An Intentionally Defective Grantor Trust (IDGT) is an advanced estate planning tool used to transfer assets out of a person’s taxable estate while retaining the responsibility of paying the trust’s income taxes. This specialized irrevocable trust is deliberately structured with a specific income tax “defect” so the grantor is treated as the owner for income tax purposes, but not for estate tax.
How Does an IDGT Work?
The IDGT’s “defect” means that while the trust’s assets and their future appreciation are excluded from the grantor’s estate—potentially reducing estate taxes—the income generated by the trust is taxable on the grantor’s personal income tax returns. By paying income taxes on the trust’s earnings, the grantor essentially makes additional tax-free gifts to the beneficiaries, allowing trust assets to grow more rapidly and free from the drag of income tax.
For example, if you transfer a family business worth $10 million into an IDGT and it grows to $20 million, the additional $10 million generally escapes estate taxes upon your death. The grantor’s payment of income tax on trust earnings preserves the entire principal and appreciation for beneficiaries.
Who Should Consider an IDGT?
IDGTs are ideal for high-net-worth individuals seeking to reduce estate tax liability on appreciating assets, transfer wealth tax-efficiently to heirs, and maintain some indirect influence over trust assets. Typical candidates include business owners, real estate investors, and those with assets likely to increase substantially in value.
The “Defect” Explained
The “defect” involves retaining certain powers by the grantor within the trust document—such as the power to substitute assets or borrow from the trust without adequate security—which cause the trust to be treated as a grantor trust for income tax but exclude assets for estate taxation. This nuanced design requires expert legal and tax guidance.
IDGT Compared to Other Trusts
Unlike revocable trusts, where assets remain in the taxable estate, or standard irrevocable trusts, which pay their own income taxes, IDGTs uniquely separate estate and income tax treatment. This allows enhanced estate tax planning while the grantor shoulders the income tax burden, accelerating wealth transfer.
| Feature | IDGT | Irrevocable Trust | Revocable Trust |
|---|---|---|---|
| Estate Tax Treatment | Assets removed from estate | Assets removed from estate | Assets included in estate |
| Income Tax Liability | Paid by grantor | Paid by trust or beneficiaries | Paid by grantor |
| Grantor Control | Limited, strategic retained powers | Limited or none | Full control and revocable |
Common Misconceptions
- “Defective” means intentionally planned, not flawed.
- You don’t lose all control; some powers and influence can remain.
- It’s mostly for individuals with sizable estates but is not exclusively for the ultra-wealthy.
- Initial transfers usually use part of your gift tax exemption; it’s not a gift tax avoidance strategy.
Practical Strategies
- Fund an IDGT with appreciating assets such as business interests, real estate, or investments.
- Pay the trust’s income taxes personally to maximize growth benefits.
- Consider selling assets to the trust via promissory notes to preserve gift tax exemptions.
- Regularly revisit the trust with legal and tax advisors to adapt to changing laws.
Frequently Asked Questions
Is an IDGT reversible? No, it’s irrevocable once assets are transferred.
Do I lose control of assets? Legal ownership transfers, but some influence might be retained depending on trust terms.
What if I don’t pay the income tax? The grantor is fully responsible; failure to pay can result in penalties.
Can any asset be transferred? Typically best for assets with strong growth or income potential.
How does it affect gift tax? Transfers are treated as completed gifts using lifetime exemptions; the benefit is on future appreciation.
For more detailed guidance, consult IRS resources and expert estate planning professionals. IRS Gift Tax Guide and resources like Nolo provide useful information.