For wealthy families who wish to transfer assets from one generation to the next while achieving significant tax savings, an intentionally defective grantor trust may be an excellent solution.
What Is an Intentionally Defective Grantor Trust (IDGT)?
An intentionally defective grantor trust (IDGT) is a common estate planning tool. IDGTs are especially useful if you have assets that will appreciate significantly over time.
An IDGT is “intentionally defective” because it purposely gives the grantor – the person creating the trust – a right or power that allows them to pay taxes on the income generated by the trust even though the trust assets are not a part of the grantor’s estate.
The trust is irrevocable, which means the transfer of assets to the trust is a complete gift for gift tax purposes. Transferring assets to an IDGT takes the appreciation attributable to the assets out of an estate, while the trust’s income is taxed at the grantor’s personal rate, not the trust’s much higher rate.
What Are the Benefits of an IDGT?
The benefit of an IDGT is that it allows the trust to grow without having to use trust assets to pay income taxes. This amounts to a tax-free gift to the trust and the trust beneficiaries.
In addition, by paying the income taxes, you are also continuing to lower your taxable estate. IDGTs work best for high basis assets that are likely to continue to appreciate significantly in value, such as stock or real estate. For example, suppose you fund an IDGT with $10 million in assets, and it earns 5 percent annually over a 30-year period. If the trust does not have to pay income tax, it might grow to more than $43 million. If the trust needs to pay income taxes from its own assets, its growth would likely be significantly less.
Are There any Disadvantages in using an IDGT?
Because an IDGT is an irrevocable trust that is normally not counted for estate tax purposes, the income tax basis in assets held in such a trust does not change when the grantor dies. In contrast, assets included in the grantor’s estate for estate tax purposes will get a new income tax basis at the grantor’s death, which may be much higher. For this reason, the selection of assets to put in such a trust must be done carefully, with the advice of a tax professional.
Gift Taxes
Bear in mind that when you transfer the assets to the trust, the transfer may be subject to gift taxes. The IRS allows you to give away a total of $13.61 million (as of 2024) during your lifetime before a gift tax is owed. Even if you gift assets to an IDGT and reduce your future gift and estate tax exemption, any future growth will occur outside of your estate. This limit increases each year. However, unless the law changes, the limit will drop significantly for gifts made, and persons dying, after 2025. For persons with substantial wealth, planning for large gifts, including gifts to an IDGT, should be considered well before the end of 2025. This is especially true for New York State residents because New York only includes taxable gifts made within three years of death in the New York taxable estate.
In addition, the annual gift tax exclusion is currently $18,000 for 2024. This means that most gifts of $18,000 or less to any one individual do not reduce the lifetime exclusion from gift taxes described above. Also, if such gifts are the only gifts made during the year, you do not have to report the gift or gifts to the IRS.
If you want to avoid gift taxes, you may be able to sell assets to the trust. This is usually done in installments through an interest-bearing promissory note. When an asset is sold to an IDGT, there are no capital gains taxes because you are selling something to yourself. If the assets in the trust gain more in value than the interest rate, then the sale will still benefit the trust overall. This strategy works best when interest rates are low.
To find out if an IDGT is right for you, contact a qualified estate planning attorney at Pierro, Connor & Strauss.
Richard S. Rothberg is Senior Counsel at Pierro, Connor & Strauss. Learn more about Mr. Rothberg here.
