Despite the moniker, estate planning with intentionally defective grantor trusts (IDGTs) has many benefits. In fact, this well-established technique isn’t defective at all; the term “defective” refers to the effect of income taxation rules on these instruments. We’ll go over the details of IDGT trust, the form including how we can use it to develop comprehensive estate plans. We’ll also see how they can be very tax “effective” for estate tax purposes. Also, we are going to be discussing some of the disadvantages of the Intentionally defective grantor trust.
What Is an Intentionally Defective Grantor Trust IDGT?
An IDGT is an irrevocable trust that is typically established for the benefit of the grantor’s spouse or descendants. The trust is irrevocable by design to remove the underlying trust assets from the grantor’s estate. It should be established with a non-interested party as trustee to avoid accidental inclusion in the grantor’s estate.
Also, for the grantor to retain income tax liability, the trust instrument must include one grantor trust provision from IRC sections 671–679. Thus, it makes it tax “effective” for estate tax purposes but tax “defective” for income tax purposes; in other words, they will tax the trust income at the grantor level rather than the trust level.
Here are some of the most common grantor trust provisions:
#1. Regaining control of trust assets
According to IRC Section 674(c), the grantor retains the authority to reacquire assets from the trust. They can substitute them for other assets of equivalent value. This retained interest does not prevent the grantor from making a complete gift to the trust.
#2. Borrowing from the trust.
IRC Section 672(a) allows the trust to include a provision granting the grantor or other nonadverse party the authority to take loans from the trust without providing adequate interest or security. Only the grantor should have this power must be retained by the grantor. It should be not relegated solely to the trustee to trigger grantor trust status.
#3. Changing the beneficiaries.
According to IRC Section 674(a), the trust may grant the grantor the power of disposition. This affects the beneficial enjoyment of the trust income or principal. For example, the grantor could retain the authority to add noncharitable beneficiaries or to direct distributions to existing beneficiaries.
The drafter of an IDGT instrument must be aware of all grantor trust exceptions that can result in the trust losing grantor trust status.
Understanding Intentionally Defective Grantor Trusts IDGT
Grantor trust rules specify the conditions under which the Internal Revenue Service will treat an irrevocable trust just as a revocable trust (IRS). These circumstances may often result in the formation of intentionally defective grantor trusts. In these cases, the grantor is responsible for paying taxes on the trust’s income. Also, they don’t count the trust assets as part of the owner’s estate. However, such assets would apply to a grantor’s estate if the individual runs a revocable trust. This is because the individual would effectively still own property held by the trust.
However, for estate tax purposes, the value of the grantor’s estate reduces by the amount of the asset transfer. The individual will “sell” assets to the trust in exchange for a promissory for a set period, like 10 or 15 years. The note will pay enough interest to qualify the trust as above-market. It’s expecting the underlying assets to appreciate at a faster rate.
Beneficiaries of IDGTs are typically children or grandchildren. They will receive assets that have been able to grow without the grantor’s income tax reductions. If properly structured, the IDGT can be a very effective estate planning tool. It allows a person to reduce his or her taxable estate while gifting assets to beneficiaries at a locked-in value. The trust’s grantor can also reduce his or her taxable estate by paying income taxes on trust assets. Essentially, the grantor gifts extra wealth to beneficiaries.
Asset Sales to an Intentionally Defective Grantor Trust
The structure of an IDGT allows the grantor to transfer assets to the trust by gift or sale. Gifting an asset to an IDGT may result in a gift tax. So, it is preferable to sell the asset to the trust. When they sell assets to an IDGT, there is no record of capital gain, so you don’t owe any taxes. However, this can still pose so many other disadvantages in the Intentionally defective grantors’ trust.
You’ll need the assistance of a qualified accountant, certified financial planner (CFP), or estate planning attorney to structure an IDGT due to the complexities.
This is ideal for removing highly appreciated assets from an estate. In most cases, the transaction is set as a sale to the trust. So, the payment is in form of an installment note payable over several years. The grantor collecting the loan payments will charge a low-interest rate that is not taxable interest income. The grantor, on the other hand, is liable for any income the IDGT earns. If the asset that you sell to the trust is an income-producing asset, such as a rental property or a business, the income it generates within the trust is taxable to the grantor.
