IDGTs Explained: How an Intentionally “Defective” Grantor Trust (IDGT) Really Works
An IDGT is designed so the person who sets it up (the grantor) is treated as the owner for income tax purposes—but not for estate tax purposes. That split treatment can create powerful planning benefits for families aiming to transfer wealth efficiently. Below, we break down what an IDGT is, how it operates, and the trade-offs to weigh.
IDGT Basics
An IDGT is an irrevocable trust drafted with specific provisions. The key idea: the grantor pays the trust’s income taxes each year, yet the trust assets (and their future growth) are kept outside the grantor’s taxable estate. This combination can speed up wealth transfer while managing potential estate taxes.
Planning insight: When structured and administered carefully, an IDGT can be a high-impact tool for high-net-worth families seeking both control over tax outcomes and long-term transfer efficiency.
How an Intentionally Defective Grantor Trust Operates
Step 1: Set Up and Fund the Trust
The grantor establishes the IDGT and moves assets into it. Common funding approaches include:
Outright gift: Use part of your lifetime gift and estate tax exemption.
Gift + sale: Seed the trust with a gift, then sell additional assets to the trust.
Sale for a note: Sell assets to the trust in exchange for a promissory note that pays interest at the IRS Applicable Federal Rate (AFR).
Step 2: Different Treatment for Income vs. Estate Taxes
Income tax: The grantor pays tax on the trust’s income. This reduces the grantor’s own estate over time and lets trust assets compound without an income-tax drag inside the trust.
Estate tax: Assets in the IDGT—and their appreciation—are generally excluded from the grantor’s taxable estate at death.
Strategic Benefits of an IDGT
Shrinking the Taxable Estate
Because the grantor covers the annual income tax bill personally, their estate may decrease while the trust grows for heirs.Using Low AFR to Your Advantage
When assets are sold to the trust for a note, the strategy works best if those assets grow faster than the note’s AFR interest rate. The growth above the AFR accrues to beneficiaries outside estate and gift tax.Added Layer of Protection
Assets held in an IDGT are typically less exposed to future creditor claims, offering extra security for beneficiaries.
Planning insight: Timing, asset selection, and proper valuation matter. Coordinating with experienced legal and tax advisors helps align the trust with your broader estate and investment plan.
Considerations and Limitations
Irrevocability: Once funded, terms are hard to change. Careful drafting up front is essential.
Cash-flow needs: The grantor must be able to pay the trust’s ongoing income taxes from personal resources, not from trust assets.
Is an IDGT a Fit for You?
For affluent individuals seeking to reduce potential estate taxes and accelerate multi-generation wealth transfer, an IDGT can be compelling. Suitability depends on your assets, goals, time horizon, and ability to handle the yearly tax obligation.
Frequently Asked Questions (FAQs)
What makes a grantor trust “defective”?
It’s drafted so the grantor pays income taxes on trust earnings, yet the trust assets are excluded from the grantor’s taxable estate.
Can an IDGT be revoked?
No. An IDGT is irrevocable, which is why careful planning and drafting are critical before funding.
Who pays the taxes in an IDGT?
The grantor pays all income taxes on trust income, allowing the trust to grow without paying its own income tax.
Are IDGT assets protected from creditors?
Typically, assets in a properly drafted and administered IDGT receive strong creditor protection (subject to state law).
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