What Is an Intentionally Defective Grantor Trust?

An Intentionally Defective Grantor Trust (IDGT) is an irrevocable trust used to transfer appreciating assets to beneficiaries, like children, while reducing potential estate and gift taxes. The trust is structured to remove these assets from the grantor’s taxable estate, allowing their value to grow for the next generation without being subject to estate tax.

Core Mechanics of an IDGT

An IDGT’s effectiveness stems from its unique treatment under federal tax law. For estate and gift tax purposes, the trust is a separate legal entity, and assets transferred to it are removed from the grantor’s taxable estate. This means the assets and any future appreciation are not subject to estate tax upon the grantor’s death.

Simultaneously, the trust is “defective” for income tax purposes and is disregarded as a separate entity. The IRS views the grantor as the owner of the trust’s assets, so all income is reported on the grantor’s personal tax return. The grantor, not the trust, is liable for any income taxes due.

Because the grantor pays the income taxes, the trust’s assets can grow without being diminished by these annual payments. According to Revenue Ruling 2004-64, this payment is not a taxable gift to the beneficiaries. This arrangement allows the grantor to make an additional, tax-free transfer to the trust each year, further reducing their taxable estate.

Establishing the Defective Nature

The “defective” status is a deliberate feature created by including specific powers in the trust document, selected from Internal Revenue Code sections 671 through 679. These powers trigger grantor trust status for income tax purposes without causing the assets to be included in the grantor’s estate for estate tax purposes.

One common provision is the grantor’s power to substitute assets of equivalent value, as outlined in IRC Section 675. This allows the grantor, in a non-fiduciary capacity, to reacquire trust property by swapping it with other property of equal fair market value. Revenue Ruling 2008-22 confirms this power creates the defect for income tax but does not cause estate tax inclusion.

Another power used is granting the grantor the ability to borrow from the trust without providing adequate security. Other options include giving a non-adverse trustee the authority to add beneficiaries. Each power must be drafted to invoke the grantor trust rules for income tax but not give the grantor enough control to cause estate inclusion under rules like IRC Section 2036.

Funding and Operating the Trust

After an IDGT is established, it is funded, often through an installment sale to minimize gift tax consequences. The process begins with the grantor making an initial gift to the trust, known as “seed money.” This contribution, recommended to be at least 10% of the value of the asset being sold, gives the trust economic substance.

Next, the grantor sells a valuable, appreciating asset, such as business stock or real estate, to the IDGT. Because the IDGT is a grantor trust, the IRS views this as a sale from the grantor to themselves. Under Revenue Ruling 85-13, no capital gains tax is triggered on this sale.

In exchange for the asset, the trust issues a promissory note to the grantor. To be treated as a legitimate sale, the note must carry an interest rate at least equal to the Applicable Federal Rate (AFR) for that month, a rate published by the IRS under IRC Section 1274.

The trust makes periodic payments to the grantor over the note’s term. The benefit of this structure is that any appreciation in the asset’s value above the fixed AFR interest rate accrues to the trust beneficiaries, free of future estate or gift tax.

Tax Reporting for the Grantor

Because the IDGT is disregarded for income tax purposes, the grantor is treated as the owner of its assets for all income tax matters. The grantor must report all income, deductions, and credits from the trust on their individual income tax return, Form 1040. The trust’s financial activity is consolidated with the grantor’s personal tax items.

To facilitate this, the trustee provides the grantor with a “grantor tax letter” each year. This letter summarizes the trust’s taxable events, such as interest, dividends, and capital gains. The grantor uses this information to complete their Form 1040.

A grantor trust is often not required to file its own separate income tax return, Form 1041. Alternatively, the trustee can file an informational Form 1041. This return is mostly blank but includes an attachment stating that all tax items are reported on the grantor’s personal return.