When it comes to estate planning, there are a lot of tools at your disposal to carry out your wishes after you’re gone. Even within the realm of trusts, there are myriad avenues that you could look into, from spousal lifetime access trusts, to charitable lead trusts, and more. Depending on your goals for your estate, you might explore different options to see which ones most closely align with your wealth transfer plan. One such tool available to you is an intentionally defective grantor trust.

What Is an Intentionally Defective Grantor Trust?

An intentionally defective grantor trust (IDGT) is an irrevocable trust with an intentional “defect”–it’s treated as if it did not exist for income tax purposes. In other words, the grantor of the trust continues to pay income tax on the income produced by the trust. However, despite it being included in the grantor’s estate for income tax purposes, it effectively removes the assets of the trust from the grantor’s taxable estate for estate tax purposes.

IDGTs come in many shapes and sizes. When structured to last across generations, an IDGT can function as a legacy trust, ensuring that family wealth is maintained for generations without incurring estate tax at each generation.

Intentionally Defective Grantor Trust Tax Reporting

The “defect” makes it a powerful estate planning tool, because in addition to removing the assets from the grantor’s taxable estate, the income taxes paid by the grantor also reduce the grantor’s taxable estate. Assets can be gifted to the trust, or assets can be sold to the trust as an installment sale. When using an installment sale, the grantor exchanges property for a promissory note. However, because of the “defect,” the sale does not incur any capital gains or reportable income on the loan interest because the trust is ignored for income tax purposes.

Funding an Intentionally Defective Grantor Trust

To fund the trust, whether as a gift or installment sale, the grantor should use assets expected to highly appreciate. For example, if a closely held family business is expected to significantly appreciate in coming years, the grantor can contribute the business to the trust, either:

• as a gift, utilizing the lifetime applicable exemption amount at the current value; or
• as an installment sale, in exchange for a promissory note at the current market value.

All the appreciation that occurs after the date of funding the trust will pass to the next generation without incurring estate taxes.

Intentionally Defective Grantor Trust Example

In a low interest rate environment, an installment sale can be particularly attractive. Take, for example, the case of Jaime, who, in addition to other assets of $15 million, owns an LLC worth $10 million, which generates $500,000 annually in profit. Jaime’s estate is above the current $11.7 million exemption amount and, since the LLC distributes $500,000 annually and is appreciating, it’s growing. Jaime gifts to an IDGT $1 million in LLC units and sells the rest of the LLC to the IDGT for a $9 million promissory note. Since this is a grantor trust, the sale of the LLC to the trust does not trigger realization of any capital gains. The interest on the note at the current applicable federal rate is 1.74% (as of October 2021), so the IDGT only needs to pay Jaime $156,600 in interest annually. This is more than covered by the $500,000 in LLC profits that the trust now receives. The rest of the LLC profits and its appreciation stay within the trust, free from estate tax.

Immediately after the transfer, Jaime’s estate tax exposure hasn’t changed; she would have used $1 million of her lifetime exemption amount, and although the LLC is no longer part of her estate, she now owns a promissory note worth $9 million that is part of her taxable estate. Therefore, at the end of one year, assuming no appreciation in the LLC, the IDGT will now have the $10 million LLC, plus $500,000 in profit, minus the $156,600 in interest payments, or $10,343,400. Jaime, on the other hand would have the promissory note of $9 million, plus the $156,600, minus $200,000 in income taxes paid on the LLC profit, or $8,956,600. Taking the estate tax consequences of the initial gift into account, the IDGT has shifted a net $386,800 out of Jaime’s estate, for an estate tax savings of $155,000, just for the first year. Over the life of the loan, and considering the LLC appreciation, the tax savings can be tremendous.

Make Sure the Trust Follows the Rules and Regulations

An IDGT is a powerful estate planning tool that can significantly reduce one’s estate tax exposure. By utilizing the grantor trust rules of the Internal Revenue Code, an IDGT removes future appreciation and current tax payments from the grantor’s estate. Additionally, when structured as an installment sale, the IDGT can leverage a low-interest rate environment to further accentuate the tax savings.

To ensure that the IDGT maintains its grantor status and yet remains outside the estate of the grantor, the trust must follow all formalities and maintain accurate records, including principal and income accounting. Although a family member is a possible trustee, family relationships complicate the rules surrounding the trust distributions when a related party is the trustee. Therefore, it is advisable to use an experienced professional trustee like Wealth Enhancement Group to ensure the trust maintains its status and is not brought back into the estate of the grantor at death.

This material has been provided for general informational purposes only and is not intended to be a substitute for specific individualized tax or legal advice. Neither LPL Financial, nor its registered representatives, offer tax or legal advice. Federal tax laws are complex and subject to change. We suggest you consult with a qualified tax advisor to discuss your specific situation.