An Intentionally Defective Grantor Trust is an irrevocable trust generally established for the benefit of the Trustmaker’s children and descendants. An Intentionally Defective Grantor Trust is often structured to benefit the Trustmaker’s children during their lifetimes and the Trustmaker’s lineal after the Trustmaker’s children pass away.
Why is the Intentionally Defective Grantor Trust defective?
From an income tax and estate tax perspective, the IDGT is purposely structured to be “defective” for income tax purposes and “effective” for estate tax purposes. Meaning that if the IDGT generates income, the Trustmaker will be responsible for paying the taxes on the income; which is generally preferable to the Trustmaker, as it gives the Trustmaker the opportunity to pay the taxes on behalf of the, essentially passing more wealth down to the beneficiaries. However, when the Trustmaker passes away, the assets of the trust will not be included in the estate of the Trustmaker and will pass estate tax free to the beneficiaries.
Making Outright Gifts to the Intentionally Defective Grantor Trust and Selling Assets to the Intentionally Defective Grantor Trust
Intentionally Defective Grantor Trusts are typically used in conjunction with the Trustmaker selling assets to the trust. This technique works to freeze, or set the value, of the property sold to the trust in exchange for a promissory note payable from the Trust to the Trustmaker. The transaction helps to pass an asset in a gift tax free manner from the Trustmaker down to the beneficiaries of the trust.
While an Intentionally Defective Grantor Trust is typically involves the sale of assets to the IDGT, the Trustmaker can also make an outright gift to an IDGT using the Trustmaker’s gift tax exemptions. The general consensus is that the IDGT should have assets worth a minimum of ten percent of the value of the assets being sold to the trust, and a gift to the trust can help to ensure that the Intentionally Defective Grantor Trust is respected by the Internal Revenue Service.
Benefits of an Intentionally Defective Grantor Trust
Through the use of an IDGT, the Trustmaker is able to transfer a portion of the Trustmaker’s assets out of his estate and save on estate taxes, without the imposition of substantial gift taxes or the use of the Trustmakers gift tax exemptions. Any appreciation in the assets in the IDGT will also pass estate tax free. Further, the payment of income taxes by the Trustmaker on the income generated by the trust assets is done without gift tax consequences, and is a good planning technique to transfer more wealth out of the Trustmaker’s estate for the benefit of the beneficiaries of the trust.