Intentionally Defective Grantor Trust

An Intentionally Defective Grantor Trust (IDGT) takes assets outside the grantor's estate for estate tax purposes but is drafted so that income generated from the trust is taxable to the grantor. An IDGT allows the grantor to gift or sell assets to the trust and any appreciation grows tax free. Payment of income tax by the grantor allows the trust principal to grow and is not considered an additional taxable gift to the beneficiaries.

Instead of using a portion of his or her unified credits and/or estate tax exemption, the grantor can sell assets to the intentionally defective grantor trust in exchange for an interest-bearing promissory note. The grantor must first gift the trust with enough money so that the trust can afford to purchase the grantor's assets. Since the IDGT is a grantor trust, the sale is not a taxable event. The note, if still existent at grantor's death, further reduces the grantor's taxable estate.

An Intentionally Defective Grantor Trust (IDGT) is an advanced estate planning tool used to transfer assets to beneficiaries while allowing the grantor to retain some control over the trust assets for tax purposes. Despite the somewhat confusing name, the "defective" aspect of the trust is intentional and designed to create specific tax advantages.

Here's how an Intentionally Defective Grantor Trust typically works:

1. Creation: The grantor establishes the IDGT and transfers assets into the trust, which can include cash, securities, real estate, or other types of property.
2. Grantor Retained Powers: Despite transferring assets to the trust, the grantor retains certain powers or interests that cause the trust to be treated as "defective" for income tax purposes. Common retained powers include the ability to substitute assets of equal value, the power to borrow from the trust without adequate security, or the power to reacquire trust assets by substituting assets of equivalent value.
3. Tax Treatment: Although the grantor retains some control over the trust assets, the trust is considered irrevocable for estate and gift tax purposes, meaning that the trust assets are typically removed from the grantor's estate for estate tax purposes. However, because the grantor is still treated as the owner of the trust assets for income tax purposes, they are responsible for paying taxes on the trust's income and gains, effectively reducing the grantor's taxable estate without triggering gift tax consequences.
4. Tax-Free Transfers: Because the grantor is responsible for paying taxes on the trust's income, any growth or appreciation in the value of the trust assets can occur outside of the grantor's estate without reducing their lifetime gift tax exemption. This can result in significant tax savings, particularly if the trust assets are expected to appreciate over time.
5. Beneficiary Distributions: The trust can provide for distributions to one or more beneficiaries, typically family members or other loved ones, according to the terms specified in the trust document. These distributions can be made during the grantor's lifetime or after their death, depending on the grantor's wishes and estate planning goals.

Intentionally Defective Grantor Trusts are complex estate planning vehicles that require careful consideration and professional guidance to ensure they are structured properly and aligned with the grantor's objectives. They offer several potential benefits, including estate tax reduction, asset protection, and tax-efficient wealth transfer strategies. 

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For personalized advice on estate planning, including strategies to minimize or avoid probate, contact Will and Trust Planning today. Our experienced estate planning attorneys can help you understand your options, draft essential documents, and create a plan that protects your assets and achieves your goals.