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Intentionally Defective Grantor Trusts & Your Estate Plan - What You Need to Know

What is an intentionally defective grantor trust? And how do you create one for your estate plan? This article details the ins and outs of IDGTs.

Patrick Hicks

Patrick Hicks, @PatrickHicks

Head of Legal, Trust & Will

An Intentionally Defective Grantor Trust (IDGT) can be an effective Estate Planning tool if you’re looking for a way to minimize estate taxes for your beneficiaries. An IDGT may be a great way for you to transfer the most wealth possible to the heirs you’ll leave your estate to. How?  

The name may be confusing, but at the heart of an IDGT is the simple fact that it allows you (the Grantor) to set up an Irrevocable Trust and pay income tax throughout your life. This effectively minimizes tax consequences for your loved ones, so they eventually receive a larger inheritance. 

Learn the ins and outs of an IDGT and its many advantages, including how you can potentially limit a large portion of tax liability that may otherwise become a burden to your loved ones. 

What is an Intentionally Defective Grantor Trust? 

An Intentionally Defective Grantor Trust is an Estate Planning tactic that lets you isolate or freeze some of your assets within your estate for estate tax purposes. This Irrevocable Trust is most often for beneficiaries like a spouse, a child(ren) or grandchild(ren). 

An IDGT is different from a regular Trust in that it essentially creates a loophole, so you can continue paying income taxes on the Trust assets while you’re living. Since income tax is paid every year, the assets continue to grow tax-free, resulting in drastically reduced tax exposure for your beneficiaries when they inherit.  

What is the Purpose of an Intentionally Defective Grantor Trust?

The purpose of an Intentionally Defective Grantor Trust is to be able to take advantage of the Trust’s tax loophole for financial gain. The loophole (that was intentionally created, as the name suggests) allows you to offset estate taxes that could dip into the value of your estate, reducing what your heirs inherit. 

Instead, you can separate high-earning assets into an IDGT and pay income taxes on those earnings along the way, substantially eliminating a portion of the estate tax liability in the future.

To learn about other types of Trusts, check out our article An In-Depth Look at the Different Types of Trusts.

What is an Intentionally Defective Irrevocable Trust?

An Intentionally Defective Irrevocable Trust (IDIT) is just another name for an Intentionally Defective Grantor Trust. Both are irrevocable, and both are created for gift and estate tax benefits. These Trusts are powerful tools that can offer steep tax benefits.

How to Fund an Intentionally Defective Grantor Trust?

Funding an IDGT is not hard. There are two ways you can go about it. You can either make what’s known as a Completed Gift, or you can use what’s referred to as an Installment Sale.

If you decide to make a Completed Gift, which is a common way to fund your IDGT, you simply need to decide which assets will be held in the Trust. Then, you just make an irrevocable gift to it. To get the most benefit out of this, you should select assets with the greatest opportunity to appreciate. This way, as the income grows, you’re paying taxes throughout the years. 

**Note that there are annual exclusions which the gift cannot exceed - depending on the size of asset(s) you’ll use to fund the IDGT, an alternative might be to use the Installment Sale, which can avoid triggering a gift tax. 

You can also choose to use an Installment Sale, which as mentioned can avoid gift tax implications. After selling any appreciating assets to the IDGT, you’ll get an interest-bearing promissory note that’s payable by the Trust. The payoff here comes in the form of no taxes on any gains resulting from the sale - since you’ve essentially sold something to yourself. The installments provide an income stream, or payments can simply be made directly to the Trust, allowing it to continue to grow in benefit of your heirs.  

Intentionally Defective Grantor Trust Example

An IDGT has several benefits, including:

  • Preserving your wealth

  • Providing incredible asset protection 

  • Minimizing some of the tax burden on your heirs

  • Keeping assets out of your taxable estate once you pass

IDGTs can be an excellent way for you to set up your Estate Plan so it continues working for you, your spouse, your children or your grandchildren in the future. Since the Trust is irrevocable, the assets you remove from your estate and place into it will be managed by your Trustee.

Set up your IDGT by first deciding on which assets the Trust should hold, and then deciding on how you’ll fund it (as a Completed Gift or an Installment Sale). 

The IDGT is distributed after you pass away, just like any other Trust would be. The key lies in the fact that estate taxes on the Trust would largely become a non-issue. There may be a gift tax, and depending on the state, your beneficiaries may pay an inheritance tax, but IDGTs are a smart way to use the system to your advantage to eliminate as much liability as possible.  

How to Set Up an Intentionally Defective Grantor Trust

Setting up your IDGT is the first step you can take to protecting your loved ones from the burden of taxes upon your passing. Create the most financially protective and sound Estate Plan possible, so you can feel good about the legacy you’re leaving behind. 

You can always find an established Estate Planning attorney to help you create your IDGT, but you should know that this can be a time-consuming and costly route to take. Working with a trusted, experienced, reputable online service like Trust & Will could be the first step you take towards creating a powerful Estate Plan. Using the tools you have at your disposal means giving your loved ones as much protection as possible.

Intentionally Defective Grantor Trusts are just one more way you can set up a solid Estate Plan. If you’re seriously thinking about adding an IDGT into your planning, or if you’d like to explore this unique, valuable type of Trust more in depth, reach out today to see how we can help.

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