The Fully Functional Intentionally Defective Grantor Trust

What is an Intentionally Defective Grantor Trust?

Why would an attorney suggest an intentionally defective trust? It is certainly better than an unintentionally defective grantor trust, believe me. These types of trusts are referred to as IDGTs because the grantor intentionally retains enough power over the trust assets  to cause the grantor to be treated as the owner of the trust for income tax purposes. Knowing the grantor trust rules, Internal Revenue Code §§ 671-678, is crucial when drafting trusts because the inclusion or exclusion of such powers determines whether trust income will be taxable to the grantor’s income tax rate or at the trust rate. It has not always been the case, but trust income reaches the top marginal rate of 37% when it exceeds $12,950. In contrast, an individual does not reach the 37% tax rate until his or her income exceeds $518,400. Therefore, a non-grantor trust rarely makes fiscal sense.

An Intentionally Defective Grantor Trust (IDGT) places assets outside the grantor’s estate for estate tax purposes but is constructed so that the grantor retains enough control that the income generated is taxed at the grantor’s income tax rate. The IDGT allows the grantor to gift appreciating assets to a trust so that the original gift grows estate tax free and income generated is passed to the beneficiaries at the grantor’s death. The trust dictates how assets pass to beneficiaries at the grantor’s death. The beneficiaries can even avoid estate tax at their own death  – similar to what you probably heard called a dynasty trust. The grantor pays income tax on the trust’s income so that the assets appreciate for the benefit of future generations.

When Does an IDGT Make Sense?

For those whose estates are expected to exceed the federal exemption level, the gift tax can be avoided altogether if the grantor sells the appreciating asset to the trust in exchange for an interest-bearing promissory note. Since the IDGT is a grantor trust, the sale is not a taxable event. The idea is to freeze the asset at its current level and let it appreciate tax free.

An added value of the IDGT is that the grantor can retain the power to substitute assets of equal value under IRC § 675(4)(C). This allows the trustee to swap out low basis assets for high basis assets – so, if timed correctly, avoid capital gains. Again, since this is a grantor trust, the exchange is not a taxable event.

To illustrate, assume that a Carroll Gardens brownstone purchased for $100,000 and transferred into the IDGT when it had a fair market value of $2,000,000. Although this accomplished the goal of removing the $2 million asset from the grantor’s estate, the cost basis remains that of the donor: $100,000. Therefore, when the building is sold upon the grantor’s death, the beneficiaries are left with $1.9 million subject to capital gains tax (upward of 30%). However, if the grantor had substituted $1.9 million in cash or other high basis asset for the real estate, the real estate would then be out of the trust at grantor’s death and thus the cost basis will be the date of death value, incurring no capital gains taxes. The brownstone was essentially a placeholder.

When the federal estate tax exemption was not at its current $11.58 million, moving assets outside of a person’s estate was crucial to avoid the 40% federal death tax (estate tax). In states that have a lower state estate tax, like New York at $5.85 million, these trusts are still used to move the excess assets, the difference between the state estate tax and the federal, outside of the estate. Additionally, with the federal exemption due to sunset in 2026, this tactic may be gaining in popularity again.

In 2021 we are welcoming President Biden and Vice President Harris into the white house. Given their proposals on decreasing the federal exemption and the havoc the pandemic has wrought on our economy, the exemption might be coming down before it is set to sunset in 2026 and maybe even decrease to $3.5 million. If this is a concern for you and your family, make sure you speak to an estate planning attorney about how to capture the current high federal estate tax exemption. Book a free 1hr consultation today online.

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