Intentionally Defective Grantor Trusts

Tax Professionals' Resource
April 18, 2013 — 2,358 views  
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A trust that takes the rules declared in Sections 671-679 of the Grantor Trust Rules (Internal Revenue Code) and runs them afoul is known as a 'Grantor Trust'. Traditionally, running the rules afoul was regarded negatively because the Grantor of a trust was the owner of the trust assets for the purposes of income tax. The grantor was also personally responsible for all income that was attributed to those assets in the trust. But, the grantor is not the owner for the purposes of estate tax. IDGT (Intentionally Defective Grantor Trusts) is the term used to refer to a trust that has been drafted with the specific purpose of invoking the Grantor Trust Rules.

Creating an IDGT

Intentionally Defective Grantor Trusts can be created in many ways. It can be created when the trustor or a spouse retains his/her power for recovering trust assets. It can also be created when the trustor or a spouse could benefit from the income of the trust. Another scenario is when the trustor or a spouse possesses an interest for revision of higher than 5 percent of the trust value on its creation.

Creating an IDGT is also possible when the trustor or a spouse controls when and to whom the principal and the income of the trust is distributed, or possesses some administrative powers which could benefit them. Other situations include when a beneficiary has been given the power for withdrawing the principal or trust income to themselves or when a non-adverse trustee or the trustor is given power for applying the income of the trust for premium payments on trustor or spouse's life insurance.

Need for IDGT

An IDGT has been an important component for several techniques of estate planning. IDGT can be created for irrevocable trusts, which benefit the grantor’s beneficiaries since the grantor pays the taxes that are incurred by this IDGT and could have unreduced growth. This induces the raising of the asset values for the beneficiaries of the trust. So, the tax payment made by a grantor is considered as a gift to the beneficiaries of the trust and it doesn't qualify for transfer tax. The grantor's income tax payment will also cause a reduction in the assets that are held in the estate of the grantor, which also works to reduce estate taxes.

Some really valuable tools for estate planning, such a GRAT, GRUT, and QPRT, lead charitable trusts and certain insurance related trusts are also considered as IDGTs. The trustor doesn't necessarily have to be a grantor in an IDGT. Rather, if the trust's beneficiaries have even a brief period of rights for withdrawing assets from a trust, for Grant Trust Rules purposes, they are considered grantors with regards to those assets that are held by the IDGT. But, this might cause issues of creditor protection for beneficiaries.

Also, an asset sale to an IDGT by its grantor will not induce gain as a grantor is considered an owner of those IDGT assets for the purpose of income tax. The interest that a grantor gets from the IDGT cannot be subjected for income tax related treatment. If an asset has been sold on installment basis, and the grantor's death occurs before the payments have been completed, all the payments made after his/her death will be considered for treatment by the income tax department.

Tax Professionals' Resource