Intentionally Defective Grantor Trust - IDGT

What is an 'Intentionally Defective Grantor Trust - IDGT'

An intentionally defective grantor trust (IDGT) is an estate planning tool 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 purposeful flaw that ensures that the individual continues to pay income taxes, as income tax laws will not recognize that assets have been transferred away from the individual.

BREAKING DOWN 'Intentionally Defective Grantor Trust - IDGT'

For estate tax purposes, however, 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.

Benefits of an IDGT

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

Due to the complexity, an IDGT should be structured with the assistance of a certified financial planner and/or estate planning attorney.

Selling Assets to an IDGT

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.

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 earned by the IDGT. If the asset sold to the trust is an income-producing asset such as a rental property or a business, the income generated inside the trust is taxable to the grantor.