The Intentionally Defective Grantor Trust (“IDGT”) is perhaps the oddest named device in the sophisticated estate planner’s tool kit. In the following article we will define what an IDGT is and why you may want to consider using it for estate planning purposes.
What is an IDGT?
An Intentionally Defective Grantor Trust (IDGT) is an irrevocable trust where the grantor retains certain powers, such as the right to receive trust income, so that the trust is considered “defective”. The IDGT contains a provision (such as the ability in the grantor to substitute property owned by the trust for property of equivalent value) which prevents the trust from being recognized for Federal INCOME TAX purposes. However, the trust is also designed so that transfers to the trust are treated as completed transfers for Federal ESTATE and GIFT TAX purposes.
This result may appear incongruous, but it is a universally recognized result of the difference between the income tax laws and the gift and estate tax laws regarding the recognition of transfers to trusts.
Because transfers to an IDGT are completed gifts for Federal estate and gift tax purposes, lifetime transfers to IDGTs consume the donor’s gift tax exemption. However, since they are completed transfers, the assets and the appreciation on any income earned by the assets are excluded from the transferor’s estate for estate tax purposes.
Further, because the trust is ignored for income tax purposes, the grantor is taxed on the income generated by the assets. This enables the grantor to pay federal income tax on income to which the beneficiaries of the IDGT (generally the children of the grantor) actually receive.
The income taxes decrease the grantor’s estate, and, because the taxes are on income treated as the grantor’s for income tax purposes, they are not treated as gifts for Federal gift tax purposes. This is one of the few instances in which a person can pay the expenses of a non-dependent child without subjecting the transfer to Federal gift taxation.
Another popular use for an IDGT is as a vehicle to purchase appreciating assets. For example, assume that a grantor sold assets worth $1,000,000 to an IDGT which is expected to generate income at 6% per year, for a $1,000,000 promissory note payable with 3% year interest, payable in 20 years. Also assume that the grantor is paying tax at a 33.3% marginal tax rate.
There would be no gift and only the promissory note would be in the Grantor’s estate if he should die within the 20 years, not the increasing value of the assets in the trust.
Assuming all went as planned, at the end of the 20th year, the IDGT would have $3,207,135.47 in assets. It would then pay $1,806,111.23 on the promissory note, leaving it with $1,401.024.24 in assets on which neither gift nor estate tax are imposed.
Further, the grantor would have paid an additional $689,759.55 in tax on the trust’s income, further diminishing the grantor’s estate while directly benefiting the IDGT beneficiaries who will enjoy the income without having to pay the tax associated with that income.
Additionally, there is ample authority for the proposition that the tax basis of assets in the IDGT at the death of the grantor are stepped-up to the date of death value even though not included in the decedent’s estate.
As icing on the cake, an IDGT may be set up so that the grantor authorizes the use of trust income to pay life insurance premiums on the grantor’s or the grantor’s spouse’s life. The benefit is that the life insurance cash value can grow tax deferred. Additionally, the death benefit of life insurance is not taxed to the trust beneficiary, allowing the beneficiary to receive a large lump sum cash payout. In this way, an IDGT may be part of strategic plan to provide for future generations similar to an ILIT.
IDGTs are a sophisticated tax planning device, which are recognized as legitimate tax planning vehicles. However, they also require care in their drafting an implementation. Grantors need to rely upon estate planners with experience and a deep understanding of the intricacies of the IDGT process and related issues.
Eric S. Ratliff, JD, LLM
Ratliff Law Firm
740 Pollard Road
Kodak, TN 37764
(865) 932-3441 x704