What Is an Intentionally Defective Grantor Trust?
An intentionally defective grantor (IDGT) trustis an estate-planning tool used to freeze certain assets of an individual for estate tax purposes but not for income tax purposes. The intentionally defective trust is created as a grantor trust with a loophole that allows the them to receive income from certain trust assets.
The grantor pays income tax on any generated income, but the estate does not incur any estate taxes when the grantor dies.
Key Takeaways
- An intentionally defective grantor trust (IDGT) allows a person to isolate certain trust assets to segregate income tax from estate tax treatment.
- It is effectively a grantor trust with a purposeful flaw that ensures the individual continues to pay income taxes.
- IDGTs are most often utilized when the trust beneficiaries are children or grandchildren where the grantor has paid income tax on the growth of assets they will inherit.
Understanding Intentionally Defective Grantor Trusts
Grantor trust rules outline certain conditions when an irrevocable trust can receive some of the same treatments as a revocable trust bythe Internal Revenue Service (IRS). These situations sometimes lead to the creation of what are known as intentionally defective grantor trusts.
In these cases, a grantorisresponsible for paying taxes on the trust's income, but trust assets are not counted toward the owner'sestate. However, such assets would apply to a grantor's estate if the individual runs a revocable trust because the individual would effectively still own the property.
Estate Taxes
For estate tax purposes, the value of the grantor's estate is reduced by the amount of the asset transfer. The individual will "sell" assets to the trust in exchange for a promissory note—also called an installment note—of some length, such as 10 or 15 years.
The note will pay enough interest to classify the trust as above-market, but the underlying assets are expected to appreciate at a faster rate.
Beneficiaries
The beneficiariesof IDGTs are typically children or grandchildren who will receive assets that have been able to grow without reductions for income taxes, which the grantor has paid.
he IDGT can be an effective estate-planning tool if appropriately structured, allowing a person to lower theirtaxable estate while gifting assets to beneficiaries at a locked-in value.
The trust's grantorcan also reduce their taxable estate by paying income taxes on the trust assets, essentially gifting extra wealth to beneficiaries.
Due to the complexity, an IDGT should be structured with the assistance of a qualified accountant, certified financial planner (CFP), or anestate-planning attorney.
Selling Assets to an Intentionally Defective Grantor Trust
The structure of an IDGT allows the grantor to transfer assets to the trust either by gift or sale. Gifting an asset to an IDGT could trigger a gift tax, so the better alternative would be to sell the asset to the trust. When assets are sold to an IDGT, there is no recognition of a capital gain, which means no taxes are owed.
This is ideal for removing highly appreciated assets from the estate. In most cases, the transaction is structured as a sale to the trust, to be paid for in the form of an installment note, payable over several years. The grantor receiving the loan payments can charge alow rate of interest, which is not recognized as taxable interestincome.
However, the grantor is liable for any income the IDGT earns. If the asset sold to the trust is income-producing, such as a rental property or a business, the income generated inside the trust is taxable to the grantor.
Frequently Asked Questions
What Makes a Grantor Trust Intentionally Defective?
Intentionally defective refers to the fact that the grantor no longer owns the assets in the trust—they are removed from the estate—but still pays income taxes on any income earned from the assets in the trust.
How Are Intentionally Defective Grantor Trusts Taxed?
IDGTs are not taxed when assets are sold into them or if they appreciate because there is no recognition of capital gains. However, the grantor pays income taxes if there is income from the IDGT.
What Happens to an Intentionally Defective Grantor Trust When the Grantor Dies?
If there was an installment note, the principal and any accumulated interest are included in the grantor's taxable estate. However, if the assets were sold into the IDGT, they are not included in the taxable estate and can be passed on to the beneficiaries.
The intentionally defective grantor trust (IDGT) is a sophisticated estate planning tool that involves creating a trust with a deliberate flaw, allowing the grantor to segregate income tax from estate tax treatment. I can break down the various concepts intertwined in this article for a comprehensive understanding.
Intentionally Defective Grantor Trust (IDGT)
- Purpose: To freeze certain assets for estate tax purposes while not affecting income tax.
- Grantor's Role: The grantor sets up the trust and continues to pay income tax on generated income, but the estate avoids estate taxes upon the grantor's demise.
- Beneficiaries: Typically children or grandchildren, allowing assets to grow without income tax reduction for the inheriting beneficiaries.
Grantor Trust Rules
- IRS Treatment: Certain conditions allow an irrevocable trust to receive similar treatment to a revocable trust concerning taxes.
- Intentional Defect: The trust, though irrevocable, has a flaw that designates the grantor as responsible for income taxes while excluding trust assets from the grantor's estate.
Estate Taxes and Asset Transfer
- Asset Transfer: The grantor "sells" assets to the trust via a promissory note, reducing the value of the estate for tax purposes.
- Appreciation vs. Interest: Assets are expected to appreciate faster than the interest paid on the promissory note, reducing the estate's value.
Selling Assets to the Trust
- Gifting vs. Selling: Preferable to sell assets to avoid triggering gift taxes.
- Capital Gain and Taxes: Selling assets to the trust avoids recognition of capital gains and related taxes.
Taxation and Grantor's Liability
- Income Tax Responsibility: The grantor is liable for any income the trust earns.
- Taxable Income in Trust: Income generated within the trust, especially from income-producing assets, is taxable to the grantor.
End of Grantor's Life and Trust Handling
- Installment Note and Estate: If there's an installment note, the principal and accumulated interest are part of the grantor's taxable estate.
- Assets Sold into IDGT: If assets were sold into the IDGT, they aren't included in the taxable estate, passing on to beneficiaries.
FAQ:
- Defect Explanation: The grantor doesn't own trust assets but pays income tax on earned income.
- Taxation of IDGTs: No taxes upon asset transfer or appreciation, but the grantor pays income tax on trust income.
- IDGT After Grantor's Death: Treatment depends on whether there's an installment note or assets were sold into the trust.
Creating an IDGT requires intricate structuring and expertise, usually involving professionals like accountants, financial planners, or estate-planning attorneys due to its complexity.
