What Is an IDGT Trust? An Estate Planning Strategy

An Intentionally Defective Grantor Trust (IDGT) is an advanced estate planning tool used to transfer wealth and minimize taxes. It is an irrevocable trust where assets are removed from the creator’s taxable estate, but the income generated is still taxed to the creator personally. This dual treatment allows assets to grow for beneficiaries free from estate tax.

The creator’s payment of the trust’s income tax further reduces their own taxable estate without being considered an additional gift. This strategy is designed for individuals whose net worth is likely to exceed the federal estate and gift tax exemption. The goal is to “freeze” the value of certain assets for estate tax purposes, allowing future appreciation to benefit the next generation.

Understanding the IDGT Structure

An IDGT involves three primary parties. The Grantor is the individual who establishes and funds the trust. The Beneficiaries are the individuals, often children or grandchildren, who will ultimately receive the trust assets. The Trustee is the person or institution responsible for managing the trust assets and making distributions.

The “defect” that gives the IDGT its name is a provision within the trust document that intentionally triggers the grantor trust rules for income tax purposes. These rules are outlined in Internal Revenue Code (IRC) sections 671-679. A common way to create this defect is by giving the grantor the right to reacquire trust property by substituting other property of equivalent value, a power described in IRC Section 675.

This power establishes the grantor as the owner for income tax purposes without causing the assets to be included in the grantor’s estate for estate tax purposes.

Key Decisions and Asset Selection for an IDGT

Before creating the trust, the grantor must make several foundational decisions. These include selecting a trustee to manage the assets and naming the beneficiaries who will receive them. The grantor also defines the terms of distribution, specifying how and when beneficiaries can access the trust funds.

The most suitable assets for an IDGT are those with a high potential for appreciation, such as interests in a family business, real estate, or growth stocks. By transferring these assets, their future growth occurs within the trust, outside of the grantor’s taxable estate. This freezes the asset’s value for estate tax purposes at the time of the transfer.

A formal, qualified appraisal of the assets is necessary to substantiate their fair market value at the time of the transaction. This independent valuation helps demonstrate to the IRS that the subsequent sale to the trust is for fair consideration, avoiding claims that the transfer was an unintended taxable gift.

To create the trust, the grantor must provide the full legal names, addresses, and tax identification numbers for themselves, the trustee, and all beneficiaries. A detailed description of the assets to be transferred, supported by the appraisal report, is also required to legally transfer ownership.

Executing the IDGT Funding Strategy

Funding an IDGT is a two-step procedure. First, the grantor provides the trust with initial capital, known as a “seed gift.” This is a relatively small, outright gift of cash or other liquid assets made directly to the trust to give it economic substance. This seed gift should be at least 10% of the value of the assets that will be sold to the trust. This transfer is a taxable gift and must be reported on a Form 709, the U.S. Gift Tax Return.

Following the seed gift, the main funding event, an installment sale, occurs. The grantor sells the highly appreciating assets to the IDGT in exchange for a promissory note. This document obligates the trust to pay the grantor back over a specified period. The principal amount of the note equals the appraised fair market value of the assets, ensuring the transaction is a sale, not a gift.

The promissory note must detail the principal amount, the loan term, and the payment schedule. It must also carry an interest rate at least as high as the Applicable Federal Rate (AFR) for the month of the sale. Using the correct AFR is necessary to prevent the loan from being reclassified, which could have adverse gift tax consequences under IRC Section 7872.

The final step is the legal transfer of the assets into the trust’s name. In exchange, the trustee signs the promissory note on behalf of the trust and delivers it to the grantor. Because the IDGT is a grantor trust, this sale is disregarded for income tax purposes per Revenue Ruling 85-13, meaning the grantor does not recognize any capital gain on the sale.

Annual Tax and Trust Administration

After the IDGT is funded, ongoing administrative and tax obligations begin. All income, capital gains, deductions, and credits generated by the trust’s assets must be reported on the grantor’s personal Form 1040. The grantor is responsible for paying any income tax due, which serves as an additional, tax-free transfer of value to the beneficiaries.

The trustee has significant fiduciary responsibilities, including managing the trust’s assets prudently and making investment decisions. A key administrative task is making the required annual payments of interest and principal to the grantor as stipulated in the promissory note. This ensures the installment sale is respected as a legitimate transaction.

The trust itself also has an annual tax filing requirement. The trustee must file a Form 1041, U.S. Income Tax Return for Estates and Trusts. Because all tax items are passed through to the grantor, this return is informational. The Form 1041 will indicate that it is a grantor trust and include an attached statement detailing all income and deductions being reported on the grantor’s personal tax return.