What is an Intentionally Defective Grantor Trust (IDGT)?
Part of the series on Everything You Ever Wanted to Know About Trusts
This is part of the series of articles titled, “Everything You Ever Wanted To Know About Trusts.” For an index of articles in this series, click here.
Table of Contents
Intro
An intentionally defective grantor trust, or IDGT, is an irrevocable trust set up by a grantor during life. The hallmark of this trust is the retention, by the grantor or grantor’s spouse, of one or more powers that causes the trust to be a grantor trust under IRC Sections 671-677. As a result, the grantor is the deemed income tax owner of all assets transferred to the trust. This income tax deemed ownership continues until the grantor dies, or the grantor or grantor’s spouse releases the power(s) making the trust a grantor trust.
Importantly, while a grantor trust may be disregarded for income tax purposes under IRC Sections 671-677, or 678, it is still treated as a separate taxpayer for gift, estate, and generation-skipping transfer (GST) tax purposes unless some other Code Section applicable to transfer taxes acts to disregard the transfer (or prior value thereof) during the grantor’s life or at the grantor’s death. The Code Sections that might act to “disregard” transfers for transfer tax purposes (due to a grantor’s retained powers over transferred assets) are different from the Code Sections that disregard transfers for income tax purposes, and while there is some crossover, each side may have some powers that only apply for income tax or transfer tax purposes (but not both). Can we intentionally take advantage of this difference?
Purposes
An IDGT is established to leverage this mismatch between the rules that treat the grantor as the income tax owner of trust assets during life (generally IRC Sections 671-677), and the rules that treat the grantor as the estate tax owner of trust assets at death (generally IRC Sections 2035-2038, and 2042). This creates two, or possibly three, key planning options that generate estate, gift, and GST tax planning benefits so long as the grantor remains just the income tax owner and not the estate tax owner of trust assets.
First Planning Option
The grantor can sell assets to the IDGT, instead of gifting them. This sale is usually in exchange for the promise by the IDGT to pay the purchase price in installments, plus interest, over time. There is no income tax on recognized gain, installment payments, or interest under the grantor trust rules. Why? Because the grantor is both the seller, and buyer, for income tax purposes by virtue of being treated as the deemed income tax owner of assets transferred to the IDGT.
So long as the purchase price is not less than the fair market value of the assets being sold, the sale avoids the use of lifetime gift tax applicable credit, GST exemption, or payment of gift tax, except to the extent necessary to fund the IDGT with sufficient assets to establish “creditworthiness” of the IDGT in the eyes of the IRS. The level of funding often recommended is 10% of the anticipated purchase price, although this is not a hard minimum. The sale is not subject to gift or GST tax, unless the consideration received (including anticipated installments) is less than the fair market value of the property sold to the trust. Valuation discounts, such as discounts for lack of control and lack of marketability, can be used to determine the fair market value and purchase price.
So long as the income generated by the assets sold to the IDGT is sufficient to pay the purchase price installments back to the grantor over a reasonable period of time (which cannot exceed the grantor’s life expectancy), the value of the assets sold to the IDGT will be partially “frozen” for estate tax purposes by exchanging them for installment payments of principal and interest. So, at the grantor’s death, all that remains in the gross estate are unspent installment payments, and (if any) the balance of the promissory note payable from the IDGT. Optimally, however, these installments should be paid in full before the grantor’s death.
Second Planning Option
The grantor’s payment of income taxes on income generated by the IDGT serves as a way to deplete the grantor’s gross estate at potentially lower tax rates than the applicable gift and estate tax rates. This outcome is due to Rev. Rul. 2004-64, which clarifies that a grantor’s payment of income tax on behalf of the IDGT beneficiaries is not treated as a taxable or reportable gift to them. As a planning tool, this is a rare exception to the general tax maxim that payment of another person’s income taxes is treated as taxable income, or a taxable gift, to them depending on the context.
Third Planning Option
For most IDGTs, especially those that are structured to invoke the grantor trust rules by use of a substitution power (discussed below), a grantor can later engage in strategic income tax planning by exchanging assets of equivalent value between themselves and the trust. For example, a grantor on their deathbed can put high basis assets or cash into an IDGT, and in exchange get low basis assets of equal value back. Then, at the grantor’s death, the low-basis assets received from the IDGT will get a step-up in income tax basis without having increased or decreased the grantor’s gross estate. This can especially be leveraged for assets that have been depreciated by the IDGT, as the step-up in basis will avoid recapture while also giving recipients (at the grantor’s death) new basis to re-depreciate.
