Deliberate estate planning is a pivotal aspect of the continuous growth of your family office for generations to come. If your existing wealth is not planned out in the most optimal way, your children or any other subsidiaries can face problems. 

One of the vehicles for estate planning is an IDGT, an irrevocable trust that is created by a Grantor during his lifetime. A popular strategy for planning is for the grantor to gift assets to the trust and later sell other assets to the trust. The sale is usually structured to include an initial gift to the trust and if the gift is sufficient to secure a portion of the purchase price (valuation of assets is important), the trust can subsequently purchase the assets from the grantor in exchange for the trust’s promissory note (valuation should be same for assets and promissory note. 

What Is An Intentionally Defective Grantor Trust?

An intentionally defective grantor trust (IDGT) is an irrevocable trust set up by the Grantor, where the trust deed is drafted to trigger grantor trust status intentionally. 

Estate Planning With Intentionally Defective Grantor Trusts

An IDGT is a great estate planning tool because it is owned by the Grantor for federal income tax purposes but treated as separate from the Grantor for purposes of estate and gift tax. This treatment enables the Grantor to pay income taxes on the trust’s income, but the appreciation on the assets in the trust is excluded from the Grantor’s estate and does not form part of their taxable estate. The income tax rate is less than the estate tax rate.

Who Owns Assets In Intentionally Defective Grantor Trust?

Legally it is owned by the trust due to it being an irrevocable trust. For tax purposes, it depends on whether it is for federal income tax or federal gift and estate taxes.

Federal income tax: Due to the trust being created with an intentional mistake to trigger the grantor trust rules, it ensures that the IRS regards you as the owner of the trust’s assets for federal income tax.

Federal gift and estate tax purposes: Due to transferring the assets out of your name and into a trust, the assets are owned by the trust and do not form part of your estate, and they will be regarded as a taxable gift. 

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Does An Intentionally Defective Grantor Trust Get A Step Up In Basis?

No. The Grantor trust rules, as set out in IRC 671-679, deem the Grantor to own the assets and liable for any federal income tax and transfer; therefore, tax-free. 

What Taxes Relate To An IDGT?

There are various types of taxes to consider for a taxpayer. Most notably: 

  • Gift and Estate Tax
  • Income Taxes, including CGT; 
  • Generation-skipping taxes (GST); and 
  • Transfer tax

Who Pays Income Tax On The Gains Inside Trust?

The Grantor, while alive, pays income tax on the gains. After his demise, the IDGT will bear its own income tax on gains made.

Tax Liabilities

The Grantor is liable for federal income tax on income generated by the trust, including any gains made in his lifetime. If the Grantor gifts the assets to the trust, they will be liable for tax on the gift and are regarded as trust assets subsequent to the gift. 

An IDGT is the preferred estate planning vehicle when generation-skipping transfer tax is a primary goal of the trust. In this case, an asset’s value is set for GSTT purposes as soon as it is sold to the IDGT. Additionally, asset appreciation will not count against the grantor for GSTT purposes if the trust is structured to repay the asset over 10 years.

Reciprocal Trust Doctrine

The reciprocal trust doctrine applies when two trusts are interrelated, “and that the arrangement, to the extent of mutual value, leaves the settlors in approximately the same economic position as they would have been if they had created trusts naming themselves as life beneficiaries“.

For example – 

Spouses set up reciprocal trusts to take advantage of the tax exemption for gifts between spouses. In this case, the husband gives up to $6,030,000 to a trust for the benefit of his wife and issue, and the wife gives up to $6,030,000 to a trust for the benefit of her husband and issue. 

When applying the “reciprocal trust doctrine,” courts often end up uncrossing the trusts. The doctrine states that if a husband creates a trust for his wife, and the wife creates a nearly identical trust for the husband, then the two trusts may be ‘un-crossed’ and treated for tax purposes as if each spouse had made a trust for themselves.

How To Fund An IDGT

There are two methods to fund an IDGT. Either by making a gift or engaging in an installment sale of the trust. 

Selling Assets To An Intentionally Defective Grantor Trust

If you sell assets to an IDGT, this is usually done via an installment sale. In order for a gift to be permanent and count towards a grantor’s lifetime gift exclusion, the trust must be seeded with a gift that is at least 10% of the asset’s value.

The grantor can then sell the assets to the trust and receive an interest-bearing promissory note from the trust in exchange. An IDGT uses the ‘applicable federal rate’ (AFR), a number published monthly by the IRS for purposes of this interest. The interest accrued on this promissory note is not taxable for federal tax purposes due to the fact that you can’t charge yourself an interest rate (i.e. an IDGT being a grantor trust). No tax is due on any gain from the sale by the Grantor to the trust. If the fair market value of the promissory note is equal to the fair market value of assets sold, there will be no gift tax liability except for the 10% initial gift. 

