What Is an IDGT? Definitions, Examples and Requirements
When it comes to estate tax planning, there is a lot of pressure to manage your finances to maximize assets and minimize tax burdens, both for yourself and for your beneficiaries. When done effectively, using an intentionally defective grantor trust (IDGT) to separate your taxable assets can be a rewarding strategy, but the process can be complex and hard to navigate on your own.
Discover everything you need to know about IDGTs, including what they are and the requirements you need to meet to invest in one.
Understanding Intentionally Defective Grantor Trusts
An intentionally defective grantor trust is a sophisticated estate planning tool designed to separate assets for different tax treatments. Essentially, an IDGT is an irrevocable trust that reduces the taxable value of an estate to minimize or avoid estate and gift tax payments, while enabling the grantor — the person who sets up the trust — to retain ownership of assets for income tax purposes.
IDGTs are highly beneficial for providing estate planning flexibility, asset growth and a smooth transfer of maximal assets to future generations.
With an IDGT, the different tax purposes are treated as follows:
- Income tax: The grantor is responsible for paying income taxes on any income that the assets within the trust generate. Therefore, the assets within the IDGT are able to grow without diverting any of the fund’s assets to pay income taxes.
- Estate and gift tax: Any assets added to an IDGT are automatically removed from a grantor’s estate, enabling the grantor to avoid gift tax and treat the payments of income tax separately.
For an IDGT, assets can be transferred using various methods, including gifting or a combination of sales and gifting.
Common Examples of IDGTs
IDGTs are typically used for estates and assets that are intended to be passed down to relatives or other beneficiaries upon the passing of a grantor.
There are many types of assets that you can benefit from placing in an IDGT. Generally, the best assets to transfer into an IDGT are those with the highest potential to appreciate over time.
Examples of suitable assets include:
- Real estate.
- Private equity investments.
- Hedge funds.
- Intellectual property.
- Business interests.
- Stocks.
How Does an IDGT Work?
There are many nuanced steps involved in setting up and benefiting from an IDGT. Here are the basics:
Create and fund: The grantor creates the irrevocable fund and adds to it a gift of cash or assets, and, in doing so, relinquishes control over those assets. This is where the ‘defective’ nature of the trust comes in — although they defer control of the assets, and consequently the need to pay gift or estate tax on them, the grantor continues to pay income tax on the trust’s earnings. The grantor will also appoint one or more trustees.
Sell or gift to the fund: After receiving initial funding, the grantor can transfer assets to the fund through sale or by gifting. At this point, the grantor and IDGT are considered the same entity for income tax purposes, so transfers of these assets are tax-free.
Tax benefits for beneficiaries: The fund’s beneficiaries are able to benefit from any asset growth without having to pay income taxes. As the assets are also no longer part of the grantor’s estate, beneficiaries also benefit from inheriting the assets without paying estate taxes.
Common IDGT Uses
Explore the primary uses for IDGT below.
The Sale of Business Interest
Hypothetically, if you wanted to transfer your company to your IDGT to benefit from tax relief, you could either gift or sell your business’s interest. The most tax-effective method in this instance would be to gift the interest, but many people feel more financially secure when they sell the interest in return for an installment note.
In most cases, the process for selling business interest to an IDGT follows these steps:
- Seed gift: You, the grantor, would gift an amount of 10% or more of the business interest being sold.
- Installment note: The IDGT would purchase the business interest from you with an installment note.
- Payment terms set: The grantor sets the payment terms of the installment note, which will usually have an interest rate in line with the IRS Applicable Federal Rate, and which will not be taxable to you.
- Payments made: The IDGT will make payments to you on the installment note by using tax distributions from the business.
A Transfer of Wealth
The most common use of an IDGT is to transfer wealth from a grantor to their beneficiaries — usually their heirs, who tend to be descendants or other relatives.
In most cases, the process for transferring wealth through an IDGT is similar to the one above, and includes establishing beneficiaries, transferring a seed gift and receiving payments on an installment note.
In this type of IDGT, once the grantor dies, the assets within the trust bypass your taxable estate, avoid probate and pass directly to your chosen beneficiaries.
Requirements for Gifting to an IDGT
You must have a comprehensive understanding of the requirements and sound financial advice before you decide on gifting to an IDGT.
The requirements for gifting to an IDGT are twofold. The IDGT must be irrevocable. Once you set up the trust, you generally cannot change its terms or retrieve your assets from the fund. The IDGT has to be considered defective. There must also be an explicit agreement on the powers you retain over the assets in the trust.
Typical retained powers for an IDGT include the power to:
- Substitute assets gifted to the IDGT with other assets of equal value.
- Use income from the IDGT to pay your life insurance premiums.
- Establish your spouse as a beneficiary, and for your spouse to, in turn, add beneficiaries to the trust.
- Change the distributions that your beneficiaries receive, or change the beneficiaries themselves.
Requirements for Selling to an IDGT
The requirements for selling to an IDGT include:
- Asset valuation: At the time of the sale, the fair market value of the assets should be established, which may require a professional appraisal.
- Seed gift: A seed gift of liquid assets or cash must be added to the fund before a sale can be made.
- Loan documentation: The terms of the loan must be properly documented in writing.
- Loan term limit: The life of the loan cannot exceed the grantor’s life expectancy.
- Interest rate: The interest rate of the promissory note must at least meet, if not exceed, the applicable federal rates at the time of the sale.
- Regular payments: The terms of the loan should include regular payments from the IDGT.
- Loan security: The loan must be secured.
Prepare for a Brighter Future With Marshall Jones
At Marshall Jones, we have over 40 years of experience delivering high-end accountancy services, including tax and compliance solutions.
Whether you are an individual, business or nonprofit organization, you can benefit from our certified public accountants’ (CPAs) wealth of expertise in strategic tax planning.
Find out how we can help you maximize your assets by calling us at 404-224-9379 or by filling out our contact form today.
