IDGT – What is it?

Due to possible major changes in gift and estate taxes by year-end, the use of an Intentionally Defective Grantor Trust (IDGT) is becoming more popular for making large gifts in 2021.  But what is an IDGT.

It is an irrevocable trust that will remove the contributed assets from your estate but you will continue to be taxed on the income during your lifetime.  If your taxable estate exceeds the current lifetime exemption amount, contributing assets to an IDGT reduces your estate and by paying the income taxes on the income of the IDGT a reduction in your estate will occur since the payment of income taxes is not considered a gift.

The trust document must contain at least one grantor tax provision from IRC sections 671-679.  By including this provision, we now have an “effective” trust for estate tax purposes and a “defective” trust for income tax purposes.  This means the income is taxed to the grantor, not the IDGT.

Let’s look at an example:

Mary creates an IDGT with an $11.7 million gift.  Mary has $10 million of other assets not contributed to the IDGT.  The IDGT generates $750,000 of income each year and Mary will pay $300,000 of income tax which reduces her estate by that amount each year.  When Mary passes away, the IDGT value has increased to $25 million.  The $13.3 of appreciation is not subject to estate tax.

However, in order for this to work well, you must have sufficient outside income to cover your retirement needs and any related income taxes that must be paid on income from the IDGT.  Remember that the assets you put into an IDGT are no longer yours, but your heirs.

You are allowed at some point in time to turn off the “grantor” status of the trust and have it or its beneficiaries start to pay the tax.

Another option allows you to sell appreciated assets to the IDGT on an installment sale.  In return, the grantor will receive an interest-bearing promissory note payable by the trust to the grantor. 

Since the IDGT is a grantor trust, no tax is due at the time of sale.  Essentially the grantor is treated as if they sold the asset to themselves.  The grantor receives an income stream from the installments and part of this income can be used to pay the income taxes on the income from the trust.  If the value of the promissory note is equal to the value of the property sold, there is no gift.

Most IDGTs are usually funded with a gift of assets and may also include the installment sale.

This can be a very complicated gift planning tool and you should discuss this with your estate tax advisor if your situation warrants the use of it.