An intentionally defective grantor trust (IDGF) is a tax loophole used to reduce estate tax exposure. The trust is constructed with an intentional flaw used to freeze assets contained within an irrevocable living trust. The individual who constructs the trust (the grantor) will continue to pay taxes on income generated by assets within the trust. However, the value of the assets held within the trust is allowed to grow tax-free. This can prove useful to your beneficiaries.
How Does an IDGT Work?
Since the IDGT is an irrevocable trust, the assets held within the trust are removed from the grantor’s estate. The trust is established by a non-interested party (someone who is neither the grantor nor a beneficiary). The trust incurs tax liability on income, but for estate taxes, is tax defective. For this to work, the trust must contain a provision outlined in IRC sections 671-679.
In basic terms, you find an attorney willing to set up the IDGT. The attorney establishes the trust with you as the grantor naming your various loved ones as beneficiaries. You “sell” assets to the trust and they are removed from your estate. In exchange for the sale, you receive a promissory note of a certain period of time. The promissory note pays enough interest to hold the trust above market; however, the assets usually are expected to appreciate faster than the interest the note pays. You pay taxes on the interest of the promissory note but your beneficiaries do not pay gift taxes on the transfer. The amount you paid does not count as a gift to your beneficiaries.
What Are the Benefits of an IDGT?
You can’t be taxed twice on the same asset. Since you are the one who is paying the income tax on the assets held in the trust vis a vis the promissory note, your children, grandchildren, or other beneficiaries, will not have to pay taxes when the assets are transferred. In other words, it completely avoids the gift tax associated with transferring valuable assets from the estate of one individual to another.
To put it another way, you reduce taxes on your estate while gifting assets at an already-established value. By paying taxes on the income generated by the assets, you ensure your beneficiaries don’t have to pay those taxes, regardless of how much the assets’ value has appreciated.
How Do I Fund an IDGT?
Grantors have two options for funding an IDGT. You can either give an asset to the trust or sell an asset to the trust. Giving the asset to the trust may incur a gift tax. The better option is to sell the asset to the trust. Assets that are sold to the trust do not incur capital gains taxes. In return, the grantor gets a promissory note that is paid in installments over several years.
While selling assets to the trust removes the burden of the beneficiaries to pay taxes on the estate transfer, gifting can also significantly reduce the amount of taxes a beneficiary would owe. This is especially true of assets that are expected to appreciate rapidly. The IDGT will freeze the value of assets held within the trust, and you will pay (or have the transfer counted against your exemption) before that appreciation occurs.
For estate planning purposes, selling assets to the IDGT makes more sense. Since you end up paying taxes on the income generated by the IDGT through the promissory note, the transfer may not eat up any of your estate and gift exemption. This is because the taxes paid on the interest generated by the promissory note does not count as a gift against your estate.
Contact a Palmdale CA Estate Planning Attorney Today
An intentionally defective grantor trust freezes the value of valuable assets by paying the appreciation out in a promissory note that you then pay taxes on. These assets are simultaneously removed from the grantor’s estate, which means that they aren’t counted toward $11.4M exemption. The money paid on the taxes is not considered a gift to the beneficiaries either, further reducing the overall value of your estate. So it’s a great way to insulate your estate from tax exposure to your beneficiaries.
Herbert Law Office can help you protect your family assets from tax liability. Contact us today to find out if an IDGT is right for you.