An intentionally defective grantor trust (IDGT) is a useful estate planning tool for a taxpayer who anticipates having a taxable estate, owns assets expected to appreciate, desires to reduce their gross estate, and is willing for the trust income to be taxed to the grantor rather than the trust or its beneficiaries.
In general, taxpayers contribute assets to a trust with the intent of removing the assets and their potential future appreciation from their taxable estate. However, an IDGT is carefully drafted to include provisions designed to exclude trust assets and future appreciation from the grantor’s estate, but intentionally defective to allow the income to be taxed to the grantor as a grantor trust.
These provisions may include certain powers retained by the grantor in the trust agreement, such as the right to substitute property in the trust with other property of equivalent value. It is possible to draft the agreement to later permit the toggling off of the grantor status of the trust.
Grantor trust status can be a desirable option for many reasons, such as:
- The grantor’s estate is further reduced by the income tax payments made, and the IRS has ruled that, under certain circumstances, this payment of the trust’s income taxes is not treated as a gift to the trust.
- Payment of income taxes by the grantor may produce a more favorable tax rate than the compressed rate schedule of a trust, which begins taxing at the top marginal rate of 37% at $13,450 of taxable income.
- The grantor may use trust losses to offset their personal income.
- A grantor trust may be an eligible shareholder of an S corporation.
Rapidly appreciating assets are ideally suited to fund these types of trusts since growth in value is removed from the gross estate.
However, there are trade-offs to consider in an IDGT structure:
- The trust is irrevocable—in other words, a grantor is not able to control or access trust assets.
- Transfers of assets to the IDGT are considered taxable gifts, which could trigger an annual gift tax filing requirement (Form 709) and possible gift tax liability if gifts exceed the annual exclusion and/or lifetime exemption.
- The grantor will pay income taxes on trust income without the corresponding cash flow from the asset.
- Grantor-retained powers needed to treat the trust as a “defective” grantor trust also may cause the trust assets to be included in the grantor’s estate. Careful drafting and coordination by your tax advisors can help mitigate.
- The grantor will incur cost to create and maintain the trust, including legal fees, professional trustee fees (if applicable), and tax advisory fees.
- Property transferred to an IDGT is generally not eligible to receive a step-up in basis upon the grantor’s death. However, the grantor may have the ability to swap assets held inside the trust with other assets of equal value. If so, the grantor may be able to swap or substitute a highly appreciated asset with an asset of equivalent value (and not significantly appreciated) to receive a step-up in the basis of the originally contributed asset.
Assets can be transferred to an IDGT by gift, sale, or by a combination of both:
- The gift of assets to the trust uses the grantor’s lifetime exemption or, otherwise, creates gift tax if the exemption has already been exhausted.
- A grantor could sell the assets to an IDGT in exchange for a promissory note bearing interest at the appropriate applicable federal rate, at a minimum. Since the IRS regards the trust and its grantor as one for federal income tax purposes, transactions between the grantor and the IDGT are ignored for federal income tax purposes, and thus the sale does not cause a taxable event but permits the removal of future appreciation from the grantor’s estate.
- In general, the IDGT will be structured to include both a gift and sale of assets to the trust in exchange for a promissory note. Since the IRS may scrutinize this transaction, the trust is generally seeded with a gift of at least 10 to 15% of the value of the asset to be sold to the IDGT prior to the sale. This “seed money” is a taxable gift.
Planning and appropriately structuring an IDGT requires a competent estate planning team. Depending on the nature of the assets transferred to the trust, the grantor should consider hiring a qualified appraiser to value the gift. A gift would require specialized reporting on the annual Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, prepared by an accountant, and drafting of the trust agreement and related documents requires a competent estate planning attorney.
If you or your family is interested in exploring an IDGT solution or other estate planning options, please contact a Forvis Mazars Private Client professional or submit the Contact Us form below.