A Matter of Ingenuity: The Defective Grantor Trust

When the assets of an estate can be expected to appreciate, one tool for preserving the value of those assets is termed the Defective Grantor Trust. It is not only a technique for dealing separately with income tax and estate tax, but also an example of the beneficiaries of an estate receiving the full value available.

Often termed an IDGT, for Intentionally Defective Grantor Trust, is structured to ensure that taxes are paid by the grantor on the income generated by the asset, and yet the assets themselves are in an irrevocable trust and not counted toward the owner’s estate. The IDGT is treated as a grantor trust for income tax purposes and as an irrevocable trust for estate tax purposes.

The aim and result are for the beneficiaries to inherit assets that had been able to grow without reductions for income taxes.

The Full Bequest

The IDGT allows a person to lower their taxable estate via a gifting strategy while transferring assets to beneficiaries.

In such an instance, the assets are not gifted, but rather sold to the trust. In this way, no gift tax is owed, and there is no recognition of a capital gain. If the asset sold to the trust is income-producing, such as a rental property or a business, then that income is taxable to the grantor, but taxes on it do not diminish the value of the eventual bequest.

Granting a Gift

An alternative is for the grantor to gift the assets to the IDGT . In this situation, the fair market value of the gift is applied to the grantor’s estate tax exemption, and the gift tax value is frozen at the time of the transfer. Any further appreciation in asset value accrues to the trust outside the grantor’s estate and its beneficiaries.

Intentionally Defective Grantor Trusts can be funded all at once or through installments. Which approach is most advantageous in any situation depends on every dimension of the estate, from grantor to assets to beneficiaries. As in any estate structure, the answers begin with a thoughtful and considerate professional conversation.