What Is an Intentionally Defective Grantor Trust?

An intentionally defective grantor (IDGT) trust is an estate-planning tool that is used to freeze certain assets of an individual for estate tax purposes, but not for income tax purposes. The intentionally defective trust is created as a grantor trust with a loophole that allows the trustor to continue paying income taxes on certain trust assets, as income tax laws will not recognize that those assets have been transferred away from the individual.

Because the grantor must pay the taxes on all trust income annually, the assets in the trust are allowed to grow tax-free, and thereby avoid gift taxation for the grantor's beneficiaries. Thus, it is a loophole used to reduce estate tax exposure.

Key Takeaways

  • An intentionally defective grantor (IDGT) allows a trustor to isolate certain trust assets in order to segregate income tax from estate tax treatment on them.
  • It is effectively a grantor trust with a purposeful flaw that ensures the individual continues to pay income taxes.
  • IDGTs are most often utilized when the trust beneficiaries are children or grandchildren where the grantor has paid income tax on the growth of assets that they will inherit.

Understanding Intentionally Defective Grantor Trusts 

Grantor trust rules outline certain conditions when an irrevocable trust can receive some of the same treatments as a revocable trust by the Internal Revenue Service (IRS). These situations sometimes lead to the creation of what are known as intentionally defective grantor trusts. In these cases, a grantor is responsible for paying taxes on the income the trust generates, but trust assets are not counted toward the owner's estate. Such assets would apply to a grantor's estate if the individual runs a revocable trust, however, because the individual would effectively still own property held by the trust.

For estate tax purposes, though, the value of the grantor's estate is reduced by the amount of the asset transfer. The individual will "sell" assets to the trust in exchange for a promissory note of some length, such as 10 or 15 years. The note will pay enough interest to classify the trust as above-market, but the underlying assets are expected to appreciate at a faster rate.

The beneficiaries of IDGTs are typically children or grandchildren who will receive assets that have been able to grow without reductions for income taxes, which the grantor has paid. The IDGT can be a very effective estate-planning tool if structured properly, allowing a person to lower his or her taxable estate while gifting assets to beneficiaries at a locked-in value. The trust's grantor can also lower his or her taxable estate by paying income taxes on the trust assets, essentially gifting extra wealth to beneficiaries.

Selling Assets to an Intentionally Defective Grantor Trust

The structure of an IDGT allows the grantor to transfer assets to the trust either by gift or sale. Gifting an asset to an IDGT could trigger a gift tax, so the better alternative would be to sell the asset to the trust. When assets are sold to an IDGT, there is no recognition of a capital gain, which means no taxes are owed.

Due to the complexity, an IDGT should be structured with the assistance of a qualified accountant, certified financial planner (CFP), or an estate-planning attorney.

This is ideal for removing highly appreciated assets from the estate. In most cases, the transaction is structured as a sale to the trust, to be paid for in the form of an installment note, payable over several years. The grantor receiving the loan payments can charge a low rate of interest, which is not recognized as taxable interest income. However, the grantor is liable for any income the IDGT earns. If the asset sold to the trust is an income-producing one, such as a rental property or a business, the income generated inside the trust is taxable to the grantor.