $10 million investment will count towards the federal unified gift and estate tax exemption, not the current $43 million value.
Transfers that exceed the current estate and gift tax exemption ($12.9 million in 2023) are taxed at 18-40%. As the trust assets continue to appreciate, the tax-free benefit of this growth increases.
In addition to tax benefits, the assets placed in an IDGT are protected from creditors and other parties. But, the grantor also retains some control over the trust throughout their lifetime.
This differs from most irrevocable trusts, which require the grantor to give up all rights and powers over the trust and its assets.
How to Fund an IDGT
There are two ways to fund an IDGT.
- A gift: A gift to the trust is the most common and straightforward way to fund an IDGT. The grantor will make an irrevocable gift of the assets to the trust.
By doing this, the grantor can pay income taxes on the assets over the years, but the transfer taxes can be avoided for appreciating assets.
However, the grantor will have to pay gift taxes on the assets if they exceed the annual exclusion amount of $17,000 in 2023.
An installment sale: An IDGT can be funded with an installment sale, which involves the transfer of property in exchange for a promissory note and installment payments over time.
- The grantor gives the trust a small seed gift to give the installment sale transaction economic substance. Then the grantor sells appreciating assets to the trust in exchange for an interest-bearing promissory note payable to the trust.
Any gains from the sale are tax free, and the grantor is essentially selling assets to themselves.
The grantor may choose to earn income from the installments or make interest payments to the trust in order to grow the trust value for the beneficiaries.
Important Legal Considerations
To gain these benefits, the grantor must structure the IDGT trust properly.
If the IDGT is improperly structured, the trust may be included in the grantor’s estate, which might increase the amount of estate taxes owed. This could happen if the grantor keeps certain powers over the trust.
An IDGT can benefit both the grantor and beneficiaries as long as it is properly structured. It can maximize the amount of money and property passed to the next generation and protect family wealth.
The estate and gift tax provisions are at historically high exemption levels, which can make funding an IDGT now a smart move.