Why it matters:

With estate tax exemptions scheduled to change in the coming years, many high-net-worth individuals are looking for ways to lock in today’s favorable thresholds while shifting future growth out of their estate. IDGTs offer a unique opportunity to do both: freeze the value of transferred assets for estate tax purposes while continuing to fund the tax liability, effectively making additional tax-free gifts over time.

What is an Intentionally Defective Grantor Trust (IDGT)?

It is common to setup an irrevocable trust as an Intentionally Defective Grantor Trust (“IDGT”). An IDGT causes the Grantor to remain liable for any income taxes generated by trust assets, while placing trust assets outside of the Grantor’s taxable estate. 

By using “your money” to pay the income taxes attributable to the income earned by the trust’s assets, you effectively allow the IDGT to grow income-tax free, you pay the taxes, while simultaneously reducing your taxable estate, by the income taxes you paid for the trust! Additionally, paying tax on income held by a IDGT is not considered a gift.

Added flexibility of an IDGT

Irrevocable trusts can be created to be intentionally defective if certain trust provisions are met in the trust formation documents. One common provision is the right of a grantor to substitute property in the trust. Provisions like the power to substitute give IDGTs added flexibility. 

Another example of added flexibility comes with the ability to reimburse the grantor for taxes paid on income related to trust. While this diminishes the benefit mentioned above, that payment of the income tax is not subject to gift tax, it gives the grantor options if they have liquidity issues. 

Best strategies for utilizing IDGTs

• Fund with appreciating assets: Assets expected to grow significantly (e.g., closely held business interests or investment portfolios) maximize the estate tax benefit.
• Use installment sales to the trust: Selling assets to an IDGT in exchange for a promissory note can “freeze” the asset value while shifting future appreciation to beneficiaries.
• Leverage valuation discounts: When applicable, discounted valuations (e.g., for lack of marketability or minority interests) can enhance transfer efficiency. 

Common misconceptions

• “Defective” means flawed: In reality, the “defect” is intentional and creates the tax advantage.
• You lose all control: While the trust is irrevocable, it can be structured with certain powers and flexibility depending on the design.
• It only benefits ultra-high-net-worth individuals: While most effective for larger estates, IDGTs can be useful in a range of wealth transfer strategies.
• It’s a one-time strategy: IDGTs often work best as part of a broader, ongoing estate and tax planning approach.