What’s A “Pot Trust”? Can An IDGT Be A Pot Trust?

A pot trust is a trust set up for multiple trust beneficiaries where distributions can be made to any beneficiaries at the trustee’s discretion. And yes, an IDGT can be a Pot Trust. 

Can An IDGT Be A Spendthrift Trust?

Yes. The Grantor may want to build safeguards into the trust to protect their beneficiaries from creditors and to ensure the assets are not misused by beneficiaries due to substance abuse, for example. 

What’s A SLAT? Can An IDGT Be A SLAT?

A Spousal Lifetime Access Trust or ‘SLAT’ is a trust where the Grantor’s spouse and their descendants are permissible beneficiaries of the trust. 

Yes, an IDGT can be a SLAT. 

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Including A Spouse As An Eligible Beneficiary

The purpose of including the Grantor’s spouse as a beneficiary is that the Grantor can transfer assets to a trust (IDGT) and ensure that the spouse has access to those assets should they need them during their life. This is referred to as a SLAT.

What Makes An IDGT A Dynasty Trust?

An IDGT can be a dynasty trust if it is designed to last for multiple generations without being subject to estate taxes on the death of a beneficiary. 

What Other Considerations Are There?

Using an IDGT should be carefully considered based on your own estate planning needs. This is not a magical estate planning tool that will work or even suit everyone. 

For instance, the IDGT is not even in the tax code, but rather gains its authority through numerous decisions from the tax courts. Every time a trust is challenged in the courts by the IRS, the decision creates new boundaries or allowances for future trusts.

Another issue is when the Grantor dies. In the case of an IDGT, there is no official guidance from the IRS as to how they will treat the trust and its assets. Nearly all tax professionals recognize that upon death, the IDGT loses its grantor status. However, it is not clear when that occurs. The IRS tends to provide guidance on how to proceed after the grantor’s death – which is not conductive to the planning process. This can leave grantors, their beneficiaries, and estate planners without a clear picture of what can be done in the case of a premature death.

Below are some of the factors to consider when looking at the feasibility of an IDGT as part of your estate planning.

Will I Need Access To The Assets I Plan To Put Into The Trust?

No, you don’t need access. However, if you want access to the assets, an IDGT may not be the best tax planning structure for you. 

Do I Expect These Assets To Appreciate Over Time?

The primary purpose of an IDGT is to ‘freeze’ a grantor’s estate. Therefore, it makes sense to transfer appreciating assets to the trust.

How Much Control Do I Wish To Give My Beneficiaries?

The Grantor can retain significant control over the trust property even if it is subsequent to the trust being created. This way, you can manage the power of the beneficiaries. For example, the Grantor can have the right to hire or fire trustees and to make investment decisions. 

Who Will Be My Trustee?

It is crucial to ensure that the trustee or trustees are someone you can trust. Appointing a spouse can have severe tax implications. 

FAQ:

What makes an Intentionally Defective Grantor Trust?

These trusts are referred to as IDGTs because the Grantor intentionally includes in the trust agreement (trust deed) a right or power (such as the Grantor’s ability to switch out and substitute assets for other assets already in the trust) that causes them to be treated as the owner of the trust for federal income tax.

Who pays taxes in an Intentionally Defective Grantor Trust?

An IDGT is considered separate from the Grantor for federal estate and gift tax purposes. However, it is treated as owned by the Grantor for federal income tax purposes. The Grantor has the income tax liability and pays income tax on the trust income, but the appreciation that builds up in the trust’s assets is excluded from the Grantor’s estate.

Does an Intentionally Defective Grantor Trust get a step up in basis?

No, due to exemption of CGT. Due to the grantor trust rules being applicable, the historical base cost will roll over, and the Grantor will still be the deemed owner for federal income tax purposes. Therefore 

Who owns assets in Intentionally Defective Grantor Trust?

Legally the intentionally defective grantor trust owns the assets. However, for tax, ownership is as follows:

Federal income tax: Due to the trust being created with an intentional mistake to trigger the grantor trust rules, it ensures that the IRS regards you as the owner of the trust’s assets for federal income tax.

Federal estate tax purposes: Due to transferring the assets out of your name and into a trust, the assets are owned by the trust and do not form part of your estate. 

Federal Gift tax purposes: If you gift your assets to the trust, you will be subject to tax, which is calculated as the asset’s value on the date of transfer. Similar to estate tax, it is regarded as owned by the trust.

Estate planning is a delicate matter and it is pivotal to have it catered to you. If you have any questions about intentionally defective grantor trusts, please reach out to Asena for more in-depth advice. 

Shaun Eastman

Peter Harper