Intentionally Defective Grantor Trust (IDGT)

An intentionally defective grantor trust is an irrevocable trust drafted to be a grantor trust for income tax purposes while remaining outside the settlor's gross estate for transfer tax purposes. Planners call it that; the phrase appears in no statute, regulation or IRS publication. The usual mechanism is the power described in Internal Revenue Code section 675(4)(C), a power exercisable in a nonfiduciary capacity to reacquire the trust corpus by substituting property of equivalent value, which triggers grantor trust status without giving the settlor anything that would cause estate inclusion.

The concept, and why anyone would want a trust taxed to its settlor, belongs to the irrevocable trust entry, which sets out the four combinations of estate inclusion and income tax ownership. What this entry covers is the transaction the structure exists to enable: an installment sale of appreciating property from the settlor to the trust.

The transaction has three moving parts. First a seed gift: the settlor funds the trust with cash or property, which is a reportable gift that uses lifetime exclusion. Practitioners generally want the trust to hold meaningful equity of its own before it borrows, so that the note is not the trust's only substance. Second the sale: the settlor sells appreciating property to the trust in exchange for a promissory note bearing interest at the applicable federal rate the IRS publishes monthly. Third the wait: the property's growth accrues inside the trust, and only the note comes back to the settlor's estate.

The sale recognizes no gain, and the authority is old. In Revenue Ruling 85-13 a grantor acquired a trust's corpus in exchange for an unsecured promissory note. The IRS's own later description of that ruling, in Revenue Ruling 2007-13, is the clearest statement of the principle: the grantor "is treated as the owner of the trust," is therefore "deemed the owner of the trust assets for federal income tax purposes," and "because the grantor is therefore considered to own the purported consideration both before and after the transaction, the exchange of a promissory note for the trust assets is not recognized as a sale for federal income tax purposes." A transaction between one taxpayer and itself has no income tax consequence in either direction, which is also why the interest the trust pays produces no interest income for the settlor to report.

The income tax the settlor pays is not a gift, and the IRS said so directly. Revenue Ruling 2004-64 holds that where the grantor of a grantor trust pays the income tax attributable to the trust's income, "the grantor is not treated as making a gift of the amount of the tax to the trust beneficiaries," because the grantor is the person liable for the tax. The practical effect is that the trust compounds without the drag of income tax while the settlor's own estate shrinks by the tax paid, year after year, with no transfer-tax cost.

The same ruling contains the drafting trap, and it is severe. Revenue Ruling 2004-64 also holds that if the governing instrument or applicable local law provides that the grantor must be reimbursed by the trust for that income tax, "the full value of the trust's assets is includible in the grantor's gross estate under section 2036(a)(1)," because the grantor has retained the right to have trust property expended in discharge of a legal obligation. A merely discretionary reimbursement power does not by itself cause inclusion, whether or not it is exercised. But the ruling names the combinations that can: an understanding or pre-existing arrangement with the trustee, a retained power to remove the trustee and appoint oneself, or local law that subjects trust assets to the grantor's creditors. The IRS also stated it would not apply the mandatory-reimbursement holding adversely to trusts created before 4 October 2004.

What is bought and what is given up. What escapes the transfer-tax system is the appreciation after the sale. The seed gift itself does not: section 2001(b) adds post-1976 adjusted taxable gifts back into the estate tax computation, so a gift moves future growth out rather than moving value out. And because the property never sits in the settlor's estate at death, it gets no new basis under section 1014. The trust's basis is the settlor's basis carried across, so the same appreciation that avoided estate tax stays fully exposed to capital gains tax whenever it is sold. For a family the estate tax will never reach, that trade is a loss, not a saving.

Three risks worth naming. A note the trust cannot service out of the property's own cash flow invites the argument that the sale was not real, and section 2036(a) reaches a transfer that was not "a bona fide sale for an adequate and full consideration." If the settlor dies while the note is outstanding, the unpaid balance is in the estate and the income tax consequences of the note at that moment are not settled ground. And grantor trust status can usually be switched off, deliberately or by accident, at which point the trust becomes a separate taxpayer on compressed brackets and the tax-burn benefit stops.

1. Draft an irrevocable trust that fires a grantor trust trigger, commonly the nonfiduciary power to substitute assets of equivalent value under section 675(4)(C), while granting the settlor nothing that would cause estate inclusion.

2. Fund it with a seed gift, reported on a gift tax return and using lifetime exclusion.

3. Sell the appreciating asset to the trust for a promissory note at the applicable federal rate for the month of the sale, supported by a defensible valuation.

4. Service the note from the asset's own cash flow. No gain, and no interest income, is reported by anyone.

5. Pay the trust's income tax personally each year. Avoid any clause requiring the trust to reimburse it.

6. Compare the outcome with doing nothing before proceeding, because the basis given up may be worth more than the transfer tax saved.

A hypothetical. Wei creates an irrevocable trust with a substitution power and gifts it $1,000,000 of cash. That gift is reportable and uses part of her lifetime exclusion; it does not disappear from her transfer-tax base, because adjusted taxable gifts are added back into the estate tax computation at death.

She then sells the trust a $9,000,000 interest in her family business for a nine-year promissory note of $9,000,000 at the applicable federal rate. No gain is recognized: for income tax purposes she and the trust are the same taxpayer. Immediately after the sale the trust holds $1,000,000 + $9,000,000 = $10,000,000 of assets against a $9,000,000 note, so its net value is the $1,000,000 she gave it.

Suppose that nine years later the business interest is worth $18,000,000. The trust has paid the note's interest each year out of the interest's own distributions, and the $9,000,000 of principal is still outstanding. The trust now holds $18,000,000 of business interest plus the $1,000,000 of seed cash against a $9,000,000 note, so its net value is $10,000,000. Wei's estate holds the note, worth $9,000,000, and the interest she was paid.

The trust's net value has gone from $1,000,000 to $10,000,000 without any further transfer. Two amounts stayed inside the transfer-tax system: the $1,000,000 seed gift, which remains in Wei's base as an adjusted taxable gift, and the $9,000,000 note, which is an asset of her estate. What sits outside both is the amount by which the interest's growth outran the fixed price she sold it for, $18,000,000 − $9,000,000 = $9,000,000, and neither the gift tax nor the estate tax ever measured it.

The cost is on the other side of the ledger. The trust's basis in the interest is Wei's original basis, not $18,000,000, because the interest was never in her estate at death. Whoever eventually sells it pays capital gains tax on the whole appreciation.

Pros

• Moves post-sale appreciation out of the transfer-tax system for the cost of a comparatively small seed gift.

• The sale itself is not a taxable event, so a low-basis asset can be transferred without triggering capital gains tax at the time.

• The settlor's payment of the trust's income tax is not an additional gift, so it is a further transfer of value at no transfer-tax cost.

• Works on assets whose growth is expected to outrun the note's interest rate, which is a lower bar than beating a market return.

Cons

• The property gets no basis adjustment at death, so transfer tax saved can become a larger capital gains bill for the next generation.

• A mandatory tax-reimbursement clause pulls the entire trust back into the gross estate under section 2036(a)(1).

• The settlor owes tax on income they do not receive, indefinitely, and turning that off has its own consequences.

• The whole structure depends on a valuation of the asset sold, which is the number most likely to be challenged.

• It is expensive to draft and administer, and the benefit is confined to estates large enough for transfer tax to matter at all.