What Is an Intentionally Defective Grantor Trust?

An Intentionally Defective Grantor Trust (IDGT) is an irrevocable trust created by a grantor to transfer assets to beneficiaries. The purpose of an IDGT is to separate the treatment of the trust’s assets for estate tax purposes from their treatment for income tax purposes. This allows the assets to be removed from the grantor’s taxable estate, while the grantor remains responsible for paying the income taxes generated by those assets. This dual classification is a method for transferring wealth that is effective for assets expected to appreciate significantly.

Core Concepts of an Intentionally Defective Grantor Trust

For income tax purposes, an IDGT is a “grantor trust.” The IRS disregards the trust as a separate entity and treats the grantor as the owner of its assets. Consequently, all income, gains, and deductions are reported on the grantor’s personal income tax return, and the grantor is liable for any resulting tax.

For federal estate and gift tax purposes, the IDGT is an irrevocable trust. When the grantor transfers assets to the trust, it is a completed gift that removes the assets and their future appreciation from the grantor’s gross estate. This can reduce potential estate tax liability. For 2025, the federal estate tax exemption is $13.99 million per individual, but this amount is scheduled to decrease significantly in 2026 if Congress does not act.

The term “intentionally defective” comes from this structure. The trust is “defective” for income tax because the grantor retains certain powers that trigger the grantor trust rules. These powers are carefully selected so they do not cause the trust’s assets to be included in the grantor’s estate. A common power is the power of substitution, which allows the grantor to reacquire trust property by substituting other property of equivalent value. Another provision is granting a nonadverse party the power to add beneficiaries.

This structure provides another advantage. When the grantor pays the income taxes on the trust’s earnings, they are making an additional, tax-free gift to the beneficiaries. The trust’s assets can grow without being diminished by income taxes, enhancing the wealth passed to the next generation.

Key Components and Decisions for Creation

The grantor is the individual who creates and funds the trust. This person must irrevocably part with the assets transferred, understanding they will be removed from their estate while they remain responsible for the income taxes.

The trustee is responsible for managing the trust assets. The grantor should not serve as the trustee to ensure the assets are not included in the grantor’s estate. An independent trustee, such as a financial institution or a trusted professional, is chosen to manage the trust and its fiduciary duties.

The beneficiaries are the individuals designated to receive the benefits of the trust assets, such as the grantor’s children or grandchildren. The grantor must define the beneficiaries and the terms under which they will receive distributions.

Before drafting the trust, the grantor must choose a specific power to include that creates the “defect” for income tax purposes, such as the power to borrow from the trust without adequate security. This decision is made with an estate planning attorney and is written into the trust agreement. The agreement details the grantor’s intentions, the trustee’s responsibilities, beneficiary rights, and the provision that establishes its grantor trust status.

Funding the Trust Through an Installment Sale

A common method for funding an IDGT is through an installment sale, which minimizes the use of the grantor’s lifetime gift tax exemption. The process begins with the grantor making an initial “seeding” gift of cash or other assets to the trust. This seed money should be at least 10% of the value of the assets that will be sold to the trust. This gift uses a portion of the grantor’s lifetime gift tax exemption and requires filing a gift tax return.

Next, a formal, independent appraisal of the assets to be sold is required to establish their fair market value. The IRS requires the sale from the grantor to the trust be for adequate consideration to avoid being re-characterized as a partial gift. A qualified appraisal provides the necessary documentation to support the sale price.

With the valuation established, the trust purchases the assets from the grantor in exchange for a promissory note. This note is a formal debt instrument that obligates the trust to pay the grantor back over a specified period. The interest rate on the note must be at least the Applicable Federal Rate (AFR) for the month of the sale to ensure the transaction is viewed as a legitimate sale.

Because the IDGT is a grantor trust, the sale is a non-event for income tax purposes. The IRS views it as the grantor selling an asset to themselves, so no capital gains tax is triggered on the sale. This allows highly appreciated assets to be transferred into the trust without immediate tax consequences.

Tax Treatment and Reporting Obligations

The primary tax responsibility falls on the grantor. All income, deductions, and credits from the trust’s assets must be reported on the grantor’s personal income tax return, Form 1040. The grantor is personally liable for paying any income tax due on the trust’s earnings.

The trustee must file an annual informational income tax return, IRS Form 1041. For a grantor trust, this return indicates it is a grantor trust and includes an attached statement. This statement details the items of income and deduction, noting they are reported on the grantor’s personal tax return.

The sale of assets to the trust is not a reportable gift, provided the sale price equals the asset’s fair market value and the note carries an interest rate at least equal to the AFR. Some practitioners advise reporting the sale on Form 709 as a non-gift transaction. This can start the statute of limitations for the IRS to challenge the valuation of the assets sold.

Trust Administration Upon Major Events

When the trust repays the promissory note to the grantor, the installment sale is complete. The assets are then owned entirely by the trust, free of the debt obligation. These assets can continue to appreciate for the beneficiaries, outside of the grantor’s taxable estate.

The death of the grantor is a transformative event for the IDGT. Upon the grantor’s death, the powers that made the trust “defective” for income tax purposes cease. This cures the defect, and the trust becomes a separate tax-paying entity that files its own Form 1041.

If the grantor dies before the promissory note is fully paid, the outstanding balance of the note is included in the grantor’s gross estate. The value of the note at the date of death, including any accrued but unpaid interest, becomes an asset of the estate and is subject to estate tax. The assets within the trust, however, remain outside of the grantor’s taxable estate.