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Intentionally Defective Grantor Trust (IDGT)

Instructor: Chang Park

Chang has taught college Finance & Accounting courses and has a terminal degree in Finance.

In this lesson, you'll learn about an intentionally defective grantor trust (IDGT). This trust takes advantage of two different sets of tax law interpretations.

What Is a Trust?

If you pass away without a trust, the average probate - or court process to determine if your will is valid - costs between 2% and 5% of your estate, which could add up to a lot of money. Also, depending on the complexity and your state of residence, the probate process can be very time consuming. It's not unusual for it to take between six months and two years.

If you set up a trust, though, you don't hold the assets. The trust does, possibly thwarting the sometimes expensive and lengthy probate process. A trust is a legal contract that lays out the rules for the administrator of the trust (also known as the trustee) to follow for the benefit of a grantor's beneficiaries.

What Is an Intentionally Defective Grantor Trust?

An intentionally defective grantor trust (IDGT) is a type of living trust that's very popular with rich grantors who have large estates that include many continually appreciating assets. This particular trust provides a rare 'loophole' to retain maximum control of the property transferred by the grantor when he or she is alive while effectively freezing the value of the estate.

If the grantor has reversion interest of more than 5% of the total trust assets at the time of the transfer, the trust is regarded to be a grantor trust. A grantor trust is a disregarded entity in the sense that the income and/or expenses of the trust are taxed at the grantor's income tax rates instead of those of the trust.

So, this trust takes advantage of two sets of tax laws applied to a single transaction. Firstly, from the perspective of transfer tax purposes, it is a complete transfer. Secondly, it is a defective trust from the perspective of income tax laws. By the way, the income tax rates for trusts are much higher in most cases than those for individuals, ever since the American Taxpayer Relief Act of 2012 increased income tax rates on top of the new net investment income tax.

Benefits of an Intentionally Defective Grantor Trust

The beneficiaries of an intentionally defective grantor trust are typically children or grandchildren, who will receive assets that have been able to appreciate without reductions for income taxes, which are picked up by the grantor. The intentionally defective grantor trust can be a very effective estate planning tool for certain grantors, allowing a person to lower his taxable estate while gifting assets to beneficiaries at a locked-in value. The grantor of the trust can also lower his taxable estate by paying income taxes on the trust assets.

Mechanics of an Intentionally Defective Grantor Trust

Technically, the transfer of assets to an intentionally defective grantor trust could be either by gift or sale (fair market value sale or installment sale). Initial contribution of assets through either outright sale or installment sale, though, is disregarded for income tax purposes.

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