4 min read
Understanding Intentionally Defective Grantor Trusts (IDGTs)
Richard English, J.D., Managing Director-West Region, Commerce Family Office
:
Aug 30, 2024 2:05:22 PM
![Understanding Intentionally Defective Grantor Trusts (IDGTs)](https://www.commercetrustcompany.com/hubfs/IDGTs-NEW-2.jpg)
What is an intentionally defective grantor trust?
The term “grantor trust” is broadly used to describe a trust for which the grantor is treated as the “owner” of the assets for income tax purposes. An “intentionally defective” grantor trust (IDGT) is an irrevocable trust that is designed to remove assets from the grantor’s estate for estate tax purposes but keep the grantor responsible for the ongoing income tax liability associated with those assets. In contrast, with an irrevocable trust that is not a grantor trust, the income tax liability for the trust’s investment activity is typically borne by the trust itself, the trust’s beneficiaries, or in many cases, a combination of the trust and its beneficiaries.
Advantages of an intentionally defective grantor trust:
Helping the beneficiaries without making a gift: When the grantor, rather than the trust or its beneficiaries, pays a tax liability, it provides a benefit to the beneficiaries without involving a taxable gift.
Preserving the trust’s value: When the grantor pays a tax liability that would otherwise be borne by the trust, such as a capital gain tax incurred when the trust sells an investment, the grantor is helping the trust keep its value intact for future growth.
Lower taxable estate: For grantors with potential estate tax liability, strategically reducing the value of their own estate by paying taxes on the trust income may be a prudent strategy to ultimately lower their estate taxes. By paying tax that would otherwise be paid by the trust or its beneficiaries, the grantor reduces the size of his or her estate, which can help reduce the grantor’s estate tax liability.
Efficiently utilizing the federal lifetime estate and gift tax exemption: The simplest form of grantor trust planning involves making a gift to a grantor trust. Most grantors will keep the amount of such gifts within the amount of the lifetime exemption from federal estate and gift taxes. Utilizing this exemption amount efficiently can help reduce or even eliminate your estate and gift tax liability.
Selling assets to an IDGT provides additional leverage: An additional planning opportunity for those with especially large estates is to sell assets to an IDGT in exchange for a promissory note. The idea behind doing so is to exchange a highly appreciated asset (such as stock in a successful business) for an asset that will necessarily decrease in value as it is paid down (a promissory note). This allows the transferred asset to continue to appreciate outside the grantor’s estate as the promissory note depreciates, which serves to lower the value of the grantor’s taxable estate and potentially reduce his or her estate taxes.
Considerations for an intentionally defective grantor trust:
Revocable versus irrevocable: A typical revocable trust, where the grantor retains the power to revoke it, is treated as a grantor trust during the grantor’s lifetime. An irrevocable trust may or may not be a grantor trust, depending on the terms of the trust and whether the grantor has retained certain powers. An IDGT will always be irrevocable because one of its purposes is to exclude assets from the grantor’s estate.
Grantor powers: If a person wishes to create a grantor trust, he or she might do so by retaining one or more powers that cause grantor trust status without also causing the assets of the trust to be included in the grantor’s estate for estate tax purposes. Among the powers that are often used are the power to reacquire trust assets by substituting other property of equivalent value, and the power to borrow from the trust without adequate security.
Income tax liability: Creating a grantor trust assumes that the grantor has the capacity to bear all of the tax liability generated by the trust’s activity. Whether the trust has ordinary income, qualified dividends, capital gains, or other forms of income, the tax liability belongs to the grantor.
Turning off grantor trust status: If the grantor wishes to terminate the grantor trust status at some point in the future, making the trust and/or its beneficiaries liable for the ongoing tax liabilities, it may be possible for the grantor to release the power(s) that cause grantor trust status.
Example of income tax planning with an IDGT:
Julia is a single woman with adult children and a substantial estate, including publicly traded stock and stock in a family business. She likes the idea of making a large gift to her children while she is living but wishes to fund an irrevocable trust for their benefit, rather than making an outright gift. She understands that typically the trust or her children would be responsible for any income tax on the trust’s investments.
As an added benefit to her children, she decides to remain responsible for these taxes by making the trust an intentionally defective grantor trust. She does so by reserving the power to reacquire trust assets by substituting other property of equivalent value, and the power to borrow from the trust without adequate security.
She funds her IDGT with cash and marketable securities. Because she does not wish to pay a gift tax, she keeps the amount of her gift below the amount of her unused exemption from estate and gift taxes. In addition, to get more value into the IDGT, she is considering selling some of the stock in her family business to the IDGT in exchange for a promissory note.
Comprehensive estate planning strategies from Commerce Trust
While an IDGT can be an impactful estate planning tool for estate tax reduction and income tax planning, its efficacy depends on careful consideration of your financial goals and a thorough understanding of applicable laws. At Commerce Trust, our wealth management teams are comprised of specialists across multiple disciplines who can help you determine which estate planning strategies best support your comprehensive estate plan. If that includes establishing a trust, we will prepare you to meet with an estate planning attorney by providing holistic guidance in advance and can work closely with them on an ongoing basis to achieve your unique objectives. Contact Commerce Trust today if you want to learn more about our private wealth management and estate planning services and how we can help you incorporate a trust into your estate plan.
The opinions and other information in the commentary are provided as of August 16, 2024. This summary is intended to provide general information only, and may be of value to the reader and audience.
This material is not a recommendation of any particular investment or insurance strategy, is not based on any particular financial situation or need, and is not intended to replace the advice of a qualified tax advisor or investment professional. While Commerce may provide information or express opinions from time to time, such information or opinions are subject to change, are not offered as professional tax, insurance or legal advice, and may not be relied on as such.
Commerce Trust does not provide tax advice to customers unless engaged to do so. Commerce Trust does not provide legal advice to its customers. Consult an attorney for legal advice, including drafting and execution of estate planning documents.
Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Commerce Trust is a division of Commerce Bank.
Investment Products: Not FDIC Insured | May Lose Value | No Bank Guarantee
How Can Our Team Help You With Your Estate Planning Needs?
Required information*
Related Articles