Question 1: What is an intentionally defective trust?
An intentionally defective trust, sometimes known as an intentionally defective grantor trust, is a special kind of irrevocable trust some people use to minimize their exposure to certain federal taxes. When you create an intentionally defective trust you, the grantor, are still considered the owner of the trust property for income tax purposes. However, for estate and gift tax purposes, it is considered to be an irrevocable trust that would not be included in your taxable estate at your death.
Question 2: Why is it called defective?
Intentionally defective grantor trusts are so named because they do not, unlike some other irrevocable trusts, protect you from income tax liability, even though they can protect your estate from some estate tax liability. Because of this failure to protect from income tax, the trusts are known as defective. However, this does not mean they are not useful, nor does it mean they are in any way illegal.
Question 3: How do they work?
When you create an intentionally defective grantor trust you transfer specific property to the trust to own. The grantor, meaning the person who creates the trust, is not a trust beneficiary and is not entitled to receive distributions from the trust, even though he or she will be taxed on the trust income. However, the irrevocable trust will essentially “freeze” the value of any asset placed within it for the purposes of estate tax purposes.
Needless to say the calculation needed to evaluate whether an intentionally defective trust is right for you can be rather complicated. This is why you should consult with an experienced and qualified estate planning attorney who is familiar with such planning to determine whether or not it is appropriate for your estate plan.