Defective Or Perfect? Intentionally Defective Grantor Trusts In Succession Planning

Something labeled “defective” usually does not work properly.  The intentionally “defective” grantor trust, or “IDGT,” however, is a proven workhorse for tax-efficient business succession planning.  A carefully planned and executed IDGT transaction enables business owners to transfer significant value in trust for the benefit of younger generations, with remarkable tax efficiency, while retaining control over the business. Two seemingly contradictory tax attributes of the IDGT underlie its tax efficiency. 

For federal income tax purposes, the IDGT is treated as owned by the person who created it (the “grantor”). The grantor, as “owner,” is required to pay the income tax on income earned by the IDGT’s property. The practical effect of each income tax payment is a tax-free gift to the IDGT. Trusts pay income tax at the highest marginal rate (37%, not including the net investment tax) as soon as taxable income exceeds $15,650, so each “tax-free gift” may be substantial. 

In contrast, the property held in the IDGT is not treated as owned by the grantor for federal estate tax purposes.  Because the grantor is not the “owner” of the IDGT property for estate tax purposes, no estate tax  is paid on the value of the IDGT’s property at the grantor’s death (a 40% savings). The synergy of the income tax and estate tax attributes of the IDGT increases the estate tax savings. The grantor reduces his[JE2.1] taxable estate by paying the IDGT’s income tax liability with property that would be subject to estate tax at his death, which payments effectively increase the value of property not subject to estate tax, the IDGT. 

The IDGT transaction is a powerful planning tool.  Is it perfect? No – but maybe close.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.