What is an Intentionally Defective Grantor Trust?
An “Intentionally Defective Grantor Trust” (IDGT) is a tool used for strategic estate planning and income tax purposes. Generally, the grantor funds the trust with appreciated or highly liquid property. Often times, the IDGT beneficiaries are the grantor’s spouse, children, or grandchildren. An IDGT is considered a grantor trust for income tax purposes but is classified as an “irrevocable” trust for estate planning purposes. An “irrevocable” trust avoids or reduces estate tax because the trust assets avoid estate inclusion upon the grantor’s death. Essentially, an IDGT “freezes” the value of the settlor’s assets that are transferred into the trust and the beneficiaries receive a benefit from the appreciation of the property without incurring transfer (estate) tax on the appreciation.
What is a grantor trust?
A trust is considered a grantor trust for income tax purposes when the creator (settlor) retains a “power” over the trust. These “grantor trust powers” may include reacquiring the trust assets (by substituting other property of an equivalent value), borrowing from the trust, and changing or substituting the beneficiary. The tax law treats the grantor like an “owner” of the trust income or principal. Together, the grantor trust and grantor are treated as the same entity as opposed to separate entities, which makes a grantor trust a very beneficial tax planning tool. The grantor is usually in a lower individual tax bracket than the trusts’ bracket, therefore by funding the IDGT with appreciating assets the grantor receives a tax benefit.
Why use a grantor trust?
A grantor trust may be an attractive tax planning tool for the following reasons:
- (1) income taxes paid by the grantor on trust property/income is not taxable income to the beneficiaries;
- (2) the grantor may sell any of the grantor trust property, without recognition of gain or loss for tax purposes;
- (3) the grantor may take trust losses against personal income; and
- (4) a grantor trust can take advantage of the income tax rates that apply to individuals without distributing any trust property to the individual trust beneficiaries.
The grantor trust offers tax benefits and a level of flexibility to the grantor. The grantor has limited ability to control the “beneficial enjoyment” of the trust. Most irrevocable trusts without the “grantor trust provisions” require the grantor to give up all powers with respect to the trust and the trust assets, with no retained interest.
How does an Intentionally “Defective” Grantor Trust work?
Although misleading, the word “defective” is used because the grantor pays the income tax on the trust income and not the beneficiary, yet the trust is irrevocable, and the grantor no longer owns the assets for estate tax purposes. The income tax paid is considered a legal obligation to the grantor and is excluded from the beneficiaries’ income and the grantor avoids any gift-tax. Essentially, the income earned by the trust is earned free of income tax liability. Over time, the trust will grow, and the beneficiaries receive tax-free growth on appreciating assets. Basically, a “tax-free gift.”
Drawback of the Grantor Trust
A grantor could run into a cash flow problem because as the trust grows over time, the grantor may be unwilling, or unable, to continue paying the income tax liability of the trust. A grantor trust is not ideal if the grantor does not have the cash available to pay the tax owed on the trust income. However, a grantor trust may include a provision that grants the trustee the power to reimburse the grantor with trust assets for any income taxes paid on trust income. However, this sort of trust provision could affect the irrevocability for estate planning purposes because any interest retained by the grantor may result in an estate inclusion of that interest.
It is critical for the drafter of an IDGT instrument to be aware of all the exceptions to the grantor trust provisions that could lead to the negative consequence of either losing grantor trust status or causing the trust to be included in the grantor’s estate. If you’d like to discuss the possibility of a grantor trust further, our team is here to help. We may be reached at (786) 837-6787 or via firstname.lastname@example.org
*Disclaimer: This blog post is not intended to be legal advice. We highly recommend speaking to an attorney if you have any legal concerns. Contacting us through our website does not establish an attorney-client relationship.*