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Intentionally Defective Grantor Trust (IDGT) Estate Planning

What Is an Intentionally Defective Grantor Trust (IDGT)?

Intentionally Defective Grantor TrustAn intentionally defective grantor (IDGT) trust is an estate-planning strategy used to freeze an individual’s assets for estate tax purposes but not for income tax purposes. The intentionally defective grantor trust is set up as a standard grantor trust, but with a loophole.  The deliberate defect allows the trustor to continue paying income taxes on certain trust assets.  This is even after the assets have been transferred away from the individual. A properly established IDGT is treated as separate from the grantor for federal estate and gift tax reasons.  However, it is treated as owned by the grantor for federal income tax purposes.  In other words, income tax laws do not recognize that those assets have been transferred away from the individual.

The grantor is required to pay taxes on all trust income on a yearly basis.  However, the assets in the trust are allowed to grow tax-free, avoiding gift taxation for the grantor’s beneficiaries. The end result is a tax loophole utilized to minimize estate tax exposure. The trust is referred to as intentionally defective since the settlor relinquishes ownership of the assets for estate tax purposes.  However, the grantor remains the trust’s owner for income tax purposes. The fundamental advantage of having a grantor trust is that the trust assets can continue to appreciate without being depleted by income tax payments.  Ultimately, it results in an additional transfer of wealth to the trust beneficiaries and is not subject to transfer tax.

Intentionally Defective Grantor Trust – A Closer Look 

An irrevocable trust may sometimes be treated in the same way as a revocable trust according to the Internal Revenue Service. Grantor trust regulations specify the criteria under which this can occur. These circumstances might sometimes result in the formation of a so-called intentionally defective grantor trust. In certain circumstances, the grantor is liable for paying taxes on the trust’s income.  However, the trust assets are not included in the owner’s estate. Such assets would apply to a grantor’s estate if the individual operates a revocable trust.  This is because the individual essentially owns property held by the trust.

For estate tax purposes, the value of the grantor’s estate is decreased by the amount of the asset transfer. The individual will “sell” assets to the trust in exchange for a promissory note for a certain period of time.  For example, ten or fifteen years. The note will pay enough interest for the trust to be classified as above-market.  Nevertheless, the underlying assets are expected to rise at a faster rate.

IDGT beneficiaries are often children or grandchildren.  They will receive assets that have been able to grow without the grantor’s income tax reductions. If properly arranged, the IDGT can be a very successful estate-planning tool. It allows a person to reduce his or her taxable estate while giving assets to heirs at a fixed value. The grantor of the trust can also further reduce his or her taxable estate.  He or she does this by paying income taxes on trust assets, thus giving extra money to beneficiaries.

Selling Assets to an Intentionally Defective Grantor Trust

An IDGT’s structure allows the grantor to transfer assets to the trust by gift or sale. Gifting an asset to an IDGT may result in a gift tax.  Therefore, selling the item to the trust is a better option. When assets are sold to an IDGT, no capital gain is recognized, which means no taxes are owed.

This is a very effective strategy for withdrawing high-value items from an estate. In most circumstances, the transaction is structured as a sale to the trust.  The payment is made in the form of an installment note over a number of years. The grantor who receives the loan installments can charge a low-interest rate that is not taxable interest income. However, the grantor is liable for any income earned by the IDGT. In other words, the income earned inside the trust is taxable to the grantor.  This can occur when the asset sold to the trust is an income-producing asset.  For example, a rental property or a business.

Due to the complexities, an IDGT should be designed with the help of a professional.  For example, a knowledgeable accountant, certified financial planner (CFP), or estate-planning attorney.

Intentionally Defective Grantor Trust Income Tax Explained

The grantor is liable for income taxes on the trust’s gains. That’s the whole point of an intentionally defective grantor trust. For income tax purposes, the trust and the grantor are considered the same person. When a trust is not a grantor trust for income tax purposes, it indicates that the trust is a separate income tax-paying entity.  In that case, it would need to file its own tax return each year and pays tax at rates depending on trust income. Trusts generally pay higher tax rates than individuals since the income thresholds for each tax bracket are substantially lower than individual tax rate threshold amounts.

However, when a Grantor retains some rights in a trust, he is deemed the trust’s owner for income tax reasons. This means that the trust income will be taxed at the grantor’s marginal tax rate.  Also, the grantor will benefit from any trust deductions. Furthermore, by paying the trust’s income tax, the grantor is effectively making further tax-free gifts to the trust. By paying the trust’s tax bill, the Grantor allows the trust assets to appreciate faster than if the tax was paid directly from the trust.

An IDGT occurs when a grantor is regarded as an owner of the trust for income tax reasons.  However, he has abandoned rights to the trust’s assets.  This is established in such a way that the grantor is not considered the owner for estate tax purposes. It is “defective” because the grantor has not completely divested herself of all ownership for tax purposes. However, the defect is purposeful because the grantor actually wants to be the income taxpayer in this scenario.

IDGT Example

There are many tax planning scenarios in which the use of an IDGT would be advantageous.  For example, consider a wealthy individual owning appreciating assets, such as real estate or stock.  He wishes to shield the future appreciation of those assets from estate taxes. The individual can sell the appreciating asset to a properly established IDGT at fair market value (FMV).  In exchange, the trust issues a promissory note bearing interest at the applicable federal rate. The note will pay enough interest for the trust to be classified as above-market.  Nevertheless, the underlying assets will continue to appreciate in value tax-free.

Over a 30-year period, an IDGT with $10 million in assets and a 5% annual return would grow to more than $43 million, unimpeded by income tax payments. A trust that must pay income taxes on its own assets would grow to only $24 million under the same conditions. It is a major planning success to be able to transfer $43 million while using only $10 million of the permitted gift-tax exemption.

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