An intentionally defective grantor trust (IDGT) is a mixture of an irrevocable and a revocable trust. It takes on the characteristics of a grantor trust for income tax purposes and an irrevocable trust for reducing estate tax. Assets in an IDGT trust aren’t part of the estate.
The grantor pays the taxes
Trusts can be set up so that the trust pays its taxes or the grantor covers the taxes. A benefit of the IDGT is that it reduces the taxable estate without taking funds from the estate or trust. In some situations, the IDGT may not incur taxes; this depends on whether the trust generates income, in which case it’s subject to income taxes.
Transferring assets to an IDGT trust
Grantors can transfer assets to an IDGT as gifts or sales. A common estate planning strategy for IDGT trusts is to incorporate both gifts and sales. Grantors may strategically stay under the lifetime gift and estate tax amount for gifts. When it comes to selling an asset to the trust, grantors usually do this for assets that are likely to significantly increase in value.
You may want to sell through an installment note at the fair market value for the intended benefit of this wealth preservation method. The IRS won’t consider it a gift because the trust bought at the fair market value. IRC Section 1274(d) stipulates that the minimum interest rate has to be at least equal to the applicable federal rate (AFR). It also requires that you follow all loan formalities.
What happens after the grantor dies?
All assets that the IDGT bought will transfer to the named beneficiaries without needing to go through probate. Installment notes, accumulated interest and principals, however, are part of the taxable estate.
An IDGT allows the grantor to separate their estate’s income from the estate so that they can reduce their estate taxes. It works best for assets that typically increase a lot in value, such as real estate and businesses.