Families who may be concerned with estate taxes, especially on high-growth assets, may want to consider an intentionally defective grantor trust (IDGT) as a way to preserve wealth across generations.
What is an intentionally defective grantor trust?
An intentionally defective grantor trust is a type of irrevocable trust that can be used to remove assets from the grantor's estate. It is typically used for high-growth or income-earning assets.
How does an intentionally defective grantor trust work?
To understand how an intentionally defective grantor trust works, it is important to understand the different tax treatment for different types of trusts.
In the case of revocable trusts, income is typically taxed to the grantor of the trust. In other words, the person funding the trust (i.e., the grantor) is treated as the owner for federal and state income tax purposes. A separate income tax return usually does not have to be filed for the trust, but the assets it holds can potentially be included in the grantor's estate for estate tax purposes.
When a trust is set up to be irrevocable, it generally is a tax entity distinct from the grantor who created it, with its own income and deductions (net of distributions paid to beneficiaries) reported on its own income tax return. Assets transferred to an irrevocable trust are generally removed from the grantor's estate for estate tax purposes.
An IDGT benefits from the advantages of both types of trusts because it retains the character of a grantor trust for income tax purposes, but also reduces estate tax exposure by removing assets from the grantor's gross estate, just as a transfer to an irrevocable trust would do.
Why is an IDGT "intentionally defective"?
An intentionally defective grantor trust works by intentionally drafting the trust using language (in accordance with IRS provisions) that contains enough provisions (or "defects") that require the trust to be deemed a revocable trust for income tax purposes, but an irrevocable trust—and a completed transfer—for estate tax purposes.
What are the benefits of an intentionally defective grantor trust?
With an IDGT, the grantor is responsible for paying the trust income taxes. This means that the trust assets can appreciate without the "tax drag" of having to pay the trust's income tax liability with trust assets. The result is more assets that can pass estate tax free to the trust beneficiaries.
This has 2 additional benefits:
- Reducing the grantor's taxable estate in an amount equal to the income taxes paid by the grantor.
- Helping to preserve the trust by not reducing it with the trust's payment of the income taxes.
How are assets transferred to an intentionally defective grantor trust?
Assets can be transferred to an intentionally defective grantor trust by a few methods:
By gift or by a part gift and part sale
A grantor can make a gift of assets to the IDGT. If the assets transferred are less than the lifetime gift and estate tax applicable exclusion amount, gift tax would not have to be paid out of pocket, but the applicable exclusion amount would be reduced by the amount of the gift. Often the assets are partially given as gifts and partially sold to the IDGT, to leverage the amount of assets that can be transferred, preserve the exclusion amount, or retain income.
By sale
A sale of assets by a grantor to the IDGT involves the sale at the assets' fair market value in return for a note at a relatively low interest rate. The asset being sold would typically be one with significant potential for price appreciation. The ultimate objective is to remove future price appreciation (above the interest rate specified in the note) from the estate.
Since the trust is purchasing the asset (albeit with a note) for its fair market value, the grantor is not deemed as having made a taxable gift. The trust would make interest payments to the grantor on the note (as would be the case with any sale involving a note). The installment note received by the grantor in return is regarded as full and adequate consideration if the minimum interest rate charged on it is equal to at least the "applicable federal rate" (AFR) as determined by the IRS, and all the formalities of a loan are followed.
What are some disadvantages of an intentionally defective grantor trust?
Like all irrevocable trusts, an intentionally defective grantor trust is very difficult to change or modify once established.
In addition, with an IDGT, the grantor is effectively making a "bet" that the assets placed in the trust will appreciate in value at a faster pace than the AFR rate, with the remainder staying in the trust for the benefit of its beneficiaries. This is an outcome that cannot be guaranteed in advance.
Who should consider an intentionally defective grantor trust?
An IDGT can provide significant leverage by minimizing the income tax burden of the trust assets. However, this strategy is only effective if the grantor has adequate resources to continue to pay the trust's income tax liabilities. An IDGT should only be undertaken after a comprehensive financial analysis and with the close involvement of qualified legal counsel. The choice of language and the practical considerations that go with it (for example, whether the grantor will have the power to substitute assets, or if the grantor's spouse will be a beneficiary of the trust) are critical to its effectiveness. Talk to your attorney if you think an IDGT might be the right choice for your family.