INTENTIONALLY DEFECTIVE GRANTOR TRUST (IDGT) – The Basics

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An Intentionally Defective Grantor Trust (IDGT) is an advanced planning strategy referred to as an estate freeze technique that relies on IRS grantor trust rules. A grantor trust is a trust that is not considered a separate taxpayer. The person who created the trust (the “grantor”) is responsible for the income tax generated by the trust assets. An IDGT is usually funded by selling assets to the trust for fair market value in exchange for a promissory note. Since the IDGT is a grantor trust, no capital gains are realized on the sale of the assets to the IDGT. The IDGT and the grantor are considered to be one in the same for income tax purposes.

For estate tax purposes, the value of the promissory note would be included in the grantor’s taxable estate, but the assets themselves and all future appreciation thereon will not be included, as they are legally owned by the IDGT. The result is that the value of the assets is “frozen” at the time of transfer in the form of a promissory note which will not increase in value, whereas the assets in the IDGT may increase in value depending on investment performance.

•  Minimize Estate Tax: An IDGT can be beneficial in the case of assets that are expected to increase significantly in value. These may include a closely-held business, family limited partnership, investment portfolio, or other assets. By “freezing” the assets at their current value in exchange for a promissory note, any future appreciation can be shielded from estate tax.
• Create a Multigenerational Trust: An IDGT can be structured to hold assets in trust for future beneficiaries including children, grandchildren, and other individuals. The grantor has considerable flexibility in specifying how the assets are to be managed and used, and may impose restrictions and guidelines on the beneficiaries’ access to the trust funds.
• Trust Assets Can Effectively Grow Tax-Free: Since the IDGT is a grantor trust, it is not considered to be a separate taxpayer for income tax purposes. In fact, in most cases, an IDGT will not have a separate EIN or file a separate income tax return. All income tax is reported and paid by the grantor under their Social Security Number. While this may seem counterintuitive, this allows the grantor to effectively pay the trust’s income taxes. This results in tax-free growth of the trust for future beneficiaries and additional amounts equal to the income tax paid removed from the grantor’s taxable estate.

• Work with an Attorney to Create the Trust: An IDGT must be carefully drafted in order to keep the trust assets out of the grantor’s taxable estate, while at the same time ensuring that the grantor remains obligated for the payment of the income tax on the trust assets. The planning and drafting of an IDGT or any other advanced estate planning technique should be done by an attorney with specialized knowledge and experience. The trust will also specify how the assets are to be managed for future beneficiaries.
• Value the Assets and Draft the Promissory Note: Since the assets will generally be sold to the IDGT for fair market value, it is essential to accurately determine that value. This may involve engaging a valuation specialist to make this determination in the case of a difficult to value asset such as a closely-held business. An inaccurate valuation may open the door for the IRS to challenge the sale transaction and treat the trust assets as includible in the grantor’s taxable estate. Similarly, the terms of the promissory note should be drafted to minimize the risk that the IRS may seek to treat the note as a retained interest in the transferred assets, which could lead to estate tax inclusion.
• Sell the Assets to the Trust: Once the trust and promissory note are drafted and the assets are properly valued, the grantor will execute any necessary documentation to transfer the assets into the trust. Since the IDGT is not considered to be a separate taxpayer, there will generally be no income tax due on the sale of the assets into the trust. Nor would there be any gift tax implication since the assets were sold for fair market value.