Definition
An Intentionally Defective Grantor Trust is an irrevocable trust with a deliberate "defect" under the Internal Revenue Code's grantor trust rules. The defect causes the IRS to treat the trust as owned by the grantor for income tax purposes, while estate and gift tax law treats the trust as a separate entity. This split means assets in the IDGT are removed from the grantor's taxable estate, but the grantor pays the income taxes on trust earnings from personal funds. The grantor's tax payments are not considered additional gifts, allowing the trust assets to compound tax-free.
How It Works
The attorney drafts an irrevocable trust with a provision that triggers grantor trust status under IRC Sections 671 through 679. Common triggers include retaining the power to substitute assets of equivalent value or allowing the grantor to borrow from the trust without adequate security.
The grantor then "seeds" the IDGT with a gift (typically 10% of the intended transfer value) and sells appreciating assets to the IDGT in exchange for a promissory note. Because the IRS views the grantor and the trust as the same taxpayer for income tax purposes, the sale does not trigger capital gains tax. The note carries interest at the Applicable Federal Rate (AFR), which is typically lower than market rates.
As the trust assets appreciate beyond the AFR interest rate, all excess growth belongs to the beneficiaries free of estate and gift tax. Meanwhile, the grantor pays income tax on all trust earnings, further reducing the grantor's taxable estate without triggering gift tax.
When Entrepreneurs Use This
- Business interest transfers: Selling ownership stakes in a growing business to an IDGT before a major liquidity event
- Real estate transfers: Moving investment real estate with strong appreciation potential out of the taxable estate
- Combining with valuation discounts: Transferring minority interests in family limited partnerships at discounted values
- High-income grantors: The income tax payment benefit is most valuable when the grantor has substantial income and the trust holds high-earning assets
- Pre-exit planning: Entrepreneurs expecting a business sale transfer interests to the IDGT years before the exit event
Dew Wealth Perspective
The IDGT is one of the most tax-efficient wealth transfer vehicles available, but the structure requires precise coordination between the estate attorney, tax advisor, and business valuation specialist. The promissory note must carry the correct AFR rate. The initial gift must be sufficient to give the trust economic substance. The valuation of transferred interests must withstand IRS scrutiny.
The Linchpin Partner ensures these pieces come together properly. IDGTs often work in tandem with GRATs: the GRAT handles assets with near-term appreciation potential, while the IDGT handles longer-term growth assets where the installment sale structure provides greater flexibility.