If your estate consists of significant assets, one of your primary considerations within your estate plan should be the impact federal gift and estate taxes will have on your estate after you are gone. One estate planning tool you may decide to use is an Intentionally Defective Grantor Trusts (“IDGT”). Let’s explore why you might want to create an Intentionally Defective Grantor Trust.
Intentionally Defective Grantor Trust Basics
An IDGT is a specialized type of irrevocable trust. Typically, it is established to benefit the grantor’s spouse or descendants. The reason it is created as an irrevocable trust is to remove the trust assets from the grantor’s estate. A non-interested party is usually appointed to be the Trustee to avoid its accidental inclusion in the grantor’s estate.
The purpose of an IDGT is to freeze certain assets to avoid paying estate taxes on those assets; however, not freeze them for income tax purposes. A loophole allows the trustor to continue paying income taxes on certain trust assets because income tax laws will not recognize that those assets have been transferred away from the individual. This effectively allows the assets in the trust to grow tax-free and avoid gift taxation.
What Makes a Trust an IDGT?
For the grantor to maintain income tax liability, the trust instrument must contain one trust provision from IRC sections 671–679, making it tax “effective” for estate tax purposes but tax “defective” for income tax purposes. This is the “defective” portion of the trust that triggers the need to pay income taxes and prevents the payment of estate taxes. For the trust to work as intended, it is crucial to understand the exceptions to the grantor trust provisions that could have the negative consequence of either losing grantor trust status or causing the trust to be counted in the estate of the grantor.
Funding an IDGT
There are two ways in which you can fund an Intentionally Defective Grantor Trust. One is to make a completed gift to the trust while the other involves making an installment sale to the trust.
Making a completed gift is the most common way to fund an IDGT. The grantor makes an irrevocable, completed gift of the desired assets to the trust. Appreciating assets are frequently used because the income can be retained by the trust and passed to the beneficiaries. Moreover, additional transfer taxes are not paid on the asset even if it increases significantly in value. Be aware, however, that if the gift you make to an IDGT exceeds the annual exclusion amount for that year ($15,000 for 2021), the excess transfer will be considered a taxable gift that will reduce your lifetime exemption.
An installment sale results in the grantor receiving an interest-bearing promissory note payable by the trust. Because the IDGT is a grantor trust, no tax is due on any gain from the sale. The grantor keeps the ability to maintain an income stream from the installments, or the interest payments are made to the trust to grow the value of the trust corpus for the beneficiaries. If the value of the promissory note is equivalent to the value of the property sold, there is no gift tax liability.
Please download our FREE estate planning checklist. If you have additional questions or concerns about how an intentionally defective grantor trust can fit into your estate plan, contact us at the Northern California Center for Estate Planning & Elder Law by calling (916)-437-3500 or by filling out our online contact form.