How does an Intentionally Defective Grantor Trust work?

For decades, tax practitioners have used a popular technique – the Intentionally Defective Grantor Trust (IDGT) - to minimize exposure to estate, gift and generation-skipping transfer (GST) taxes. The technique may involve a gift to the IDGT or a sale to the IDGT in exchange for a promissory note.

An Intentionally Defective Grantor Trust (IDGT) is a type of grantor trust, which means the grantor pays the income tax earned by the trust. When you hear the term “intentionally defective,” you may think the trust is broken or somehow ineffective. An IDGT is a trust that is “defective” only because it is ignored for income tax purposes. The IDGT is very effective by helping beneficiaries avoid gift and estate taxes.

What is a Grantor Trust?

A grantor trust is purely a tax concept. In a grantor trust, the grantor is treated as the owner of the trust for income tax purposes. So, the grantor pays income tax on the trust’s dividends, interest and capital gains. To be treated as a grantor trust, the grantor can retain certain powers. Including any of the following provisions in a trust will cause the trust to be treated as a grantor trust:

Grantor has the power to reacquire trust assets by substituting other property of an equivalent value
Grantor has the power to control trust investments
Grantor has a revisionary interest in the trust greater than 5% of the trust’s value
Grantor or grantor’s spouse can receive trust income at the discretion of a non-adverse party
Grantor can borrow from the trust without adequate interest or adequate security.

What makes the Grantor Trust defective?

An IDGT is an irrevocable trust as opposed to a revocable trust. Control becomes a key aspect in an IDGT. When the grantor moves assets into an irrevocable grantor trust, it may be considered a gift. As an irrevocable trust, the grantor may lose control over the trust assets to ensure they are excluded from the grantor’s estate for estate tax purposes. Because the grantor still pays income taxes on the trust’s income after the gift is made (and the trust is not paying the tax), he/she can shift additional wealth to the beneficiaries of the trust and further reduce the size of his/her estate.

Why should I use an IDGT if I must pay income tax?

Grantors are willing to pay income tax on trust assets because they will be able to transfer additional wealth to family members and avoid any gift or estate taxes on the payment of income tax for their benefit. Whether an IDGT is worth it comes down to a cost-benefit analysis that compares income tax versus estate and gift taxes.

Who should use an IDGT?

The IDGT is appropriate for high-net-worth individuals, whose assets exceed $12.99 million (the current lifetime gift and estate tax exemption). The primary goal of an IDGT is to avoid estate and gift taxes (and perhaps GST tax). Estate taxes kick in upon death if the individual’s assets are above $12.99 million. This means than an individual can leave assets of up to $12.99 million to their beneficiaries without being subject to the 40% estate tax. Transferring assets to an IDGT can prevent any appreciation on those assets from being subject to estate tax. In addition, if you sell assets to an IDGT when values are low, you only need to include the value of the promissory note or any proceeds received on the sale in your estate.

Considerations to make before creating an IDGT

If your assets are significant, here are some final things to should consider before you decide to create your own IDGT:

Will you need access to the assets that you plan to put in the trust? An IDGT is irrevocable, and not meant to provide easy access to the grantor. While there are ways to gain access to the trust’s assets, if you really need to control and use the trust’s assets without restriction, then an IDGT may not be for you.
Do you expect the assets to appreciate over time? The best type of asset to put in an IDGT is one that has appreciated or is appreciating. This benefits you by avoiding the the amount of asset apprecitation in your estate. If the assets are not growing in value, they may not be suited for an IDGT.
Can you afford to pay the income tax on the trust’s income? You should not overburden yourself with income tax on the trust’s income. If you don’t have more than enough money outside the trust to live on and pay the trust’s tax, then you may want to reduce the amount being contributed to the trust or take back a note from the trust to ensure some flow of income from the assets you transfer.

For help in understanding and structuring your IDGT, give us a call at 571-203-9355 or visit us on the web at zelllaw.com.