How to Fund an IDGT
To fund intentionally defective grantor trusts, grantors have two options: either to make a completed gift or engage in an installment sale to the trust.
#1. Completed gift.
Gifts are the most common way to fund an IDGT. The grantor makes an irrevocable, completed gift of the desired assets to the trust. Gifting appreciating assets provides the greatest benefit. This is because the trust can keep the income and pass it on to the beneficiaries. Furthermore, even though the asset’s value rises significantly, the grantor avoids paying extra transfer taxes on it.
Transfers to an IDGT, however, are taxable gifts that reduce the grantor’s unified gift and estate tax credit (That’s if the gift reaches the annual exclusion limit for the year ($15,000 in 2020)).
#2. An Installment Sale
One way to escape gift tax implications is for the grantor to sell the appreciating asset(s) to the trust in an installment sale. In exchange, the grantor receives an interest-bearing promissory note payable by the trust.
Since the IDGT is a grantor trust, there is no tax on any benefit from the sale. The grantor is treated as having sold anything to himself or herself. The grantor has the right to sustain an income stream from the installments, or interest payments on the trust. Hence, it increases the value of the trust corpus for the beneficiaries. There is no gift tax liability if the value of the promissory note equals the value of the property sold.
Intentionally Defective Grantor Trust Form
This is a form of Intentionally Defective Grantor Trust. The grantor maintains administrative control over the Trust (here, the power of substitution). This makes the grantor liable for trust income tax. This administrative authority, however, is not a legitimate retained interest to enable the trust property to be included in the grantor’s assets. The aim here is for the grantor to pay all of the income tax obligations resulting from the trust while allowing the real trust income to accumulate. Otherwise, the payment should be to the trust beneficiaries without income or gift tax repercussions to them.
In the “typical” Intentionally Defective Grantor Trust form, the grantor makes a “seed money” donation to the trust. It then sells an additional property to the trust at fair market value in return for an interest-bearing installment bond. There is no tax for the grantor on the sale. This allows the value of the grantor’s asset sold to the Trust to be “frozen” at its value on the date of sale by the use of the note. Also, it allows the grantor’s other retained assets to be “burned off” by the grantor’s required income tax payments on the trust’s income.
The Benefits of IGDT
1. Since the grantor is the beneficiary of the IDGT for federal income tax purposes, he or she is responsible for paying the trust’s income tax. Thus, it allows trust assets to expand without income tax-reducing it.
2. The grantor’s payment of income tax from his or her own properties is the same as making a tax-free donation to the trust.
3. The grantor’s potential estate will reduce by the trust’s income tax bill.
4. The grantor will contribute valued assets to the trust and still pay income tax on those assets when the trust sells them.
5. Trust assets (including any appreciation) are usually not includible in the grantor’s estate and develop within the trust tax-free.
6. In general, trust distributions to beneficiaries are exempt from federal estate and gift taxes.
7. Trust assets can be secured from creditors of the beneficiaries, including ex-spouses.
Benefits of Selling to IDGT
1. For federal income tax purposes, you are the beneficiary of the IDGT.
- If the grantor survives the duration of the promissory note, the selling of valued assets to the trust will result in no benefits.
- if the trust’s interest payments on the promissory note associated with the sale will not produce interest income during the grantor’s lifetime.
2. The grantor can obtain a tax-free wealth transfer to trust beneficiaries if the trust’s combined rate of income and growth on assets acquired from the grantor exceeds the relevant AFR for the associated promissory note (this technique works best when the AFR is low).
Now we have seen the benefits, let’s also look at the disadvantages of an intentionally defective grantor trust.
Disadvantages of Intentionally Defective Grantor Trust
Despite all the benefits of the intentionally defective grantor trust, it still has many disadvantages. Let’s see some of the disadvantages of the IDGT
1. In future years, the grantor will choose not to pay the IDGT’s income tax. This is the major disadvantage of intentionally defective grantors’ trust.
2. After the grantor’s death, the IDGT may pay its own income tax, plus tax on any valued property sold after the grantor’s death.
3. Unless the IDGT has adequate assets of its own, the grantor cannot sell assets to the IDGT without first making an initial gift to it.
