An introduction to intentionally defective grantor trusts

April 12, 2013

An introduction to intentionally defective grantor trusts

Article provided by Spencer Law Firm
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Intentionally defective grantor trusts are valuable estate planning tools that have been used for years to transfer assets to heirs while minimizing estate tax liability. IDGTs came under threat in President Obama's federal budget proposal for 2013, which sought to change the rules governing their tax treatment, making them less attractive for people seeking to transfer assets in a tax-efficient manner. Congress rejected the proposal, however, so IDGTs continue to serve an important function as part of a carefully crafted estate plan.

How intentionally defective grantor trusts work

The main appeal of an IDGT is that it allows assets to be moved out of a taxable estate and transferred to heirs without triggering estate taxes. While not without risks, IDGTs can be very effective at minimizing the tax liabilities of grantors and beneficiaries when used correctly.

An IDGT is a grantor trust that is created with a deliberate flaw that affects the way the assets in the trust are treated for tax purposes. In terms of estate taxes, the assets in an IDGT are considered removed from the estate, which prevents the beneficiaries from having to pay estate taxes on them when the grantor dies. As a result, more money is able to pass to the beneficiaries.

At the same time, however, federal income tax laws do not recognize the assets in an IDGT as having been transferred away from the grantor. Thus, an IDGT allows the grantor to continue paying the income taxes on the trust assets, which further benefits his or her heirs by allowing more money to remain in the trust.

An IDGT can be structured in a number of different ways. The process typically involves creating a trust in the name of a beneficiary, such as a child or grandchild, and placing assets in the trust that are expected to appreciate substantially, such as real estate, business assets or securities. In a well-structured IDGT, the assets will appreciate over time and eventually transfer to the heirs without triggering estate taxes.

Recent challenges to intentionally defective grantor trusts

President Obama's 2013 budget proposal contained three key changes regarding IDGTs. First, it would have included trust assets in the grantor's estate for estate tax purposes. Second, it would have made any distributions from the trust to a beneficiary during the grantor's life a taxable gift. Third, if the grantor stopped paying the trust's income tax during his or her lifetime, the remaining trust assets would have been subject to gift tax, according to the Department of the Treasury.

In the so-called fiscal cliff deal and the American Taxpayer Relief Act that emerged following Congress' last-minute negotiations, these potential changes were avoided, saving the value of IDGTs. If you would like to learn more about IDGTs or a different type of trust as part of your estate plan, contact a knowledgeable attorney with experience in establishing trusts.