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An Intentionally Defective Grantor Trust is a specific kind of irrevocable trust set up by the grantor that can benefit the trustees in the long run. Tax implications make an Intentionally Defective Grantor Trust an excellent choice for those with the wealth they want to pass down.
Keep reading to understand Intentionally Defective Grantor Trusts and how they work.
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What Is an Intentionally Defective Grantor Trust?
An Intentionally Defective Grantor Trust or IDGT is an estate-planning tool that allows a trust beneficiary to separate the trust from estate tax treatment. When using an IDGT, the trust assets and money will still be subject to income tax but not to estate tax.
The reason people do this is to prevent frozen assets from being diminished by the consistent estate tax. In its essence, the grantor of the trust sells the assets to the IDGT, so while they still technically own it, it will not count when they must pay estate tax. But as mentioned, they will still need to pay income tax on any interest or other income generated by the trust.
Estate tax purposes- An estate tax is a tax that people must pay when they own assets and property over a certain threshold determined by law. The estate taxes impact any estate value that exceeds an exclusion limit set by law, and only the overage of the estate value is taxed.
Income tax purposes- Income taxes are a tax paid whenever you generate money for yourself. So you pay income taxes on work wages, property sale profits, stock and investment profits, and more. If your trust generates interest year after year, or any bank account does, then you must pay the IRS income tax on this interest.
Gift tax purposes- Gift tax is a tax paid when there is a transfer of property where the gifter makes no profit. You may be thinking that paying tax on a small gift is silly, and it is. Gift tax only applies to massive gifts, such as an entire property. When contributing money or assets to the IDGT, you may do so as a gift, but then the assets will be subjected to a gift tax.
GST tax purposes-When you leave assets to grandchildren or other generations down the line, you or they must pay a tax on these assets.
This GST tax is the generation-skipping tax, which applies to any assets given to grandchildren, great-grandchildren, great-nieces, great-nephews, and any other family members that are more than one generation removed. But when you use an IDGT to gift assets, they are not subject to the GST tax.
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What Is a Grantor?
The grantor is the person that creates and funds the trust. They are the benefactor, meaning they are responsible for the income tax on the assets while they’re alive. Grantors can have different levels of control depending on the type of trust. But the grantor usually has great control over a revocable trust and can add or remove assets based on their decisions.
There are revocable trusts and then irrevocable trusts. Revocable trusts are more fluid, and the grantor will have more control over the assets and if they want to remove, add, or rename trustees involved. But with an irrevocable trust, it is more difficult to access the assets and make changes. IDGTs are irrevocable trusts, so ideally, they aren’t touched until the trustee receives the transfer.
If a grantor needs to access the IDGT, it will depend on the restrictions they set in place when they created the IDGT. For example, irrevocable trusts are primarily for when the benefactor is close to death, as this means the trust will be in place when they are no longer around.
Who Is the Trustee of an Intentionally Defective Grantor Trust?
The trustee of an IDGT can be almost anyone. The trustee and beneficiaries are most commonly spouses, grandchildren, or other family members. But children and non-relatives may also be the trustee, depending on the situation.
How to Fund an IDGT
There are two options for funding an Intentionally Defective Grantor Trust. You can either gift the trust to the trustee or beneficiary or sell the assets to the IDGT. They are subject to the gift tax when you gift them, but there is no income tax on the sale if you sell them.
That is because the grantor receives an interest-bearing promissory note payable by the trust, and the sale is seen as the grantor selling the assets to him or herself. Therefore, there is no income tax on the exchange.
Transferring Assets With an IDGT
As discussed, a transfer of assets can be made by either gift or sale by the grantor. However, because it is an irrevocable trust, the beneficiary must be set before the trust becomes irrevocable.
The generally accepted trust principle regarding IDGT distributions is that the trustee of an IDGT is permitted to withhold distributions to trust beneficiaries that face a known creditor.
Current Proposals Before Congress
Under President Biden and the current sitting congressmen and women, some upcoming changes may impact your estate planning and use of an Intentionally Defective Grantor Trust. Below are the possibilities that may force you to change your plan depending on your assets and desires:
- Reduction in the estate tax exemption to $3.5 million
- Change in annual exclusion for gifts made to trusts
- Elimination of valuation discounts for family entities
- Irrevocable trust must terminate 50 years after the creation
- Taxation of appreciating assets upon the death of grantor or gifted assets
- Elimination of step up based on grantor death
- Elimination of grantor trusts to avoid estate tax
These new changes will be determined by the enactment of the 99.5% Act and the STEP Act. While this shift in the laws could sully many people’s trust and estate plans, IDGTs are still a useful way to transfer assets amongst the wealthy.
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Intentionally Defective Grantor Trusts have a fair amount of pros to consider. Many affluent families use IDGTs to transfer wealth and assets from generation to generation. Below are the pros to consider to help you decide if this is the right way for you to transfer assets.
- Allows the advantage of appreciation
- Prevents beneficiaries from additional tax transfer fees
- Removes assets from grantor’s estate to avoid estate tax
- Creates a solid irrevocable trust for generations
There are also some cons to using an IDGT to transfer assets. They mainly concern the grantor’s ability to pay the income tax on the trust’s interest. Read the cons below to understand why an IDGT isn’t always the best choice.
- Must have the second income to pay IDGT income tax
- Irrevocable trusts can be hard to access
- Gift and income tax still applies
Read the frequently asked questions below if you have more questions about Intentionally Defective Grantor Trusts.
Can an IDGT Be a Pot Trust or Slat?
An IDGT can be a SLAT (Spousal Lifetime Access Trust). It just means that the beneficiary of the IDGT will be the grantor’s spouse. The spouse will be a permissible beneficiary of the trust, as will their descendants.
An IDGT can also be a pot trust. A pot trust is a trust with multiple beneficiaries that makes distributions at the trustee's discretion. Meaning the assets in the IDGT can be dispersed amongst different beneficiaries.
What Makes an IDGT a Dynasty Trust?
An IDGT trust becomes a Dynasty Trust when it passes down to more than one generation. Many affluent families use Dynasty Trusts to continuously transfer the assets to their descendants without paying estate tax on them over the years.
Can You Transfer Life Insurance Into an IDGT?
You can transfer life insurance into an IDGT, which is a common thing to do. This transfer allows the grantor to gift the life insurance payout to the trustee and keep them exempt from paying the life insurance premium.
When Is the Best Time to Set Up an Intentionally Defective Grantor Trust?
Try to set up the IDGT as early as possible to establish decent interest and understand how it works. People often set these up when their children or grandchildren are young, if they have been diagnosed with a terminal illness, or expect a sudden death.
But it is not a good idea to set up an IDGT when you do not have sufficient secondary income to pay the income tax on the trust’s interest.
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IDGTs can be the right choice for many people who want to pass down a great deal of wealth to loved ones. These trusts can be an excellent option, but make sure you weigh the pros and cons before funding one and consider the impending laws that may impact your estate plans.