An estate planning tool that might be considered in certain circumstances is an “Intentionally Defective Grantor Trust” also known as an IDGT.
It is a valid trust. The “defective” part means it is not valid for income tax purposes. Since it is a Grantor Trust, it means all income, deductions, credits etc. are reported on the individual income tax return of the person setting up the IDGT. That person is known as the Grantor or Settlor.
It is valid for gift or estate tax purposes of transfer taxes. The Grantor is also known as the “deemed owner” and is separate from the trust. Significant wealth can be transferred by the Grantor without transfer taxes using an IDGT. It all stems from the lack of coordination between the rules for income tax and the rules for gift and estate (transfer) taxes that apply to grantor trusts.
A grantor trust (also known as a living trust) is revocable. The owner (grantor) can change the terms, add assets and take assets from the trust. All income is reported on the individual income tax return. A grantor trust is not required to file form 1041, income tax return for estates and trusts.
The usual transaction has the grantor sell an asset that is expected to grow in value, to the defective trust in exchange for a promissory note in the amount of the fair market value of the item (common stock for example) with interest at the applicable federal rate (AFR).
Since the transaction is a sale for gift tax purposes, gift tax does not apply. It also is a sale for estate tax purposes. The grantor owns only the promissory note. When the grantor dies only the value of the note is included in the grantor’s estate. The appreciation passes to the beneficiaries of the trust (frequently children of the grantor) without any gift or estate tax. This is another asset “freeze” type of planning.
Part of the idea is to have an asset that will grow or appreciate in value. That could be real estate or common stock of a public or private company.
The transaction does not mean the trust pays income taxes. The “defective” feature means the grantor still reports and pays taxes on trust income such as dividends or rents. Since the grantor pays those income taxes out of other assets, that further reduces the estate of the grantor. However, payment of those income taxes is not a gift.
This is mainly for those folks with lots of assets and a desire to reduce the estate tax.
Did you hear “You can’t just sit and wait for people to give you that golden dream. You’ve got to get out there and make it happen for yourself.” Diana Ross