Intentionally Defective Grantor Trusts (“IDGTs”) are a commonly used estate planning vehicle to transfer wealth to family members during the life of the grantor. In this whitepaper we will explore the four tax types relevant to IDGTs, and the mechanics of how IDGTs work. The use of the phrase “intentionally defective” is confusing, but it simply refers to an irrevocable trust where the grantor pays the trust’s income tax bill during his or her life.
What taxes relate to an IDGT?
There are four types of taxes to consider: estate, gift, generation-skipping transfer (GST) and income. An IDGT allows the grantor to be the “owner” of the trust for income tax purposes, but removes the assets contributed to the trust from the grantor’s estate for estate tax purposes.
How does estate tax apply here?
A typical IDGT is not subject to estate tax at the grantor’s death. Upon death, any assets in an individual’s name above a specified threshold amount are taxed at a set percentage rate prior to transferring to the individual’s beneficiaries. The current threshold in 2024 is $13.61M per person; meaning that an individual may leave up to $13.61M in assets to any beneficiary without paying Federal gift or estate tax. Anything above that threshold amount will be taxed at a rate of 40% in 2024.[i]
However, certain exclusions and exemptions apply. If the individual is married at her death, for example, the assets passing to her spouse may pass estate tax free under the marital deduction. In addition, if the individual designates a charity as her beneficiary, the assets may pass estate tax free via the charitable deduction.
The grantor also has to think about state estate tax. The grantor may live in a state such as New York that doesn’t impose a gift tax, but that imposes a state estate tax at a lower threshold than the Federal estate tax. When this is the case, it’s even more impactful from an overall estate tax perspective to make a lifetime gift to an IDGT. For a New Yorker, there would be no New York gift tax cost, and you are reducing your New York estate tax bill at your eventual death.[ii]
When a Grantor of a trust relinquishes control over the assets and doesn’t retain an interest in the income or principal of the trust, the assets contributed to the Trust are removed from the Grantor’s estate. However, any contributions will be subject to Gift Tax.
So how does the gift tax work, then?
In the vast majority of cases, the grantor won’t have to pay a gift tax, but she will have to use part of her lifetime exemption to transfer assets to an IDGT. Any gifts made during an individual’s life that exceed a certain threshold amount may be taxable to the individual at a specified rate, currently 40%.
Similar to the estate tax, there are certain exclusions that apply. For example, there is an exclusion for “medical/educational” gifts if payments are made directly to the provider. Where a taxable gift occurs, the individual may use the same credit available to her under the estate tax rules to avoid immediate payment of tax. However, any gifts made will be included in the taxable estate of the individual at her death.
The main advantage of making a taxable gift and using lifetime tax credits rather than waiting until death is that any growth on the assets gifted during the lifetime of the individual will not be taxed at her death. In other words, by gifting assets during life that are likely to appreciate, the individual is essentially freezing the value of the assets for transfer tax (i.e., estate or gift tax) purposes, allowing any appreciation to pass to beneficiaries transfer tax free.
How does the GST tax work, then? Is the trust forever estate tax-free, even when it makes distributions to grandkids?
Possibly. If the grantor used his GST exemption when making the gift to the IDGT, the trust will NOT be taxed on distributions to grandkids. The trust will be exempt from GST tax because the grantor “paid a price” to get the dollars into the trust by virtue of using some or all of his GST exemption to shield the value of the gift.
Generally, assets passing through an individual’s estate will be taxable at her death, then pass to her children. At the death of her children, the assets will be taxed again when they pass to her grandchildren. In order to avoid the “double taxation” that occurs when assets pass through two generations, individuals would make direct gifts to grandchildren either outright or in trust to circumvent the taxation of the estate at their children’s death. To prevent this method of tax avoidance, the IRS imposed a generation skipping transfer tax, taxing any assets that pass directly or indirectly to a “skip person” (someone who is more than one generation younger than the individual) in addition to the estate tax and gift tax. Currently GST Tax, estate tax and gift tax are linked at a rate of 40% each.
Like the estate tax and gift tax, there is a threshold amount that can pass to an individual’s beneficiaries without GST Tax, also tied to the estate and gift tax exemption. In 2024, an individual may make direct or indirect gifts to a skip person of up to $13.61M without being subject to GST Tax.
Last but not least, who pays income tax on the gains inside trust?
The grantor. That’s the whole point of an “intentionally defective” grantor trust: the trust and the grantor are considered the same person for income tax purposes.
When a trust is not a grantor trust for income tax purposes, it means that the trust itself will be a separate income tax-paying entity, and will file its own tax return each year, paying income tax at rates based on the compressed trust tax brackets. Generally, trusts pay higher tax rates than individuals, as the threshold income levels for each tax bracket are much lower than individual tax rate threshold amounts.
