The intentionally defective grantor trust has become a popular estate planning tool. If structured properly, a grantor trust can be treated differently for income tax and gift and estate tax, creating planning opportunities, particularly when used with other wealth shifting techniques.
Smart Business spoke with Richard Nelson, director of the Tax Strategies Group at Kreischer Miller, about how a defective grantor trust works.
How does an intentionally defective grantor trust work?
An intentionally defective grantor trust (IDGT) is an estate planning tool used to shift wealth by removing an appreciating asset from an individual’s estate without creating a taxable gift. It also removes future appreciation from estate tax.
The trust must be a grantor trust and also irrevocable. If properly structured, the trust will be disregarded for income tax purposes and the trust’s income or deductions will be taxable to the grantor (individual creating the trust).
The IDGT will be treated as a grantor trust if it fails one or more of the grantor trust rules found in the Internal Revenue Code.
Generally, if the grantor retains sufficient control over the trust and the trust assets, it will be treated as a grantor trust even if irrevocable.
Two of the common drafting techniques used to ensure that the grantor trust fails the rules is to give the grantor the power to reacquire the trust property by substituting property of an equivalent value or by giving an individual the power to add to the trust additional beneficiaries.
These powers should result in the grantor being treated as the owner of the trust for federal income tax purposes but not for inclusion of the asset for estate tax purposes.
Generally, once the trust is created, the grantor would sell the asset to the trust in exchange for a note — generally an installment note. The asset must be sold at its fair market value and an adequate interest rate must be charged on the installment note.
When using an installment sale it is essential that the asset sold to the trust is not the only source of payment regarding the note.
Once the trust is created, and prior to the sale, the grantor must gift cash or other assets with a value of a minimum between 10 percent and 20 percent of the value of the asset being sold in exchange for the installment note.
