Learning that your estate plan contains a defect might not seem like good news. But despite the moniker, an intentionally defective grantor trust (IDGT) can be a valuable tool for minimizing estate taxes and maximizing the money and property passed on to a spouse, descendants, or other beneficiaries.
The defect, in this case, refers to trust provisions that make the grantor (the person creating the trust)—not the trust—the trust owner and, therefore, liable for trust income taxes. By not having annual income taxes come directly from the trust’s money and property, more value remains for beneficiaries. Further, drafting the trust in this manner excludes the appreciation of accounts and property from the trust owner’s taxable estate.
Typically used by wealthy families to preserve intergenerational wealth, IDGTs are an irrevocable trust. They are best suited to holding appreciating assets, such as real estate and securities.
The trust holds these assets outside the grantor’s estate for transfer tax purposes (gift and estate tax). But for federal income tax purposes, the IRS treats them as though the grantor owns them. Thus, the grantor pays income tax on the appreciation of the assets placed in the trust. But the trust excludes those assets from the grantor’s estate, which amounts to a tax-free gift to the trust. Any appreciation that occurs does so outside of the grantor’s estate. In other words, once the grantor places those assets into the trust, they have effectively frozen their value.
The “defective” part of this arrangement is the intentional inclusion of a right of power that results in the IRS treating the grantor as the trust owner from an income tax standpoint. You can find these powers enumerated in §§ 671–679 of the Internal Revenue Code and include the right to take the following actions:
For example, suppose the grantor wants to set up an IDGT to benefit the grantor’s children. The grantor funds the trust with $10 million in assets that earn 5 percent annually. Over thirty years, the $10 million initial investment would grow to $43 million.[1] If those same assets were held in a non-grantor trust, that $10 million would grow to only $24 million due to the trust paying income taxes on the assets. As a result, assets held in an IDGT would be worth almost $20 million more over the thirty-year period.
At the time of transfer (i.e., when the grantor dies and the trust transfers to the beneficiaries), only the initial $10 million investment—not the current $43 million value—counts towards the unified federal gift and estate tax exemption ($12.06 million in 2022). The IRS taxes transfers exceeding this amount at 18–40 percent.
Even better, as time passes and the value of the trust assets continues to grow, the tax-free benefit of this growth only increases. As an added benefit, the assets placed in the IDGT enjoy protection from creditors and other parties, such as the spouse of a divorcing beneficiary. Plus, since the trust is a grantor trust, the grantor has some ability to control the trust during their lifetime. This differs from most irrevocable trusts that do not contain grantor trust provisions and which force the grantor to give up all rights and powers over the trust and its assets.
You can fund IDGTs in one of two ways: with a completed gift or an installment sale.
Funding an IDGT with a gift is the most common and straightforward way to place assets in the trust. It simply entails you deciding which investments to hold in the trust and then making an irrevocable gift to the trust. This method is most beneficial for appreciating assets because it allows the grantor to pay income taxes on the assets over the years. Still, you can avoid additional transfer taxes if the assets appreciate. However, the grantor may have to pay gift taxes on the gifted trust assets if they exceed the annual exclusion amount ($16,000 in 2022).[2]
Funding an IDGT with an installment sale is also an option. In this scenario, the grantor gives the trust a small seed gift. Absent a note guarantee; a seed gift is necessary to provide the installment sale transaction economic substance. An installment sale involves selling appreciating assets to the trust in exchange for an interest-bearing promissory note payable by the trust. The IDGT is a grantor trust, meaning the installment sale amounts to the grantor selling assets to themselves. The benefit of this arrangement is that any gains from the sale are tax-free. The grantor may choose to earn income from the installments or make interest payments to the trust and grow its value for the benefit of heirs.
You can see up an IDGT as a dynasty trust (a trust spanning multiple generations) to provide long-term wealth preservation that is not subject to estate taxes when the beneficiary passes away. But not every state allows dynasty trusts due to the rule against perpetuities that limits how long a trust may legally exist. Some states, including Delaware, Nevada, and South Dakota, have eliminated the rule against perpetuities, while others have modified it. If you want to set up an IDGT as a dynasty trust, be mindful of state laws where you live.
To fully realize the benefits of an IDGT, your attorney must draft the trust appropriately. The Tax Adviser, a publication of the American Institute of CPAs, notes that an improperly structured IDGT could result in the trust’s inclusion in the grantor’s estate. This might increase the amount of estate taxes owed.[3] This could happen, for example, if the grantor keeps certain powers over the trust. Furthermore, an improperly structured IDGT could mean the IRS would no longer consider the trust a grantor trust. This would eliminate the added flexibility that this type of trust gives the grantor.
A well-considered estate plan can contain tools like IDGTs. Such tools help maximize the money and property passed on to the next generation. It can also protect family wealth. An IDGT can benefit the grantor and beneficiaries. But an attorney must appropriately draft, and a client must correctly fund it to get the most out of it. Some in the tax and legal community feared the Inflation Reduction Act would lower the estate and gift tax exemption. While these provisions were not included in the law, funding an IDGT at the current historically high exemption amounts might be wise.
A basic estate plan that includes a will, powers of attorney, and healthcare directives is just the start. High-net-worth individuals may require a more sophisticated strategy that involves tools like an IDGT. Please schedule an appointment to discuss this unique type of trust and your unique estate planning needs with our attorneys.
[1] Andrew Seiken, Maximize Next Generation Assets with Intentionally Defective Grantor Trusts, BNY Mellon, https://www.bnymellonwealth.com/insights/maximize-next-generation-assets-with-intentionally-defective-grantor-trusts.html (last visited Nov. 2, 2022).
[2] Frequently Asked Questions on Gift Taxes, IRS.gov, https://www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-gift-taxes (last visited Nov. 2, 2022).
[3] Barbara Bryniarski, Helping a Client Benefit from an Intentionally Defective Grantor Trust, Tax Adviser (Nov. 11, 2021), https://www.thetaxadviser.com/newsletters/2021/nov/helping-client-benefit-intentionally-defective-grantor-trust.html (last visited Nov. 2, 2022).
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