Estate planning is a complicated process. This is especially true with intentionally defective grantor trusts (or “IDGTs”). First of all, this well-established planning strategy isn’t “defective” at all. Instead, the term “defective” simply describes the effect of income taxation rules on these instruments.
In this post, we’ll review how IDGTs work. We will address how they can be a great tool in your estate plan and, finally, how they are very tax “effective” for estate tax purposes.
Table of contents
What is an intentionally defective grantor trust (IDGT)?
An IDGT is technically an irrevocable trust. It is typically set up to benefit the grantor’s spouse or descendants. The trust is designed to be irrevocable to remove the trust assets from the grantor’s estate. As a result, it must be set up with a non-interested party as a trustee. The goal is to avoid accidentally being included in the grantor’s estate.
Even though it is an irrevocable trust, the IDGT will provide essentially pass-through taxation to the grantor. The trust document must include one grantor trust provision from IRC sections 671–679. This inclusion will make it tax effective for estate tax purposes but tax defective for income tax purposes. Said differently, the grantor pays tax on the trust earnings rather than at the trust entity level.
Below are some of the more common grantor trust provisions:
Reacquiring the trust assets
The grantor can reacquire trust assets under IRC Section 674(c) and replace them with assets of equivalent value. Under this provision, the retained interest will not exclude the grantor from making a completed gift to the trust.
Borrowing from trust
The trust can have a provision under IRC Section 672(a) that gives the grantor (or a nonadverse party) the power to borrow from the trust without having adequate interest or security. This power will need to be retained by the grantor and not allocated to the trustee to trigger grantor trust status.
Changing the beneficiaries
The trust can give the grantor under IRC Section 674(a) the power to dispose of assets, impacting the trust income or principal. For example, the grantor can add other noncharitable beneficiaries or allocate direct distributions to any existing beneficiaries.
The drafter of an IDGT instrument must be aware of all the exceptions to the grantor trust provisions that could negatively affect either losing grantor trust status or causing the trust to be counted in the grantor’s estate.
How to Fund an IDGT
Grantors have two options when funding IDGTs:
- they can make a completed gift to the trust; or
- make an installment sale.
IDGTs are typically funded through gifts. The grantor will make an irrevocable, completed gift of the designated assets to the trust. The gift of appreciating assets has the most benefit. This is because the trust passed the income onto the beneficiaries. The grantor will avoid additional transfer taxes on the asset even if they increase in value.
If the gift is over the annual exclusion amount for the year in which the gift is made, transfers to the IDGT are taxable gifts that will lower the grantor’s gift and estate tax credit.
Initiate installment sale
Gift tax can be avoided when the grantor sells appreciating assets to the trust. This is usually accomplished through an installment sale. In return, the grantor gets an interest-bearing note that is payable by the trust.
Since the IDGT is a grantor trust, there is no tax due on any gain from the sale. The grantor merely sold an asset to him or herself.
The grantor can maintain the income stream from the installments. Any interest payments that are made to the trust will increase the value of the trust assets for the benefit of the beneficiaries. When the promissory note value is equal to the value of the property sold, there is no gift tax liability.
Let’s take a look at how an IDGT works in practice. Here is some background:
- Jim is 63 years old and expects to live another 20 years.
- He has an extensive real estate portfolio and an estate valued at $18 million.
- He wants to establish a trust to remove certain appreciated assets from his estate and pass them to his kids.
- One of his properties is an apartment building that is worth $5 million. He expects this property to be worth $15 million in 20 years.
Let’s take a look at what his options are:
- If Jim does no estate planning and continues to hold the apartment building himself, the apartment building will pass to his kids. It will most certainly be above his federal unified gift and estate tax exemption.
- He could gift the apartment building to an IDGT. He will use just $5 million of his unified exclusion, and his kids will benefit from the building’s growth in that situation.
- If Jim decides to sell the asset to the IDGT in an installment sale, he will get an interest-bearing note in exchange for the real estate. The interest can then be used to pay any taxes or remain in the trust and further increase the gift to his children.
Estate Planning Advantages of an IDGT
The above example shows the significant benefits of IDGTs. Here are the advantages:
- They can be funded with appreciating assets.
- They serve as an estate freezing strategy by allowing the beneficiaries to benefit from asset appreciation.
- There are no additional transfer taxes.
- The grantor can remove the assets from his or her estate through the contribution to an irrevocable trust.
When the grantor pays taxes, it reduces the estate value. In addition, the payment is not considered an additional gift to the beneficiaries or the trust. Should the grantor decide to sell the assets to the trust for a promissory note, there will be no gain or loss recognition.
Any income earned by the trust is passed along to the grantor. The advantage of tax-free asset growth will only increase over time as the assets appreciate. With high trust tax rates, the grantor is usually in a lower tax bracket than the trust. This makes funding the IDGT with appreciating assets also suitable for income tax savings.
Remember that the IDGT is still a grantor trust. This gives the grantor some form of control. There are types forms of irrevocable trusts that do not contain grantor trust provisions. They usually require the grantor to give up all rights and powers relating to the trust and the corresponding assets while having no remaining interest.
Because IDGTs are designed to be irrevocable, they offer tax benefits and an added level of flexibility for the grantor.
A Planning Structure
When properly drafted and funded, IDGTs can be a handy tool in estate planning. They can freeze the asset value transferred to the trust and gives flow-through taxation to the grantor. Upon final distribution, the beneficiaries will have the tax-free growth of the assets.