An intentionally defective grantor trust (IDGT) can be a useful part of your estate plan. With an IDGT, beneficiaries inherit property at the value it has at your death, without having to pay estate taxes or taxes on any income the property generated while it was held in trust. Preserving the property and avoiding estate taxes can be a huge benefit for your beneficiaries.
How an IDGT Works
You, as the grantor, place assets into an irrevocable trust, a transaction that can be structured as either a gift or a sale. In a sale, assets are sold to the trust, which then provides you with a promissory note with a low interest rate. The trust pays you interest on the note over the years of the loan, which is income you pay tax on. The trust assets grow at a rate faster than the interest the trust is paying you.
An IDGT is so named because it is set up to have a flaw so that the grantor of the trust continues to be the legal owner of the property, which is the opposite of the purpose of most trusts. As such, the grantor must pay tax on the income from the trust.
The "mistake" the trust contains that makes you liable for income taxes can be:
- A provision that names your spouse as a trustee who can add beneficiaries
- A section that allows you to take back or swap out assets into the trust
- Authorization for a trustee to give you loans from the trust without security
- A clause that allows the trust to use its income to pay for your or your spouse's life insurance
Taxes and IDGTs
There are several types of taxes to consider with IDGTs:
Estate tax. Because assets belong to the trust and not your estate, estate taxes do not apply to them—a benefit for your overall estate. Estate taxes start at 40 percent, so avoiding this tax is a huge savings.
Income tax. The trust is created with an intentional "mistake" that ensures that you as the grantor are seen as the owner/controller in the eyes of the Internal Revenue Service (IRS). You continue to pay tax on income the trust generates, as well as income tax on the interest you are paid if there is a promissory note. There is no capital gains tax on the sale of the asset to the trust.
Gift tax. When you gift an asset to an IDGT, it is subject to gift tax, which is calculated using the value of the asset at the time of the transfer. The asset remains in the trust and continues to appreciate in value, but none of that appreciation is taxable.
Generation-skipping tax. An IDGT allows you to avoid the generation-skipping tax, which is an additional estate tax that applies when you leave assets to grandchildren or great-nieces and -nephews.
An IDGT is generally created to pass assets to children or grandchildren. You choose the beneficiaries of the trust, who then receive the trust assets after you pass. Estate taxes don't apply to the trust assets, helping to preserve the value of your estate, although you as the grantor pay income tax on them. Income tax is taxed at a far lower rate than estate taxes, making this an enormous benefit for your beneficiaries. Income taxes also apply only to the actual income of the trust, not its principal, whereas estate tax applies to the principal. Your beneficiaries receive the asset at its value at your death without any taxes applied to it.
For example, you own a building worth $6 million that you place in a trust and whose value continues to rise over the years. When you pass away, the building's value is now $9 million. When your beneficiaries receive the building, neither they nor your estate pay any taxes on that $9 million. In comparison, if you'd kept the building and it passed to them via a will and probate, estate taxes of at least 40 percent of its value would apply, reducing the amount of the overall estate, meaning your beneficiaries would inherit less. Because you placed the building in a trust, the income taxes you paid over the years on the income from the property are far less than the amount of estate taxes that would be owed on the full value of the property.
Creating an IDGT is a very complex process, so it is important that you work with an attorney or an online service provider to set one up. This type of trust is one way to transfer assets to your heirs while reducing your estate tax and preserving the value of the asset for the heirs.