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                Perhaps one of the most unfortunate vocabulary choices in the estate planning field lies with the “Intentionally Defective Grantor Trust,” or IDGT.  While the use of the term defective may cause clients to cringe, there is nothing to fear about the IDGT’s legality or effectiveness. Let’s analyze the acronym:

I.D.: Intentionally Defective

                So what is defective? Essentially nothing – the term defective just relates to the grantor’s retention of a power that makes the trust a grantor trust, as explained below. The trust at its core is an irrevocable trust. An irrevocable trust is a “non-grantor” trust. By retaining one of the listed powers under the tax code, you make it a grantor trust. Done! There is the defect. Your trust just defected from the irrevocable trust world, partially, in order to pay income taxes. However, it only partially defected because it is still an irrevocable trust that moves assets out of your estate like all good irrevocable trusts do.

G.T.: Grantor Trust

        Classifying a trust as a “Grantor Trust” under the tax code is important for federal income tax purposes. A grantor trust consists of assets that are owned by a “person” rather than the trust for tax purposes.  In general terms, “ownership” means “power” under the tax code.  A person is treated as an owner of whatever trust assets the person retains power over. The grantor’s retention of one of the powers listed under the grantor trust provisions of the tax code will qualify the trust as a grantor trust, and as a result, the grantor will pay all income taxes tied to the trust assets. This “grantor trust” status terminates upon the grantor’s death because the power retained by the grantor ceases to exist when the grantor dies:  no grantor – no power.


         To summarize, an IDGT is an irrevocable trust that wants to be different. It still wants to make an irrevocable completed gift of assets for gift and estate tax purposes, but it wants the grantor, and not the trust, to pay income taxes. In order to pay income taxes, the IDGT needs to qualify as a grantor trust. Therefore, the grantor, the trust’s owner, creator, or maker (i.e., the client – the person who the attorney is drafting the trust for) retains one of the powers listed under the tax code by stating so in the trust document. By retaining one of the listed powers, the IRS treats the grantor of the trust as the owner for income tax purposes only, and pins the income tax liability on the owner. Had the grantor not reserved the powers listed in the tax code, the trust would not qualify as a grantor trust, and therefore, the trust would retain 100% income tax liability and the trust would be responsible for paying the income taxes.

                Under the tax code — the grantor is classified differently for estate tax purposes than for income tax purposes just by stating so in the trust document.

Bringing it All Together

                So what does grantor tax status achieve in the grand scheme of things. This schism creates two planning opportunities.  First, you cannot sell something to yourself for tax purposes.  That is, a sale transaction where you are both the seller and the buyer is not considered a “transfer” for income tax purposes.  That means you can create and fund intentionally defective grantor trust, which is outside your estate for estate tax purposes, and then sell an asset to that trust without incurring any capital gains tax on the sale.  This technique also avoids other penalties and consequences that may apply to certain transfers, such as transfers of like insurance.

                The second key benefit is that, when the grantor pays income tax on the trust’s income, it is effectively the same as making a tax-free gift to the beneficiaries equal to the amount of the income tax he or she would pay if the trust were a non-grantor trust.

                Qualifying as an IDGT is easy; it is the strategy behind its application to the family that is difficult. The value is not in what the trust states, it is structuring the plan that provides value to the client.

Who Should Do This?

                It depends. Estate planning techniques are goal based and based on the circumstances of the client:  Do you want to gift assets out of your estate for estate tax purposes, but want to avoid capital gains during your life? Is avoiding capital gains during your life more important than reducing your income tax liability? What are your family dynamics – the beneficiaries? …

                This is only one of a number of potential strategies and tools to consider in estate planning.  Estate tax mitigation and potential avoidance is multi-faceted and fact specific. Your goals have to align with the strategy, and your strategy has to align with your goals. Picking the technique first and figuring out your goals second will create an imbalanced estate plan with potential unintended results.



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