What Is an Intentionally Defective Grantor Trust?

It is a vehicle for tax-free wealth transfer. The term “defective” in IDGT implies that the irrevocable Trust contains similar elements to a revocable trust. For one, all Intentionally Defective Grantor Trusts should include a provision that requires you (the grantor) to continue paying income tax on the Trust until the end of your life.

Meanwhile, the assets you move into the intentionally defective grantor trust are not considered part of your estate. Therefore, that means that the Trust serves to reduce your estate’s size to remove or minimize estate taxes when your heirs and beneficiaries inherit it.

You remain in control.

An intentionally defective grantor trust attorney can help to enforce or set up a trust with these provisions:

• Power to swap assets: If you want, a clause may be included that allows you to reacquire the assets in the IDGT and replace them with assets of equal value.
• Ability to borrow money from or against the Trust: The attorney can create a trust deed that allows the grantor, trustee, or beneficiaries to take loans from the IDGT with minimal interest.
• Power of disposition: If it serves you well to retain the ability to add or remove non-charitable beneficiaries, such a clause can be added to the IDGT deed.

It’s not just the name’s complexity. There are quite a several legal technicalities involved in setting up and enforcing an IDGT. A trust attorney can help grantors, trustees, and beneficiaries create, implement, and use a Trust without incurring undue taxation, fines, and penalties.

How the IDGT works

To start with, you would make a grantor trust, to profit people of your family member and relatives at death. Please note that you cannot name yourself as a beneficiary in this kind of Trust.

The Trust is termed as “defective” for income tax, meaning that you would continue to pay income tax on the assets you put into the IDGT. It is considered “effective” for estate and gift tax, meaning that you will be exempt from these when the assets pass down to the beneficiaries.

Okay, once the IDGT is set up, you sell assets to the Trust in exchange for a promissory note. The note pays you annual interests calculated on its original value and the applicable federal interest rate.

The underlying assets continue to appreciate. After the term of the Trust expires, whatever assets remain are passed over to your named beneficiaries.

The beneficiaries will receive significantly appreciated assets without being burdened by income tax because you have paid for that as a grantor. At the same time, when they inherit the assets, the distribution is free of estate or gift taxes.

 IDGT and Income tax

With an IDGT, where income tax is concerned, you are treated as still the assets owner. That means that an income tax return will be due on income from the Trust.

Even so, when you sell assets to the IDGT, the transaction is exempt from the capital gains task. And your payment of the income tax on the assets is considered a taxable gift to exempt beneficiaries from future income taxes for the Trust.

Estate tax

An intentionally defective grantor trust is exempt from estate tax when the grantor dies. However, certain thresholds are set. The 2020 threshold is $11,580,000 per person.

Gift tax

The assets transferred to an IDGT are exempt from gift tax. However, one is required to use part of the exemption to move resources to an IDGT. Gifts that surpass set thresholds may be taxed at a specified rate.

Generation-skipping transfer

The Trust and its appreciation over the years are exempt from generation-skipping transfer tax if the grantor used the GST exemption to move assets to the Trust.

Selling assets to an Intentionally Defective Grantor Trust (IDGT) allows you to safeguard your wealth and pass it to your beneficiaries with virtually zero taxes. Working with a trust attorney is elemental for the effective creation, enforcement, and utilization of the IDGT.