Grantor’s Retained Powers
As noted above, the grantor or grantor’s spouse must retain certain powers in order to invoke the grantor trust rules. However, two key considerations come into play. First, the retained powers cannot be of the type that would cause the grantor to be the deemed estate tax owner of trust assets at death. Second, the powers optimally should apply to all trust income and principal.
While not a requirement, grantors may prefer to have the ability to release powers that invoke grantor trust status. As discussed in this article, a failure to do so can constrain the grantor’s cash flow while increasing the risk of estate inclusion under IRC Section 2036 or a deemed gift back from trust beneficiaries (if the trust pays or reimburses the grantor’s share of income taxes).
The most popular power that checks all of these boxes is the grantor’s power to substitute trust assets with the grantor’s own assets of equivalent value. This power, described in IRC Section 675(4)(C), has been condoned by the IRS under Rev. Rul. 2008-22. This Ruling concluded that a substitution power would not cause the grantor to be the deemed estate tax owner of trust assets under IRC Sections 2036 or 2038, so long as the trustee confirms equivalence of value and so long as the power cannot be exercised by the grantor to shift benefits among trust beneficiaries.
The benefit of the substitution power is assurance that the grantor will be the income tax owner of all principal and income of the IDGT. Optimal tax planning depends on this all-in outcome.
While there are a variety of other powers that could invoke grantor trust status, such powers may not cause the trust to be a 100% grantor trust with respect to all IDGT income and principal. Some powers also may not be releasable without jeopardizing the purposes of the trust. Examples of such powers are found in IRC Section 677, under which a retained by a grantor or grantor’s spouse to receive current or accumulated trust income, or to have current income applied towards the payment of premiums of life insurance, can invoke grantor trust status at least to income. Such power might be found in a SLAT or ILIT, respectively.
If these powers are present, a grantor’s release of a substitution power may not terminate grantor trust status. So, if release of grantor trust status is a desired outcome, it may be better to structure the IDGT not to have any other grantor trust powers. This means that, for most IDGTs, spouses are not beneficiaries. These types of trusts are best deployed where children, descendants, or other individuals are beneficiaries.
Risks
One of the biggest risks for an IDGT is a mismatch between the purchase price paid (in cash, property, or by a promissory note) from an IDGT, and the gift tax value of the property being sold to the IDGT. If the trust pays less than the gift tax value, this results in a gift from the grantor to the IDGT equal to the bargain. If the trust pays more than the gift tax value, this could result in a gift from the trust beneficiaries to the grantor while also increasing the amount potentially subject to estate tax at the grantor’s death. Such overpayment can also jeopardize the trust’s ability to repay a promissory note to the grantor.
The death of the grantor prior to the payment of the promissory note is another significant risk. If the grantor dies before the note is paid, this usually terminates grantor trust status. Thus, the sale to the IDGT that was previously disregarded for income tax purposes becomes a taxable sale at the grantor’s death. If the balance of the promissory note is greater than the basis of the property in the IDGT (usually a carryover basis from the grantor), this may cause the grantor’s estate to recognize gain. The note, at the time the sale becomes recognized, may bear inadequate interest at that time result in additional deemed interest being taxed to the estate for income tax purposes. And, of course, the note balance would be subject to estate tax – possibly with no liquidity to pay the estate tax generated by the note.
This risk is exacerbated by the potential sunset of the basic exclusion amount. The estate tax potential of the promissory note will be greater post-sunset, as a sale to an IDGT does not use gift tax applicable credit. But, taxpayers could forgive notes payable from a grantor trust to generate a taxable gift that uses basic exclusion amount pre-sunset.
It may be possible to create a self-cancelling installment note which is forgiven at the grantor’s death, but these arrangements are better arranged for sales to an individual than a sale to a trust. The possibility of note cancellation could cause the IRS to disregard the note and recast the transaction as a gift to the IDGT. Even if a self-cancelling installment note was respected in substance for sales to an IDGT, there must be an adequate premium payment from the IDGT to the grantor.
The promissory note should bear adequate interest at the time it is issued by the IDGT. If it does not, there is a risk that the IRS could disregard the note and treat the grantor as having made a gift to the trust. The minimum recommended rate is usually the applicable federal rate under IRC Section 7520, depending on the term of the note. So, in higher interest rate environments, this can create an additional cash drag on the IDGT. Keep in mind, however, that interest does not generate income tax so long as the IDGT is a grantor trust. This also means the IDGT cannot deduct the interest.
