What are IDGTs?
To understand what they are, it helps to have a little background on the dichotomy within the Internal Revenue Code (IRC) between the rules for income taxation and those for federal gift and estate taxation—particularly as they relate to trusts:
An IDGT benefits from the advantages of both types of trusts because it:
How is this legal "sleight of hand" accomplished?
It's achieved by intentionally drafting the trust using language (in accordance with IRC provisions) that contains enough provisions (or "defects") that require the trust to be deemed a revocable trust for income tax purposes, but an irrevocable trust—and a completed transfer—for estate tax purposes.
It’s important to note that the income from an IDGT is taxed to (but not received by) the grantor of the trust—even though the grantor is not a beneficiary of the trust. In addition, the trust assets are not included in the estate of the grantor.
Benefits of an IDGT
Assuming that the grantor (rather than the trust, which does not exist for income tax purposes) uses funds from outside the IDGT to pay the tax liability on income generated by the assets held within it, the balance of the IDGT will be higher than would otherwise be the case with a more "conventional" irrevocable trust.
This has 2 additional benefits:
The establishment of an IDGT should not be undertaken without the close involvement of qualified legal counsel. That's because the choice of language and the practical considerations that go with it (for example, whether the grantor will have the power to substitute assets, or if the grantor’s spouse will be a beneficiary of the trust) are critical to its effectiveness.
Assets can be transferred to an IDGT by a few methods:
By gift or by a part gift and part sale—A grantor can make a gift of assets to the IDGT. If the assets transferred are less than the lifetime gift and estate tax applicable exclusion amount ($11.7 million in 2021, or $23.4 million for a married couple), gift tax would not have to be paid out of pocket, but the applicable exclusion amount would be reduced by the amount of the gift. Often the assets are partially given as gifts and partially sold to the IDGT, to leverage the amount of assets that can be transferred, preserve the exclusion amount, or retain income.
By sale—A sale of assets by a grantor to the IDGT involves the sale at the assets' fair market value in return for a note at a relatively low interest rate. The asset being sold would typically be one with significant potential for price appreciation. The ultimate objective is to remove future price appreciation (above the interest rate specified in the note) from the estate.
Since the trust is purchasing the asset (albeit with a note) for its fair market value, the grantor is not deemed as having made a taxable gift. The trust would make interest payments to the grantor on the note (as would be the case with any sale involving a note). The installment note received by the grantor in return is regarded as full and adequate consideration if the minimum interest rate charged on it is equal to at least the "applicable federal rate" or AFR as determined by IRC Section 1274(d), and all the formalities of a loan are followed. So you can see how critical it is to the success of the strategy to have the assistance of counsel in drafting the note to ensure adherence to all requirements.
Bear in mind, however, that the grantor is effectively making a "bet" that the assets placed in the IDGT will appreciate in value at a faster pace than the AFR rate, with the remainder staying in the trust for the benefit of its beneficiaries. Of course, this is an outcome that cannot be guaranteed in advance.