When a Grantor retains certain rights to a trust, however, she will be considered the owner of the trust for income tax purposes. This means that the trust income will be taxed at the grantor’s tax rate, and the grantor will benefit from any deductions available in the trust. In addition, when the grantor pays the income tax owed by the trust, she is essentially making additional tax-free gifts to the trust. By covering the trust’s tax bill, she is also allowing the trust assets to appreciate faster than they would if the tax was paid directly from the trust.
When a grantor is considered an owner of the trust for income tax purposes but has relinquished rights to the assets in the trust in a way that allows the grantor to not be considered the owner of the assets for estate tax purposes, this is called an Intentionally Defective Grantor Trust. It is “defective” because the grantor hasn’t rid herself of all ownership for income tax purposes. But the defect is intentional because, in this case, we want the grantor to be the income taxpayer.
How are distributions made?
It’s up to the grantor. When the trust is created, the grantor determines the way in which trust distributions are made. The IDGT can preserve the family wealth by limiting distributions to a standard set by the Grantor or at the discretion of a carefully selected Trustee. Access to funds by the beneficiaries can be as limited or as broad in scope as the Grantor decides. The assets owned by the IDGT are for the benefit of the beneficiaries but are not their personal assets. The IDGT can serve as a partial substitute for a prenuptial agreement, preserving the trust assets as separate property to which the beneficiary has only limited access.
What’s a “Pot Trust”? Can an IDGT be a pot trust?
Yes. A pot trust (also sometimes referred to as a “sprinkle” or “spray” trust) is simply a trust for multiple beneficiaries where distributions can be made to any beneficiary at the trustee’s discretion.
By way of example, let’s say mom and dad have 3 kids and each kid has children of his or her own. Mom and dad may wish to create an IDGT for the benefit of all of their descendants. A typical structure would be to set up the trust as a general “pot” trust for ALL descendants during mom and dad’s lives. Then, when the survivor of mom and dad die, the trust splits into 3 separate pot trusts. But this time, each pot trust is only for the child and that child’s kids. The way in which the grantor decides to structure the trust will depend on his or her own unique family circumstances.
Can an IDGT be a spendthrift trust?
Yes. The Grantor may wish to build safeguards into the trust to protect her beneficiaries from creditors, and to allow her trustee to protect the assets from misuse by a beneficiary whose judgment has become clouded by substance abuse, improper influences, or any other issues that would jeopardize the trust assets.
Can I transfer life insurance policies to the trust?
Yes. The trust may hold life insurance policies on the life of the Grantor, allowing the proceeds of the policy to pass safely in trust to her intended beneficiaries.
What’s a SLAT? Can an IDGT be a SLAT?
Yes. The Spousal Lifetime Access Trust, or “SLAT”, is simply an intentionally defective grantor trust where the Grantor’s spouse is a permissible beneficiary of the trust along with descendants. By including her spouse as beneficiary, the Grantor is able to transfer assets to an irrevocable IDGT but still ensure that the spouse has access to those assets should he need it during his life. While all of the aforementioned tax benefits generally apply to SLATs, careful drafting and funding must occur to be certain the assets do not fall back into the Grantor’s estate, particularly if each spouse wishes to create a SLAT for the benefit of the other spouse.
What other considerations are there?
IDGTs are an excellent planning vehicle for the right individual. However, caution must be exercised when creating this type of trust. Things to consider before working with your estate planning attorney:
- Will I need access to the assets I plan to put into the trust? If the answer to this question is yes, an IDGT may not be for you. While it may be possible to access assets by swapping your individual assets for those in trust, or by borrowing funds from the trust, an IDGT is not meant to be revocable or easily accessible to the Grantor.
- Do I expect these assets to appreciate over time? The optimal assets for funding an IDGT will appreciate over the term of the trust, benefiting the Grantor by reducing her estate by the amount of appreciation accumulated in the trust. Where assets are not expected to appreciate, the Grantor may wish to hold the assets until her death.
- How much control do I wish to give my beneficiaries? The Grantor can retain significant control over the trust property even after the trust is created. The Grantor, for example, may retain the ability to hire and fire the Trustee, and may set limits regarding when (if ever) his descendants become Trustees. The Grantor can often retain the ability to determine the trust investment policy and may even have the final say regarding investments of trust capital for future investment opportunities.
- Who will be my Trustee? Choosing the right Trustee is integral to your plan. Choosing a spouse or child can pose tax issues and requires very careful drafting of the documents.