Why Would I Create a Defective Trust Intentionally?
If your estate contains substantial assets, you should consider minimizing federal estate and gift taxes in your estate planning. It may seem counter-intuitive but an Intentionally deficient grantor trust (IDGT) is a useful advanced estate planning tool. This irrevocable Trust is designed to strategically reduce tax liabilities while transferring wealth to your family during your lifetime. The purpose of an Intentionally Defective Grantor Trust is to benefit the spouse, children or other descendants of the Grantor (person who created the trust). Its primary goal is to remove the assets placed in the trust from the Grantor’s taxable estate which helps to protect the assets from estate taxes after the Grantor’s death while allowing the trust’s assets to appreciate over time without additional taxation.What makes an IDGT unique, however, is the ability to freeze its assets for estate tax purposes while keeping the Grantor liable for income taxes generated by those assets. The trust takes advantage of this loophole by using provisions in the Internal Revenue Code that label the trust “defective” when it comes to income tax. The result is that the trust’s assets can grow free of gift taxes while avoiding inclusion in the Grantor’s estate for estate tax purposes.What Makes a Trust “Defective”?
The “defective” part of an IDGT arises from specific provisions in the IRC (sections 671-679). These provisions ensure that, while assets are treated separately from the Grantor in estate tax purposes they are not treated separately for income tax purposes. This setup creates an unusual but beneficial scenario wherein the Grantor continues to pay income tax on the trust’s earnings, further reducing the Grantor’s taxable estate without reducing the value of the trust’s assets for the beneficiaries.
To function as intended, the trust must be carefully drafted to include the right provisions. Likewise, it should avoid provisions that might accidentally nullify Grantor trust status and bring trust assets back to the Grantor’s Estate. The Trustee, typically an independent third party, is also vital in ensuring the trust operates correctly.
Funding an Intentionally Defective Grantor Trust
An IDGT can be funded in one of two primary ways, either through a completed gift or via an installment sale. A completed gift is the most common way to fund an IDGT. In this situation, the Grantor transfers assets that appreciate, such as real estate, stocks, or business interests into the trust in the form of an irrevocable transfer. This strategy is very effective, but you must be aware of the gift tax rules. Any gift exceeding the annual gift tax exclusion amount ($19,000 per recipient for 2025) will be subject to federal gift tax and may reduce your lifetime exemption; however, the potential tax savings from future appreciation often outweigh the upfront cost of exceeding the exclusion limit.
Another way to fund an IDGT is through an installment sale. In this scenario, a Grantor sells assets in exchange for a promissory notes. The note requires the trust to make periodic interest-bearing payment to the Grantor. This strategy allows the Grantor a steady income stream from the installments while transferring future appreciation to the beneficiaries of the trust. As long as the value of the assets sold matches the value of the promissory note, there is no immediate gift tax liability.
Should I Include an Intentionally Defective Grantor Trust in My Estate Plan?
An IDGT is a powerful estate planning tool, but it requires precise drafting and careful administration to work as intended. Join us for a FREE seminar to learn more about whether an Intentionally-Defective Grantor trust would benefit your estate plan. If you think that an Intentionally-Defective Grantor Trust could benefit your estate plan, please contact the Indianapolis trust attorneys at
Frank & Kraft
or call
(317)684-1100
for an appointment. Read More!
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