What Is an Intentionally Defective Grantor Trust?

An Intentionally Defective Grantor Trust, or IDGT, is an estate planning tool used to transfer wealth to beneficiaries, often children or grandchildren, while minimizing transfer taxes. It is an irrevocable trust, meaning once created, its terms cannot be changed. The “defective” nature of the trust is not an error but a deliberate feature of its design. This intentional defect allows the trust to operate under a unique dual tax identity, which is central to its effectiveness. The purpose of an IDGT is to move assets with high growth potential out of an individual’s estate, “freezing” their value for estate tax purposes and allowing future appreciation to occur within the trust.

The Dual Tax Identity

The effectiveness of an IDGT stems from a deliberate inconsistency in how it is treated by the income tax system and the transfer tax system, which governs estate and gift taxes. The IDGT is structured to be “owned” by the creator for one tax purpose but not for the other. This dual identity is not a loophole but a consequence of specific rules within the Internal Revenue Code.

For income tax purposes, an IDGT is a “grantor trust.” The individual who creates the trust, the grantor, is treated as the owner of the trust’s assets. Consequently, all income, dividends, and capital gains generated by the assets must be reported on the grantor’s personal income tax return. The grantor is personally responsible for paying the income taxes on the trust’s earnings, even though they do not receive the income themselves.

For estate and gift tax purposes, the situation is reversed. The transfer of assets into the IDGT is a “completed gift,” meaning the grantor has relinquished control and ownership of the assets in a way that removes them from their taxable estate. Once the assets are in the trust, they and all their future growth are excluded from the grantor’s estate value. This reduces potential liability from the 40% federal estate tax on assets above the exemption amount.

A benefit of this structure is that the grantor’s annual payment of the trust’s income taxes is not considered an additional gift to the beneficiaries. This allows the assets inside the trust to grow without being diminished by income taxes, a concept sometimes called “tax burn.” This tax-free growth, combined with the removal of the assets from the grantor’s estate, allows for a more substantial transfer of wealth.

Essential Parties and Powers

An IDGT’s operation depends on its legal architecture, which involves three roles: the grantor, the trustee, and the beneficiaries. The grantor is the individual who creates and funds the trust, working with legal counsel to establish its terms and transfer assets into it, initiating the wealth transfer strategy.

The trustee is responsible for managing the trust assets according to the trust document. This role can be filled by an individual or a corporate entity, but selecting an independent trustee is helpful to ensure transactions are respected as legitimate by the IRS. The trustee’s duties include making investment decisions, managing distributions, and handling administrative tasks.

The beneficiaries are the individuals intended to receive the benefit of the trust assets. The grantor designates the beneficiaries and outlines the terms for distributions from the trust’s income or principal. The assets held in the trust are protected for the beneficiaries and are not considered their personal property, which can offer protection from creditors.

The “defective” nature of the trust is created by including specific “powers” in the trust agreement that trigger grantor trust status for income tax. One of the most common provisions is the grantor’s power to substitute assets of equivalent value. This allows the grantor to swap personal assets for trust assets, as long as they are of equal fair market value. This power creates the link for the IRS to deem the grantor the owner for income tax purposes, but because the exchange is for equivalent value, it does not cause the assets to be included in the grantor’s estate.

Information and Decisions for Trust Creation

Before an attorney can draft the documents for an IDGT, the creator must make several foundational decisions. The grantor must formally identify the beneficiaries who will receive the trust assets and select a trustee to manage the trust.

Next, the grantor must decide which specific assets will be transferred to the trust. IDGTs are most effective when funded with assets expected to appreciate significantly, such as stock in a privately held business, real estate, or a growth-oriented investment portfolio. Assets that are not expected to grow, or those with tax-deferred status like retirement accounts, are generally unsuitable for this strategy.

A qualified appraisal for the selected assets is required. An independent, formal valuation by a qualified appraiser establishes the fair market value of the assets at the time they are transferred to the trust. This appraisal serves as the basis for the sale price in the funding transaction and is a key piece of evidence to defend the transaction’s legitimacy if it is ever scrutinized by the IRS. An accurate appraisal ensures the transaction is treated as a bona fide sale for fair value.

The Trust Creation and Funding Process

Once preparatory decisions are made, an estate planning attorney drafts the trust agreement. This legal document is the blueprint for the trust, naming the trustee and beneficiaries and detailing the terms for managing and distributing assets. The attorney will also embed the specific “defective” provisions, like the power of substitution, required to establish grantor trust status.

The most common method for funding an IDGT is through an installment sale. This technique allows the grantor to move high-value assets into the trust without using a large portion of their lifetime gift tax exemption. The process begins with the grantor making an initial “seed” gift of liquid assets to the trust, often equal to at least 10% of the value of the assets to be sold. This gives the trust economic substance and shows the IRS it is a legitimate buyer.

Following the seed gift, the grantor sells the appraised assets to the trust in exchange for a formal promissory note. The note’s principal amount must equal the asset’s appraised fair market value. It will also have a fixed term, such as nine or fifteen years, and must carry an interest rate at least equal to the Applicable Federal Rate (AFR) for the month of the sale.

The AFR is a minimum interest rate published by the IRS, and using it ensures the transaction is not considered a below-market loan, which would have adverse gift tax implications. The trustee will then make regular interest payments to the grantor from the trust’s assets or income. The principal is often paid back in a balloon payment at the end of the term.

Annual Tax and Administrative Duties

After an IDGT is created and funded, the grantor and trustee have ongoing annual responsibilities to maintain the trust’s proper standing. The primary annual duty falls to the grantor. Because the IDGT is a grantor trust for income tax purposes, the grantor is legally obligated to pay the income taxes on all income and capital gains generated by the trust’s assets each year. This payment is made from the grantor’s personal funds, which allows the trust’s assets to grow unencumbered by taxes.

The trustee also has an annual filing requirement. The trust must file an annual informational income tax return with the IRS using Form 1041. This return reports the trust’s financial activities for the year, such as income earned and expenses paid. The form will include a statement indicating that it is a grantor trust and that all tax liability is passed through to the grantor, whose name and Social Security number are provided.