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Intentionally defective grantor trusts can be highly effective

On Behalf of | Nov 21, 2022 | Estate Planning, Trusts |

With intentionally defective grantor trusts or IDGTs, the name can be misleading if you just take it at face value. Despite the defect stated explicitly in this trust type’s title, they do serve an important purpose quite effectively in Maryland.

What makes them so defective?

The logic behind why IDGTs are called defective comes from the way that income tax regulations affect these trust instruments – the written agreement that the settlor’s beneficiaries will be allocated. One way of thinking about IDGTs is that the income of the trust will still be taxed at the grantor level but not at the trust level.

An irrevocable trust is usually created in estate planning so that the partner or other relatives of the grantor can benefit from it. The reason why the irrevocable quality of these trusts is an important part of their design is that it allows any trust assets that are underlying in your estate to be removed.

What do you need for your IDGT?

When you’re establishing your intentionally defective grantor trust, one crucial point to make sure of is that the trustee you choose should be a party with no interest in the arrangement. Otherwise, they may end up unintentionally included in your estate.

In order for grantors to maintain income tax liability, it is necessary for the instrument of the trust to have an IRC section 671-679 grantor trust provision. This is where the defective aspect of these trusts comes in. By including this provision in the instrument, it renders the trust defective for the purposes of income taxes, while it remains effective for your estate taxes.

Intentionally defective grantor trusts can be funded in one of two ways. The first option is to give a complete gift to the trust, which is the most common solution. The other choice is to have an installment sale to the trust, in which you sell the trust’s appreciating assets.

Although intentionally defective grantor trusts may sound like they’re broken from the start, don’t let the name fool you. Many grantors have used them to help their estate planning process by freezing select assets for the purposes of estate taxes but not income taxes.