What is an intentionally defective grantor trust?

An Intentionally Defective Grantor Trust (IGDT) is an estate planning tool often used by estate tax planners who are attempting to freeze the value of an asset for estate tax purposes. Generally, when an irrevocable trust is created, the value of the assets transferred is removed from the grantor’s gross estate on the date of the trust’s funding, thus it is removed from the estate tax inclusion. Since IGDT’s are considered irrevocable trusts for estate and gift purposes, the future value of the assets is not included in estate tax. However, because the grantor does retain certain powers over the trust, the grantor will be taxed on all the trust’s income. The goal of an IGDT is to “freeze” the asset from the estate, therefore assets that are either depressed in value and/or are expected appreciate substantially should be selected for sale to the trust.

An IGDT can be an excellent tool for estate planning and wealth transfer. IGDT’s can be beneficial because: (1) the sale between the grantor and the trust are not recognized as income tax, therefore the sale of the asset to the trust will not be taxed; (2) the transfer is treated as a sale and therefore will not be treated as making a taxable gift; and (3) the value of the asset will be frozen for estate tax purposes, lowering the taxable amount of the estate.[1]

While these are a few of the benefits of having grantor trust status, there are some disadvantages of grantor trust status that must be carefully considered before this type of trust is created. The most obvious disadvantage to grantor trust status is the possibility that the grantor will not have enough cash to cover the taxes on the trust income.

An IGDT generally is created by the sale of specific assets to a grantor trust. An IDGT can be created when the grantor sells assets to a grantor trust in exchange for a promissory note of some length (usually 10 or 15 years) payable by the trust. When the sale occurs, the grantor becomes the “owner” of all trust property and any income received by the trust will be included in federal income tax that the grantor must pay, but the sale itself will be ignored for federal income tax purposes and no gain or loss on the sale is recognized.[2] The note will have required interest payments, and the installment note will be treated as full and adequate consideration if the minimum interest rate charged on the installment note is at least the applicable federal rate and all of the formalities of a loan are followed. When the end of the term of the note occurs, the note can either be repaid or refinanced. Since currently there is a low interest rate environment, it is the goal that the assets within the trust will appreciate faster than the AFR rate on the note, with the remainder staying in the trust for the benefit of the beneficiaries.[3]

[1] Alistair M. Nevius, Intentionally Defective Grantor Trusts, Oct. 31, 2008, J. of Accountancy

[2] IRC § 671

[3] Rob Clarefeld, Estate and Gift Tax Considerations for 2012: IGDTs-And you Must Act Now!, February 22, 2012, Forbes.com

Michael Hepworth

Michael Hepworth

Managing Attorney at Hepworth & Associates
Michael is the Managing Attorney of Hepworth & Associates, LLC.
Michael Hepworth

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Lauren

4 years ago

Thanks for the explanation of the IGDT. It is good to know the benefits as well as the disadvantages.

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