The Intentionally Defective Grantor Trust: A Tax Advantaged Freeze
An IDGT is out of your estate for estate tax and still yours for income tax. That mismatch lets you pay the trust's income tax as a tax free gift and sell appreciating assets to the trust with no capital gain. The trade is the loss of a basis step-up.
The name sounds like a mistake. Intentionally defective grantor trust describes a trust that is deliberately drafted to fail the income tax rules while passing the estate tax rules. The result is a trust whose assets are outside the grantor's taxable estate but whose income is taxed to the grantor as if nothing had happened. For a family with an appreciating business, real estate or a concentrated stock position, that mismatch is one of the most useful tools in the planning toolkit.
Why the mismatch works
The grantor trust rules in sections 671 through 679 of the Code decide who pays income tax on a trust's earnings. If the grantor keeps one of the listed powers, the grantor pays.1 The estate tax rules in sections 2036 through 2038 decide what is included in the grantor's estate, and they use a different list. Drafters choose a power that appears on the first list but not the second. The most common is the power, held in a nonfiduciary capacity, to swap trust assets for other assets of equal value, which the IRS has confirmed does not by itself cause estate inclusion.2
Two consequences follow.
- The grantor's payment of the trust's income tax is not a gift to the beneficiaries. The trust grows without the drag of income tax, and the grantor's estate shrinks by the tax paid, all without using any exemption.3
- Transactions between the grantor and the trust are ignored for income tax purposes. The grantor can sell an asset to the trust and recognize no gain, and the trust can pay interest on a note to the grantor and the interest is not income.4
The installment sale
The classic IDGT transaction is a sale rather than a gift. The grantor first gives the trust a seed gift, conventionally at least ten percent of the value of what will be sold, so the trust has real equity. The grantor then sells the appreciating asset to the trust in exchange for a promissory note bearing interest at the applicable federal rate, often with interest only payments and a balloon at the end.5 Everything the asset earns and gains above that interest rate accrues to the trust and the beneficiaries, free of gift and estate tax. The grantor receives back a note worth exactly what was sold, which is frozen in the estate at its face amount.
The asset sold is usually an interest in an entity, which allows valuation discounts for lack of control and lack of marketability, and which keeps the trust's purchase price lower than the underlying value. A qualified appraisal is essential. Grantors who sell for too little have made a gift of the difference, and the IRS scrutinizes these transactions closely.6
The price: no step-up
Assets a person owns at death receive a new income tax basis equal to fair market value.7 Assets in an IDGT do not, because they are not in the grantor's estate, and the IRS has ruled that grantor trust status alone does not change that.8 The children inherit the trust's assets with the grantor's old basis. For a long held asset with a low basis, the estate tax saved may still dwarf the capital gains tax deferred, but the comparison has to be run. The swap power is the usual answer: late in life the grantor exchanges cash or high basis assets for the low basis assets in the trust, bringing the low basis assets back into the estate for a step-up and leaving the high basis assets in the trust. That requires liquidity, and the plan should provide for it.
Who it fits
An IDGT makes the most sense for someone who expects to have a taxable estate, who owns an asset likely to appreciate faster than the federal rate, who can afford to pay the trust's income tax for years, and who does not need the asset back. The trust is irrevocable. The grantor's spouse can be a beneficiary, which keeps indirect access in the family, but the grantor cannot be. Drafting, valuation and administration all have to be done carefully, because the technique's advantages come from the rules being followed precisely, not from any shortcut around them.
Notes
- IRC sections 671 to 679. ↩
- IRC section 675(4)(C); Rev. Rul. 2008-22, 2008-16 I.R.B. 796. ↩
- Rev. Rul. 2004-64, 2004-27 I.R.B. 7. ↩
- Rev. Rul. 85-13, 1985-1 C.B. 184. ↩
- IRC sections 1274(d), 7872; the AFR for the month of the sale sets the minimum interest rate. ↩
- Treas. Reg. section 25.2512-8; see Estate of Woelbing v. Commissioner, T.C. Dkt. Nos. 30261-13, 30260-13 (settled 2016), in which the IRS challenged the valuation and the note in a sale to a grantor trust. ↩
- IRC section 1014(a). ↩
- Rev. Rul. 2023-2, 2023-16 I.R.B. 658. ↩
Terry L. (T. L.) Turnipseed, J.D., LL.M., CTFA, is a tax, trust and estate attorney in Fort Lauderdale, Florida, and Head of Estate and Tax Planning at Alta Trust Company. He is a former tenured professor of law at Syracuse University. Reach him at tl@turnipseed.law or on LinkedIn. This article is general information, not legal advice.