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Intentionally defective grantor trusts (IDGTs)

See how an IDGT can potentially yield significant savings on estate taxes.

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:

  • When a trust is set up to be irrevocable, it generally is a tax entity distinct from the grantor who created it, with its own income and deductions (net of distributions paid to beneficiaries) reported on its own income tax return. Assets transferred to an irrevocable trust are generally removed from the grantor’s estate for estate tax purposes, although there are often gift tax implications when funding these trusts.
  • In contrast, a grantor trust is one whose income is taxed to the grantor of the trust rather than the trust itself. In other words, the person funding the trust (i.e., the grantor) is treated as the owner for federal and state income tax purposes. As such, a separate income tax return usually does not have to be filed for the trust, but the assets it holds can potentially be included in the grantor's estate at death. Therefore, it may do nothing to reduce estate taxes. The most common type of grantor trust is a revocable trust, such as a living trust whose primary objective is to avoid the legal process of probate.
  

An IDGT benefits from the advantages of both types of trusts because it:

  1. Retains the character of a grantor trust for income tax purposes (i.e., the income it generates is taxed to the grantor).
  2. Reduces estate tax exposure by removing assets from the grantor's gross estate, just as a transfer to an irrevocable trust would do.
  

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:

  1. Reducing the grantor's taxable estate in an amount equal to the income taxes paid by the grantor.
  2. Helping to preserve the trust by not reducing it with the trust’s payment of the income taxes.
  

Transferring assets

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, 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.

Note

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.

Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

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