Intentionally defective grantor trust

An intentionally defective grantor trust (IDGT), pronounced “ID JIT,” is a type of irrevocable trust that takes advantage of an inconsistency between the Federal Income and Transfer Tax regimes. By retaining certain powers over the trust, you, the grantor (or donor), are treated as the owner of the trust assets for income tax purposes but not for estate, gift or generation skipping transfer (GST) tax purposes. The purpose is twofold: you pay income taxes on gifted trust assets, which continue to reduce the size of the taxable estate, and the de facto tax exempt growth is achieved for assets inside the trust. These results equate to a powerful estate planning opportunity that effectively “freezes” your estate value and benefits the beneficiary.

Who should consider an IDGT?

This estate freeze technically is effective if you:

• Are sufficiently wealthy to support your lifestyle
•  Anticipate that your net worth will surpass the federal lifetime estate/gift tax exemption ($12.92 million for individuals as of 2023, adjusted for inflation)
• Desire to transfer excess wealth to children or family
• Own or intend to purchase assets with strong potential for appreciation
• Are able to pay income tax liabilities without cash flow from the transferred asset
• Are willing to tolerate complexity

Purposes of an IDGT

• To transfer appreciating assets to younger family members at a reduced transfer tax cost
• To shift the future appreciation of the underlying assets to the trust beneficiaries (i.e., creating an “estate freeze”)
• To leverage the lifetime estate tax exclusion
• To be able to pay the trust income taxes and treat it as tax-free gifts to beneficiaries of an IDGT
• To provide an alternative to other estate freeze methods like Grantor Retained Annuity Trusts (GRATs)

Key points

• You transfer assets to the IDGT by gift or sale
• Any transaction between you and an IDGT are ignored for income tax purposes so a sale of appreciated assets to the IDGT doesn’t result in capital gain recognition
• All income tax attributes (trust income/ capital gains) flow back to you as the grantor
• You pay all income taxes
• Assets transferred to the IDGT are excluded from your estate
• If IDGT assets grow faster than the IRS applicable federal rate (AFR), the appreciation is transferred to beneficiaries free of gift tax

Powers to be retained

Proper drafting of the IDGT is critical to its success. The retention of only certain powers will satisfy both the income tax and transfer tax regime requirements. The more commonly retained powers are beneficiary interest powers and administrative powers. Beneficiary interest powers include the right to enjoy or the power to control the enjoyment of the income or principal from the trust, or the right to revoke the trust. With administrative powers, it includes the power to reacquire trust assets via substitution of other assets, the power to borrow from the trust, or the power to apply income to life insurance premiums.

Additional planning concepts

The IDGT becomes additionally powerful because you have the ability to use it in various manners. Some planning opportunities include:

• Outright sale to an IDGT. The objective is to sell (not gift) an asset to the trust in exchange for a promissory note. The value of the estate is “frozen” based on the sale price.
• Sale using Promissory Note. This can be structured as a regular note or self-cancelling note. The value of the estate is “frozen” at the promissory note value.
• Use as a Dynasty Trust. IDGTs can be structured as GST trusts that leverage the GST exemption and provide multigenerational tax savings.
• Use as a Domestic Asset Protection Trust. In specific jurisdictions like Alaska, Delaware and Nevada, with proper drafting, the IDGT can shield assets from creditors and spendthrifts while including the original grantor as a potential beneficiary.

Conclusion

With significant possible benefits and minimal downside risk, the IDGT is a powerful way to freeze your estate and meet family gifting goals. Although prior planning is required and proper legal drafting is critical, it often makes sense for individuals with estates larger than the lifetime exemption to leverage this estate planning technique to reduce their estate tax exposure.

Legal disclaimer:

SEI Private Wealth Management is an umbrella name for various wealth advisory services offered through SEI Investments Management Corporation (“SIMC”). This presentation is provided by SEI Investments Management Corporation (SIMC), a registered investment adviser and wholly owned subsidiary of SEI Investments Company. Investing involves risk including possible risk of principal.

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. This information is for educational purposes only and should not be interpreted as legal opinion or advice.

Neither SEI nor its affiliates provide tax advice. Please note that (i) any discussion of U.S. tax matters contained in this communication cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor.