When it comes to estate planning, certain tools offer tax advantages while allowing for flexible control over assets. One such tool is the Intentionally Defective Grantor Trust (IDGT), a strategy used primarily by high-net-worth individuals to transfer appreciating assets to future generations with minimal estate and gift tax exposure.
While the term “defective” might sound negative, in this case it’s intentional—and beneficial. The term "defect" pertains to particular clauses in the trust that keep the grantor, who establishes the trust, obligated to pay income taxes on the trust's income, despite the fact that the trust's assets are no longer included in the grantor's taxable estate.
This combination can create a win-win scenario: the trust assets can grow without being reduced by income taxes, and the grantor’s payment of those taxes effectively becomes an additional, tax-free gift to the trust beneficiaries.
How an Intentionally Defective Grantor Trust Works
An IDGT is an irrevocable trust, meaning that once it’s created and funded, the grantor cannot reclaim the assets or change the terms (except under certain limited circumstances).
Here’s the general process:
- Establish the trust with intentionally defective provisions for income tax purposes.
- Transfer assets to the trust. These are often assets with strong potential for appreciation, such as real estate, closely held business interests, or marketable securities.
- Allocate gift and GST exemptions (if applicable) to shield transfers from immediate transfer taxes.
- Grantor pays income taxes on trust earnings each year, allowing the trust to grow unburdened by income tax obligations.
The “defective” status is created by including provisions that trigger grantor trust rules under the Internal Revenue Code, such as retaining certain powers over the trust’s income or assets. These powers are enough to cause the trust’s income to be taxable to the grantor, but not enough to pull the trust assets back into the grantor’s taxable estate.
Intentionally Defective Grantor Trust Benefits
- Estate Tax Savings
By moving the assets—and any future gains—out of the grantor’s estate, the strategy can help lower potential estate tax liability. - Income Tax Advantage
The grantor’s payment of trust income taxes allows trust assets to grow faster, since no income tax is paid from the trust itself. - Effective Tax-Free Gifting
Paying income taxes for the trust is not considered an additional taxable gift to beneficiaries, yet it benefits them directly. - Asset Protection
Assets inside an IDGT can be protected from beneficiaries’ creditors, lawsuits, or divorce settlements. - Flexibility in Structuring
Can be combined with other estate planning vehicles, such as dynasty trusts, to enhance generational wealth transfer strategies.
Examples When You Could Use an IDGT
- Transferring a Rapidly Appreciating Asset
If an individual owns an asset that is expected to significantly increase in value—such as a growing business—placing it in an Intentionally Defective Grantor Trust early locks in today’s value for gift tax purposes.
Example:
A business owner transfers shares of a closely held company into an IDGT. Over the next 20 years, the business quadruples in value. The appreciation occurs outside the owner’s taxable estate, providing noticeable savings in potential estate taxes.
- Combining with a Dynasty Trust for Multi-Generational Planning
Families who want to ensure their wealth benefits children, grandchildren, and future descendants without erosion from estate and GST taxes can structure an IDGT as a dynasty trust.
Example:
A real estate investor funds an IDGT that is also a dynasty trust, using a GST exemption. Income taxes are paid by the grantor, and the trust property is managed for the benefit of current and future generations, with strong asset protection features.
- Freezing the Value of an Estate While Retaining Tax Responsibility
An Intentionally Defective Grantor Trust can also serve as the vehicle for a sale, with the grantor transferring assets to the trust and receiving a promissory note in return. This type of sale locks in the current value of the assets for estate tax calculations, while any subsequent appreciation takes place inside the trust.
Example:
An investor sells an interest in an LLC to an IDGT for a note. The trust pays off the note using the LLC’s income, and all appreciation beyond the note’s interest rate benefits the trust beneficiaries.
Key Considerations
An Intentionally Defective Grantor Trust is a highly effective tool for those seeking to transfer wealth efficiently, reduce estate taxes, and allow assets to grow free from income tax burdens within the trust.
An IDGT is a complex strategy that requires careful drafting and coordination with estate planning attorneys, tax advisors, and financial professionals. The irrevocable nature of the trust means the grantor gives up direct control over the assets. Additionally, the grantor must have sufficient liquidity to pay income taxes on the trust’s earnings each year.
Jurisdiction selection also matters—especially if the IDGT is paired with dynasty trust provisions—since state law will determine how long the trust can last and the level of asset protection provided.
Have questions about an Intentionally Defective Grantor Trust? Contact a trust officer at Peak Trust Company today!