What is an Intentionally Defective Grantor Trust?

Most estate planning documents are not intentionally drafted with defects, but an Intentionally Defective Grantor Trust (or IDGT) is an exception to this general rule. What is an Intentionally Defective Grantor Trust? This estate planning tool provides a strategic way to lower your taxable estate while gifting assets to beneficiaries at a locked-in value. 

Understanding IDGTs

An Intentionally Defective Grantor Trust is a type of irrevocable trust that allows the grantor (trust creator) to freeze certain assets for estate tax purposes, but not for income tax purposes. The “defective” nature of the trust refers to intentional flaws in the document that render it incomplete for income tax purposes while keeping it effective for estate tax purposes. 

By transferring assets to an IDGT, the grantor freezes the current value of the assets for estate tax purposes. This can be particularly beneficial in the context of appreciating assets, as any future appreciation generally occurs outside the grantor’s taxable estate.

While the grantor will pay income tax on any generated income from the trust assets, the trust beneficiaries will not owe any estate taxes after the grantor’s death. Typically the trust beneficiaries are the trust grantor’s children or grandchildren. Essentially, an IDGT helps to gift extra wealth to your loved ones.

How to Fund an IDGT

To fund an IDGT, the grantor “sells” appreciating assets to the trust in exchange for a promissory note (aka installment note) which is payable over several years. 

The interest rate on the note can be set at the applicable federal rate, which is often lower than the expected rate of return on the assets transferred. This allows the grantor to effectively transfer wealth to the trust with minimal gift tax consequences.

When an asset is sold to an IDGT, the IRS does not recognize this as a capital gain, which means no capital gains taxes are owed either. However, the grantor is liable for any income the IDGT earns. If the grantor sells an income-producing asset to the trust, like a rental property or business, the grantor would need to pay taxes on the income generated. 

Benefits of an IDGT

Intentionally Defective Grantor Trusts are attractive for multiple reasons, including:

• Reducing Future Estate Taxes: By transferring assets to an IDGT, the grantor reduces their taxable estate and freezes the current value of the assets for estate tax purposes. 
• Asset Protection: Assets held within an IDGT may be shielded from creditors and potential legal claims, providing an added layer of protection.
• Flexible Estate Planning: The grantor retains certain powers over the trust, allowing for flexibility in adjusting the terms to adapt to changing circumstances.

Seek Legal Counsel

An Intentionally Defective Grantor Trust is a sophisticated estate planning tool that requires careful consideration and professional guidance. While its complexity may seem daunting, the potential benefits in terms of tax efficiency, asset protection, and flexible estate planning make it a valuable option for those seeking to reduce their estate and gift tax liabilities.  

As with any estate planning matter, consult an experienced estate planning attorney to determine whether an IDGT aligns with your specific goals and circumstances.

If you have any questions about Intentionally Defective Grantor Trusts, feel free to contact our law firm.

Law Offices of Daniel A. Hunt

The Law Offices of Daniel A. Hunt is a California law firm specializing in Estate Planning; Trust Administration & Litigation; Probate; and Conservatorships. We've helped over 10,000 clients find peace of mind. We serve clients throughout the greater Sacramento region and the state of California.