For sales to a grantor trust to avoid income tax, the grantor must be treated as the income tax owner of all trust income and principal both before and after the sale. As noted above, a substitution power may be the safest method to ensure this outcome. Otherwise, if the trust is only a partial grantor trust, then taxable gain could be recognized by the grantor on the sale. In such a situation, the trust would be a related party under the installment sale rules of IRC Section 453 as well, which could limit the grantor’s ability to defer gain until the installments generating that gain are received. This can also create issues where spouses are both named grantors of a trust, as the death of one spouse might cause the trust to become a partially grantor trust. I will discuss this outcome in a separate article.
When it comes to any grantor trust, as I discussed in this article relating to SLATs, it can be challenging for a grantor trust to reimburse tax or pay tax on behalf of the grantor without running the risk of IRC Section 2036 inclusion or a gift back from trust beneficiaries to the grantor. But, in the case of an IDGT, installment payments on a promissory note can provide the cash needed by the grantor to pay income tax on behalf of the IDGT. Of course, if the asset appreciates significantly in value and is sold by the IDGT during the grantor’s life, the note payments may not be sufficient to satisfy the grantor’s income tax liability. So, care should be taken when planning for liquidity events.
If gross estate inclusion is a risk in general, it may be possible to include a contingent gift within the IDGT to use the estate tax marital or charitable deductions. Note that this is best deployed where the assets transferred to the IDGT itself are subject to gross estate inclusion. But, where it is the transfer of assets to an entity such as a family limited partnership (instead of the IDGT itself) that could cause gross estate inclusion. a contingent gift within the IDGT itself may not work because the IDGT could only transfer entity interests (which are not included in the gross estate) and not the assets of the underlying entity (which are included in the gross estate).
Note also that, for complex trusts, the distribution of trust (accounting) income to beneficiaries can shift the taxation of the income from the trust to the beneficiaries. However, this option is not available for grantor trusts. The grantor will pay income tax on all trust taxable income, whether accumulated, distributed, or allocated to principal.
The leverage of an IDGT also relies on rate arbitrage between the growth rate versus the interest rate, and the effective income tax rate versus the effective estate tax rate.
For interest versus growth, let’s assume that the required interest rate on a note payable back to the grantor from the IDGT is 5%. If the assets, after being transferred to the IDGT, appreciated at a rate of 8% per year, net growth of 3% during the term of the note will have been removed from the gross estate. If, however, the growth rate is only 4%, the IDGT will pay more in interest than the growth in assets. Thus, if the interest rate is greater than the growth rate, the strategy is not effective unless or until the note is paid off. Of course, the grantor and IDGT could consider refinancing the note if interest rates go down, and while this would not be an income tax event it could be treated as a gift from the IDGT to the grantor.
If the combined federal and state income taxes are less than the potential estate tax, this will create positive rate arbitrage. But, if combined federal and state income taxes exceed potential estate taxes, the IDGT may lose its advantage (outside of possible liquidity to pay estate tax). This tends to favor the use of long-term capital gain property, perhaps with a higher basis, for sale to an IDGT. The income tax drag should also be considered from the perspective of potential liquidity events, as noted above.
Finally, the cashflow for paying the note must be considered. The IDGT should have enough cash, either from internal returns or future liquidity events, to pay the note during its term (which should not exceed the grantor’s life expectancy). Care must also be taken to ensure that not all income is used to pay income and principal; otherwise, you run the risk of IRC Section 2036 inclusion. Why? Because the IRS could argue substance over form in determining that the grantor had retained the right to receive all income from the assets transferred to the IDGT if there is substantial correlation between income to the IDGT and payments to the grantor.
Structure
The structure of the trust is not the only consideration. One must enter into a commercial sales transaction with the IDGT which should contain the terms usually applicable to such a sale. Documents would usually include a purchase and sale agreement, a promissory note bearing interest that equals or exceeds the applicable federal rate for the month of sale (based on the term of the note), and a security or pledge agreement allowing the grantor to recover collateral if the IDGT fails to make note payments when due. Use of customary commercial terms that would usually apply to a sale between unrelated parties decreases the risk that the IRS could recast the sale as a gift.
