Intentionally Defective Grantor Trust (IDGT)

What is an IDGT?

An Intentionally Defective Grantor Trust (IDGT) is an irrevocable trust used in estate planning to separate estate tax treatment from income tax treatment. Assets transferred into an IDGT are removed from the grantor’s taxable estate for estate tax purposes, but the grantor remains responsible for paying income taxes on income generated by those assets. This arrangement lets the trust assets grow free of estate tax while the grantor’s payment of income tax effectively benefits the trust beneficiaries.

Key benefits

• Freezes estate value: Future appreciation of the transferred assets occurs outside the grantor’s taxable estate.
• Tax-efficient wealth transfer: The grantor’s payment of the trust’s income taxes is an additional, tax‑effective transfer to beneficiaries.
• Capital-gains deferral: Properly structured sales of appreciated assets to an IDGT typically do not trigger immediate capital gains recognition.
• Useful for family succession: Commonly used to transfer businesses, real estate, or other appreciating assets to children or grandchildren.

How an IDGT works

1. Trust setup: The grantor creates an irrevocable trust and includes specific “defective” provisions that cause the trust to be treated as a grantor trust for income tax purposes while remaining outside the grantor’s estate for estate tax purposes.
2. Funding the trust: Assets are transferred to the IDGT either by gift or—more commonly—by sale to the trust. A sale is usually structured as an installment (promissory) note payable over a number of years.
3. Interest and growth: The promissory note must bear adequate interest (often tied to the applicable federal rates) so the transaction is respected for tax purposes. If the underlying assets appreciate faster than the interest owed on the note, that excess appreciation passes to beneficiaries free of estate tax.
4. Income tax: Although the trust owns the assets, the grantor reports and pays income tax on the trust’s income. Paying those taxes reduces the grantor’s estate without using gift tax exemptions.

Selling assets to an IDGT

• Sale vs. gift: Selling appreciated assets to the trust (rather than gifting) avoids or minimizes gift tax exposure and preserves gift tax exemptions. Sales are typically financed with a promissory note.
• Capital gains: When the grantor sells to an IDGT, income tax on the sale is generally not triggered immediately because of grantor trust rules. The trust’s subsequent appreciation is shifted out of the grantor’s estate.
• Income-producing assets: If the transferred assets generate income (rent, business income), the grantor must report and pay the income tax on that income.

Tax and estate implications

• Estate tax: Assets properly transferred into an IDGT are excluded from the grantor’s taxable estate, so appreciation after the transfer is not subject to estate tax at the grantor’s death.
• Income tax: The grantor pays tax on trust income; those tax payments are effectively additional, tax‑free wealth transfers to beneficiaries.
• At death: Outstanding promissory notes and any interest owed may be scrutinized and, depending on structure and facts, could be included in the grantor’s estate. Assets actually sold into the trust are generally excluded from the estate if the sale was bona fide and the trust is properly drafted.

Risks and limitations

• Complexity: IDGTs require careful drafting and compliance with complex grantor‑trust rules.
• IRS scrutiny: Transactions must be bona fide, properly documented, and reflect arm’s‑length terms (adequate interest, realistic repayment terms) to withstand review.
• Liquidity: If the trust lacks cashflow to repay the promissory note, complications can arise.
• Professional cost: Legal, tax, and valuation advice is essential and can be costly.

Who should consider an IDGT?

• High‑net‑worth individuals seeking to reduce estate tax exposure.
• Owners of appreciating assets (businesses, real estate, marketable securities) who want to shift future appreciation out of their estate.
• Individuals who can continue to pay the income taxes on trust earnings and want to provide a tax‑efficient legacy to heirs.

Practical steps to implement

1. Consult an estate‑planning attorney and tax advisor experienced with IDGTs.
2. Draft an irrevocable trust with the appropriate grantor trust provisions.
3. Obtain asset valuations and determine a financing structure (promissory note terms).
4. Document the sale or gift carefully and follow payment terms.
5. Monitor trust administration and tax reporting annually.

Frequently asked questions

Q: Does paying the trust’s income taxes reduce my taxable estate?
A: Yes. When the grantor pays income taxes on trust income from personal funds, those payments are not treated as gifts and reduce the grantor’s net worth, effectively increasing the amount passed to beneficiaries.

Q: Are the assets really excluded from my estate?
A: If the IDGT is properly drafted and the sale or gift is bona fide, the trust assets (and future appreciation) are generally excluded. Improper structure or poor documentation can lead to inclusion.

Q: Is the promissory note included in my estate at death?
A: That depends on facts and structure. A properly negotiated, arm’s‑length note may not be included, but insufficient documentation or non‑market terms increase the risk that tax authorities or courts will include the note in the estate.

Conclusion

An IDGT is a powerful estate‑planning tool for transferring appreciating assets out of an estate while keeping income tax obligations with the grantor. Because of the technical and legal nuances, it should be implemented only with guidance from experienced estate‑planning and tax professionals.