Individuals with sizable estates have a variety of estate planning strategies available to them. One popular strategy is the Intentionally Defective Grantor Trust, often referred to as an IDGT.
While there are many benefits to IDGTs, the primary benefit from an estate tax perspective is that the grantor (i.e., an individual gifting or selling assets to the trust) can move asset(s) out of their estate via sale or gift, allowing the appreciation on the gifted or sold asset to continue to grow. During this period, the grantor continues to decrease their estate by paying income taxes personally related to the trusts income, as long as it keeps its grantor status.
In this guide, we provide an overview of how IDGTs are structured and funded, detail important tax considerations and benefits, and explore the key factors individuals should bear in mind before establishing an IDGT.
What is an Intentionally Defective Grantor Trust?
In essence, an IDGT is a trust set up by a grantor that is treated as separate from the grantor for federal estate and gift tax purposes but is treated as owned by the grantor on a federal income tax basis. The IDGT is “defective” for income tax purposes, and “effective” for estate and gift tax purposes.
Funding an Intentionally Defective Grantor Trust
IDGTs can be established in a couple of different ways. First, individuals may gift assets outright to the IDGT. The fair market value of these assets at the time of the transfer is counted toward the individual’s lifetime exemption if it exceeds annual gift tax exclusions.
- This may be the most common and easiest method to fund an IDGT. The grantor will make an irrevocable gift of the asset to the trust, and in return the grantor will pay income taxes produced by the assets within the trust.
- This accomplishes three things:
- Gifting appreciating asset(s) out of the grantor’s estate freezes the post-gift appreciated value of the asset out of the grantor’s estate.
- The grantor will pay income tax produced by the gifted asset(s), thus continuing to lower the grantor’s estate.
- Allows the grantor to essentially make tax-free gifts to the trust by paying the income tax, which helps the assets in the trust grow unencumbered by taxes and pass to the next generation free from estate taxes.
The second way to fund an IDGT is to sell an asset to the trust in exchange for a promissory note. The interest rate on the promissory note is the minimum required by the IRS, also known as the AFR (Applicable Federal Rates).
- The grantor usually makes an initial “seed” gift of at least 10% of the asset’s value that is intended to be sold to the IDGT. This gives the sale validity in the eyes of the IRS as a real sale without a retained interest. The grantor can use their full or remaining lifetime gift/estate exemption to avoid gift taxes.
- After the seed gift, the grantor sells an asset(s) to the IDGT in exchange for a promissory note. This accomplishes the following:
- Because the IDGT is purchasing the asset, it is not considered a gift to the trust, thus it will not lower the grantor’s lifetime exemption or create taxes from a gift if the grantor does not have any remaining (or a lower amount) lifetime gift/estate exemption.
- Because there is a sale of the asset to the IDGT – which for income tax purposes, is the grantor there is triggering of a taxable gain and the interest payments made back to the grantor from the promissory note are not taxable to the grantor. The interest payments from the note back to the grantor can – and often are – be used to pay the income taxes generated in the trust.
- Provides the ability to “freeze” the value of the highly appreciated asset. Once sold to the IDGT, any future income and appreciation from the asset grow outside the grantor’s estate
Key Considerations When Forming an IDGT
IDGTs can be a great estate planning tool and strategy, but it’s important to understand the ramifications of establishing an IDGT before starting the process. Consult with qualified professionals, including financial advisors, tax planners, and attorneys. Below is an overview of the key tax and non-tax considerations that individuals should weigh.
Grantors retain responsibility for paying certain taxes when implementing an IDGT:
- Income Taxes via Gift to IDGT: the grantor pays income tax on any income generated by the assets within the IDGT, such as dividends, interest, taxable income from a business, and realized capital gains.
- Taxes Via Asset Sale to IDGT: the gifted “seeded” assets before the sale to the IDGT may produce income. The grantor is responsible for paying taxes – as mentioned above – that are generated from these assets. The sale of the asset to the IDGT and installment note interest payments are not taxable to the grantor.
- Gift Taxes: Asset gifts to an IDGT are subject to gift taxes. To the extent the asset gift is larger than annual exclusions, which it most likely will be, the gifted asset would lower the grantor’s remaining gift/estate lifetime exemption.
- Estate Taxes: Assets gifted or sold to the IDGT pass to the beneficiaries outside of the grantor’s estate. If the grantor passes before the expiration of the installment note term, the value of the note as of the date of death would be included in the grantor’s gross estate.
Additional Benefits of IDGTs
While many benefits of IDGTs were highlighted above, there are some important additional benefits provided by these trust structures.
- Substitution or “Swap” Powers: if structured properly, the grantor has the ability to swap assets out of the trust in exchange for assets of equal fair market value.
- For example, the grantor could exchange cash into the IDGT in return for highly appreciated stock and then gift this stock to charity, helping the grantor from a personal income tax perspective. Or, vice versa, the grantor could exchange highly appreciated stock to the trust in exchange for cash or high basis stock if they needed the funds for liquidity.
- Valuation Discounts: the asset sale to an IDGT can be further leveraged through valuation discounts. If the grantor is gifting shares of a business, generally certain shares – typically ones that lack marketability and/or control – receive discounted valuations, thus reducing the value of the sale to IDGT, which then reduces the amount of interest payment back to the grantor. It also reduces the amount of the common 10% “seeded” gift to the IDGT before the sale.
Non-Tax Considerations of IDGTs
IDGTs offer impactful tax benefits, enabling high-growth assets to appreciate outside of the grantor’s estate. But in addition to those tax benefits, there are a range of other non-tax considerations that individuals should consider:
- Liquidity: individuals should consult with their financial planner to ensure that they are not gifting or selling assets that they need to sustain their current standard of living. Individuals should also confirm they have the ability to pay the added income tax from the IDGT.
- Asset Sale Cash Flow: Assets sold to the IDGT need to provide income at or above the ARF rate to make the installment interest payments back to the grantor. The “seeded” gift before the asset sale can help with this during the beginning of the note period.
- Post-Mortem Control: an IDGT is an irrevocable trust. This means that the terms of the IDGT cannot be changed or amended easily. However, grantors do benefit from post-mortem control of the distribution of the trust’s assets per the terms of the IDGT when it was created. These benefits include generational wealth continuity, creditor protection, and probate avoidance, to name a few.
- Choosing a Trustee: grantors should take care to select a responsible, knowledgeable trustee to steward the trust.
Smith + Howard Wealth Management: Experienced Estate Planning Professionals
Intentionally Defective Grantor Trusts are powerful estate planning techniques that can help high-net-worth individuals in a myriad of ways.
Start by consulting with a financial planner to determine your ongoing liquidity needs. Individuals should also connect with a CPA to clarify the tax implications of an IDGT, both from an income tax and an estate tax planning perspective. Finally, an experienced estate planning attorney is required to draft the legal documents.
At Smith + Howard Wealth Management, our estate planning experts are on hand to help clients design and execute highly effective estate planning strategies. Our financial planners work closely with tax advisors and estate planning attorneys.
To start exploring the estate planning process with Smith + Howard Wealth Management, contact an advisor today.
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