4. IDGT assets will only be available to trust beneficiaries following the terms of the trust contract.
5. Because the IDGT is irrevocable, the grantor cannot cancel it and take back the trust assets after it has been supported.
6. The Internal Revenue Service may contest the valuation of the assets sold to the IDGT to determine that the grantor made a gift to the IDGT in the amount of all or a portion of the value of the assets sold to the IDGT.
7. The Internal Revenue Service may use a variety of reasons (e.g., the IDGT was not adequately financed or the IDGT’s promissory note is equity rather than debt) to determine that the grantor made a gift to the IDGT equal to all or a portion of the value of the assets sold to the IDGT.
8. The IDGT must repay the loan even if the aggregate rate of income and growth on the grantor’s assets does not surpass the relevant AFR on the associated promissory note.
Other considerations in IDGT
For the right person, IDGTs are an excellent planning tool. However, when establishing this form of trust, care must be taken. Remember the following before consulting with your estate planning attorney:
Will I need access to the assets I intend to place in the trust?
Will I need access to the assets I intend to place in the trust? If you answered yes, an IDGT might not be for you. Although it may be possible to access assets by exchanging your personal assets for those in trust or borrowing funds from the trust, an IDGT should not be revocable or readily available to the Grantor.
Do I anticipate that these assets will increase in value over time?
Do I anticipate that these assets will increase in value over time? The best assets for financing an IDGT would appreciate over the trust’s lifetime, benefiting the Grantor by reducing her estate by the amount of appreciation accrued in the trust. Where you don’t expect assets to appreciate, the Grantor may wish to keep them until her death.
How much power do I want to offer my beneficiaries?
Even after the trust is established, the Grantor may maintain substantial control over the trust property. The Grantor, for example, may maintain the right to employ and fire the Trustee and may change the provisions on when (if ever) his descendants become Trustees. The Grantor frequently retains the right to evaluate the trust investment strategy and may also have the final say on trust capital investments. As a result, the Grantor will have ongoing access to the trust capital for potential investment opportunities.
Who will be my Trustee?
Choosing the right Trustee is critical to the success of your strategy. Choosing a spouse or child may present tax issues. It necessitates very carefully intentionally defective grantor trust from drafting.
How do I know if IDGT is a good investment for me?
The suitability of IDGT as an investment depends on an individual’s investment goals, risk tolerance, and financial situation. It is important to consult with a financial advisor to determine if IDGT is a good fit for your investment portfolio.
What is the performance history of IDGT?
The performance history of IDGT will vary depending on the specific fund and the performance of the underlying index. It is important to research and compare the historical performance of different IDGT ETFs before investing.
Can I lose money if I invest in IDGT?
Yes, like all financial investments, there is the risk of losing money when investing in IDGT.
What is the minimum investment for IDGT?
The minimum investment for IDGT will vary depending on the specific fund. Some IDGT ETFs may have a minimum investment requirement, while others may not.
Is IDGT taxed as a stock or bond?
The taxation of IDGT will depend on the specific fund and the investor’s tax situation. It is important to consult with a tax professional to determine the tax implications of investing in IDGT.
IDGT FAQs
Does an IDGT file a tax return?
An IDGT is valid for gift or estate tax purposes. … Income is reported on the individual income tax return, and the grantor trust is not required to file Form 1041, an income tax return for estates and trusts.
Can the grantor be the trustee of an IDGT?
On the one hand, the grantor must give up dominion and control over the IDGT to avoid the inclusion of the trust’s property in the grantor’s gross estate. IRC §§ 2036–2042. … In this regard, some IDGTs expressly prohibit the grantor, or anyone related or subordinate to the grantor, from ever becoming a trustee
Does an IDGT need an EIN?
The one key thing that all parties should be aware of is that the IRS does not require or recommend obtaining an EIN/Tax ID Number for “Grantor Trusts.” The client can use their own social security number when they open the account because income from the account is to be reported on the individual income tax return of
Who is the responsible party for an irrevocable trust?
So, once the assets go into the irrevocable trust, the trustee, as fiduciary for the beneficiaries, has the legal responsibility for, among other things, making sure the taxes are paid appropriately. Thus, the trustee is the responsible party.