The purchase price should equal the gift tax value of assets sold to the IDGT. A qualified appraisal is usually recommended. There is, however, a risk that the IRS could audit the transaction and increase the gift tax value – resulting in use of gift tax applicable credit and possible gift tax payable out of pocket by the grantor. To reduce this risk, many practitioners include a price adjustment clause in the sale documents that increase or decrease the purchase price (and promissory note) if the gift tax value is correspondingly increased or decreased on audit. This price adjustment clause was condoned by 10th Circuit in King v. United States, 545 F.2d 700 (1976). This type of adjustment clause is often considered safer to draft and enforce than the formula gift clause described in Wandry v. Commissioner, T.C. Memo 2012-88.
As previously discussed, spousal powers should be limited if the grantor wishes to release grantor trust powers in the future. Why? Because, at the very least, spousal rights are attributed to the grantor under IRC Section 672(e), and certain powers (like a spouse’s beneficial interest in a SLAT) may have to be completely released. So, for example, while a spouse could remove and replace a trustee, the guidance of Rev. Rul. 95-58 would require a restriction on the spouse’s (and grantor’s) ability to name a replacement trustee who is related or subordinate to them under IRC Section 672(c).
Further, avoiding naming the grantor as trustee can be important for purposes of IRC Sections 2036 and 2038. While some guidance suggests that a grantor/trustee’s discretionary distribution power might not run afoul of 2036 and 2038 if limited by an ascertainable standard, this exception usually requires that each beneficiary have an enforceable state law right to demand at least a nominal distribution each year. For similar reasons, the grantor should not be a beneficiary nor retain a power of appointment over the trust.
The grantor can name any beneficiaries, other than a spouse if a unilaterally-releasable grantor trust power is desired. There may also be room for upstream planning, through which parents or ancestors of presumably-shorter life expectancy than the grantor can be given a testamentary general power of appointment over appreciated assets in the IDGT. This allows for a step-up in basis at the death of each holder of such a general power of appointment, even if it is not exercised. But, to avoid payment of estate tax out of the IDGT under IRC Section 2207 in such an event, the general power of appointment should be limited to a value of assets that does not exceed the power holder’s available estate tax applicable exclusion (or if less, GST exemption) at death.
Choice of assets is paramount. Certain assets, like QSBS stock under IRC Section 1202, may not be good candidates (as grantor trust status disregards the additional gain exclusion that might otherwise be available to the trust). While asset basis is not as much of a concern as with gifting transactions, lower-basis assets could generate greater income tax to the grantor (or trust) if later sold.
As a bonus, so long as the IDGT remains a grantor trust, it can hold S corporation stock without the need for a QSST or ESBT election. However, if grantor trust status terminates, a QSST or ESBT election would be required at that time. A termination of grantor trust status during the grantor’s life would usually require a concurrent QSST/ESBT election, unless the trust immediately becomes a grantor trust with respect to a beneficiary (a subject for another time). But, if grantor trust status terminates as a result of the grantor’s death, the trust has 2 years to make the QSST or ESBT election under Treas. Reg. 1.1361-1(h)(1)(iii).
Conclusion
The IDGT can be a valuable planning tool for freezing the estate tax value of assets during life with minimal use of gift tax applicable credit. A seed gift of up to $13,610,000 (the 2024 basic exclusion) could be leveraged to sell assets valued at up to $136,100,000 in exchange for a promissory note. If this promissory note is paid off (with interest) during the grantor’s life, the grantor will have exchanged the value of (possibly illiquid) assets in their gross estate, plus future growth (net of interest) on those assets, for liquid cash. This amount could be doubled for married couples through a gift-splitting election (but only for an IDGT under which the grantor’s spouse is not a beneficiary).
As noted above, if the basic exclusion amount sunsets on January 1, 2026, taxpayers could make an 11th hour gift to use their remaining basic exclusion amount by forgiving part or all of a promissory note payable from an IDGT. This could allow an irrevocable gift now, with flexibility to preserve cashflow from a note and/or forgiveness of the note (which would reduce future cashflow but would also reduce potential estate tax). While not well-settled, there may even be a possibility of leveraging a discount on the gift tax value of the note.
And, while the cash paid or payable back from the IDGT to the grantor is subject to estate tax to the extent not spent before death, this cash can be spent or even applied to the grantor’s payment of income tax generated by the IDGT. Positive rate arbitrage between the potential estate tax rate, and the combined federal and state income tax rates, can create leverage in reducing future estate tax.
In subsequent articles, we will discuss ways to specifically handle some of the risks and alternatives discussed herein.