An intentionally defective grantor trust, or IDGT, is a way of shifting tax burdens for very wealthy households. With this structure, you can create a trust that leaves wealth to your heirs while minimizing gift, estate and income tax liability. Find out how the IDGT works and what tax advantages may exist if you decide to create one. A financial advisor can walk you through all of the ins and outs of each type of trust and help you determine the right financial strategy to use the IDGT or another type that may be more beneficial.
What Is an Intentionally Defective Grantor Trust?
An intentionally defective grantor trust (“IDGT”) is a form of trust that’s used for managing estate and gift taxes. It’s most useful for assets that generate significant revenues over time, for example, high-yield investments and real estate.
It is potentially least helpful for low-yield, high-appreciation assets. Estate law lets you step up the tax basis of assets that you leave to your heirs through inheritance law, helping them to reduce capital gains taxes. An intentionally defective grantor trust generally does not allow you to do this, minimizing estate taxes while potentially maximizing capital gains liability.
To establish an IDGT, you create an irrevocable trust, meaning that you cannot rescind or change the trust once it’s been created. Legally, the trust becomes a third party. Any assets you put into this trust no longer count as part of your household or estate for tax purposes, but you also cannot access those assets for your own use.
You then make that trust legally defective by including language in the trust agreement that reserves the right for you to access or use its assets in some way. Most people do this by retaining the right to swap assets in the trust for assets of equal value that they own, but any rights to access or use the trust’s assets will generally do.
The result is a trust with mixed legal status. You effectively surrender control over its assets, so the trust’s beneficiaries can receive their distributions tax-free. However, you technically retain some control over your assets, so the IRS considers you the owner for income tax purposes.
Tax Advantages of an Intentionally Defective Grantor Trust
An IDGT is used for estate and gift tax planning. It’s important to note that these trusts are generally only relevant to wealthy households. As of 2022, you can leave up to $12.06/$24.12 million single/married to your heirs tax-free. The same limits apply to gifts, meaning that an individual could leave another individual more than $24 million in combined inheritance and gifts before taxes apply.
However, for households with particularly high net worth, an intentionally defective grantor trust has two major tax benefits:
Estate and Gift Taxes
Anything you put into an irrevocable trust is eliminated from your household wealth. It formally belongs to the trust now, not you. When you die, this means that the size of your estate has been reduced by that same amount.
This is often used as a form of estate planning. When you create a trust you name its beneficiaries, who will receive the trust’s assets based on your instructions. Since this isn’t part of your estate, trust distributions don’t trigger estate taxes. Since you already paid income taxes on the trust’s principal, its beneficiaries don’t pay taxes either.
For example, say that you put a house worth $500,000 into an IDGT. You will have reduced the size of your estate by that amount, which in turn reduces any potential estate tax liability for your heirs. Instead, your heirs can receive the property as beneficiaries under the trust. They won’t pay income taxes on the $500,000 value of the property because, as far as the IRS is concerned, you already paid those taxes before putting the property in the trust. Depending on the size of your estate, this might allow you to pass on your house without making your heirs pay taxes on its value.
Ordinarily, when you create an irrevocable trust the trust entity itself pays its own taxes. This means that if assets in the trust generate income or capital gains, money in the trust is used to pay any resulting taxes. The trouble is that this reduces the total amount that you can leave to your heirs since the trust’s value is reduced by those tax payments.
This is the particular value of an intentionally defective grantor trust. By making your trust defective you have retained enough control over it that, in the eyes of the IRS, you still technically own its assets. This means that you, not the trust, pay any income taxes that the trust generates.
For example, say that you create a trust and put a stock portfolio into it. In a given year, dividends from those stocks lead to $20,000 worth of income taxes. Ordinarily, that money would come from the trust itself. However, with an IDGT, you pay that tax bill. This preserves the value of the trust and effectively increases its value for the beneficiaries by $20,000.
The income tax structure of an IDGT allows you to effectively give a second tax-free benefit to your heirs. Every time you pay the trust’s taxes, it’s functionally an untaxed windfall for your heirs since they will now receive that money tax-free upon distribution.
Limits of an Intentionally Defective Grantor Trust
The intentionally defective grantor trust can carry some great benefits but it isn’t for everyone. In fact, there are three main limits to an IDGT that could prevent you from moving forward, depending on what your financial situation and estate planning look like. The three main limits are:
1. Grantor Limitations
There are two ways that you can put assets into an IDGT.
First, you can put assets into the trust as a gift. If you do this you have to stay within gift tax limits. In 2022, this means that you can put up to $12.06 million worth of assets into the trust over the course of your lifetime, plus an additional $16,000 per year. If you gift more than this, you will trigger gift taxes.
Second, you can “sell” assets to the IDGT. The specifics of selling assets to a trust are beyond the scope of this article, however in general you will put assets into the trust and receive a promissory note in exchange. This note generally promises that the trust will pay you an amount of money and/or a rate of interest for transferring your assets into the trust. This allows you to move those assets into the trust without it technically counting as a gift, although readers will correctly note the seeming oddity of selling assets and receiving payment with what is effectively your own money.
2. Capital Gains Growth
An IDGT is a good way to save your heirs and grantees from paying taxes on the principal of any assets you give them. It also can save them taxes on any income those assets generate. However, there is some confusion as to capital gains issues, which creates a significant limitation on an IDGT.
When a trust’s beneficiaries receive assets from the trust, they don’t owe taxes based on the value of those assets when you placed them in trust. However, they may owe taxes based on the value of those assets today. This is known as the asset’s tax basis.
For example, say you put a house worth $500,000 into an IDGT. Years later, when your beneficiary receives the house, it is worth $600,000. The nature of the trust keeps them from having to pay taxes on the first $500,000 of the house’s value. However, if they sell the house, they may owe taxes on the $100,000 in appreciation.
Your beneficiaries will absolutely owe taxes on this appreciation if you gifted the assets to the trust. This is known as a “carryover basis.” However, there is some confusion as to how the IRS evaluates an asset’s tax basis if you sell the asset into an IDGT. In this case, be sure to discuss the capital gains implications of any distribution before you make it.
3. You Still Pay Taxes
This is a straightforward issue, but it’s still worth noting: You have to pay the taxes on any income this trust generates. Now, if you have sold assets to the trust, you can use the proceeds of this sale to pay the trust’s taxes. Regardless of the IDGT’s structure, though, you need to budget for these taxes, because they can be a very real expense depending on the assets in your trust.
The Bottom Line
An intentionally defective grantor trust is a form of trust which lets you reduce estate, gift and income taxes on money that you want to leave to your heirs. It can get complicated and isn’t always the right option, but for wealthy households, it’s a potentially powerful tool. The question is whether this is the right trust for your financial situation, which can best be answered by a financial advisor.
Tips for Creating Trusts
- Utilizing trusts in your estate plan can be great, but only if you’re using the right trusts in the right way. A financial advisor can help you figure out the best trusts to use for your personal situation and make sure they are created correctly. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Trusts are one of the most flexible ways to give money or leave money without triggering a tax event. The key is, though, that they come in many different forms. Reading up on the types of trusts will be beneficial to see how each may help your situation.
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