What is an Intentionally Defective Grantor Trust (IDGT)?

An intentionally defective grantor trust (IDGT) is among the many estate planning strategies that can help your clients preserve wealth and leave a lasting legacy. It is especially effective for high net worth individuals who want to pass on highly appreciated or high-growth assets while minimizing estate taxes and potentially reducing income taxes. 

Due to their more complex nature, IDGTs can sometimes be misunderstood and underutilized, causing clients to miss out on their many tax-saving benefits. So what is an intentionally defective grantor trust? What makes it “defective” and how can this feature be used to help your clients pass on more wealth with less taxes?

Here, we help you understand the workings of an IDGT, its pros and cons, who can benefit from it, and how to help your high-net worth clients determine how and when to use this tool properly to help them achieve their goals.

What is an intentionally defective grantor trust (IDGT)?

An intentionally defective grantor trust is an irrevocable trust structured to allow certain assets to be passed on without being subject to estate taxes while still retaining the settlor’s liability for income taxes generated within the trust.

Unlike a standard irrevocable trust, an IDGT is typically structured as a “grantor trust,” allowing the settlor to retain certain powers over the trust. This intentionally defective grantor trust tax reporting feature is what makes it “defective” for income tax purposes, allowing clients to take advantage of certain income tax or estate tax planning strategies to minimize taxes.

IDGTs are commonly used by clients who own highly appreciating or fast-growing assets such as real estate, stocks, or business that they want to pass on to future generations. The benefits of using an IDGT in estate planning are numerous.

The benefits of using an intentionally defective grantor trust (IDGT) in estate planning

Using an intentionally defective grantor trust can help your clients:

1. Minimize estate taxes to pass on more wealth

Because an IDGT is irrevocable, any assets that your client transfers into it will be removed from their estate for federal estate tax purposes. This means that your clients’ heirs will not pay estate taxes on the assets once placed into the trust.

When selling assets into an IDGT through a promissory note (as we’ll touch on in more detail shortly), your client is essentially engaging in a business transaction and not making a gift for estate tax purposes. While the assets sold and the promissory note are initially part of your clients’ taxable estate, the IDGT strategy is designed to freeze the value of those assets, allowing them to appreciate outside of the estate.

In certain states that allow dynasty trusts that can go on for perpetuity, an IDGT can shield assets from estate taxes for several generations.

2. Lower potential income tax liability on trust assets

Another benefit of an IDGT is that the settlor of the trust is responsible for the income tax on assets within the IDGT. While this might not seem to be a benefit at first, it’s actually a great opportunity to allow the IDGT assets to grow outside of the estate without being burdened by the higher tax rates associated with trusts. 

Because the trust income is reported on the settlor’s individual income tax return, it is subject to their personal income tax rate. As long as the client is in a lower tax bracket than the trust would be, this allows them to retain more of the income generated within the trust.

In addition, by paying the tax liability from their personal assets, the settlor is using assets that would have faced estate taxes regardless. This reduces the value of the estate, effectively decreasing the tax burden on the trust’s future beneficiaries. 

3. Reduce capital gains for highly appreciated assets

Clients with assets that are likely to grow in value substantially can benefit from selling or gifting those assets to an IDGT. This locks in the current value of the assets and keeps future appreciation out of the estate, thus reducing potential capital gains.  Also, because the assets in the IDGT grow tax-deferred, this can lead to more significant growth over time, as illustrated in the example below.

Intentionally defective grantor trust example

Your client John owns a successful tech business that’s growing fast. The business is currently worth $20 million, but John projects that the business will be worth $40 million within five years. If John were to pass away in five years with the shares of the business in his name, the entire $40 million would be part of his estate for federal estate tax purposes. This could potentially cause his family to have to sell a portion of the business to pay estate taxes up to 40% on anything that exceeds the estate tax exemption at that time. But if John sold the business into an IDGT, all of that additional business growth would no longer be subject to estate taxes because the business was removed from his estate. If John had to pay taxes on the income generated from the business by using the business assets, he wouldn’t be able to to use those assets for other purposes such as to reinvest into the business for future growth.

4. Retain a certain amount of control over the assets

The downside of using estate planning strategies that involve an irrevocable trust often revolves around the loss of control over the assets once they are placed into the trust. However, an IDGT is different because it requires the settlor to retain some powers in order to be deemed a “grantor trust.” 

Here are some of the powers clients can retain in order to properly structure the IDGT so it’s “defective” for income tax purposes but “effective” for estate tax purposes:

• The power to reallocate assets
  The settlor can exchange assets of different cost basis within the trust so they can more strategically minimize income and capital gains taxes.
• The power to amend trust terms
  If circumstances within the family change, the settlor can amend distribution provisions as needed.
• The power to remove and replace trustees
  This power allows the settlor some ability to indirectly control the management of the trust by being able to remove and replace trustees.
• Retained right to income
  Clients who are concerned about financial security or want to increase their income stream in retirement can structure the trust so they receive the income generated from it during their lifetime.

 

In addition, the settlor of the IDGT has the right to be one of the beneficiaries so they can benefit from the trust assets during their lifetime in other ways.

5. Protect estate assets from creditors

Because an IDGT removes assets out of your client’s estate, those assets are typically shielded from creditors. This provides protection for clients who would otherwise have a bigger exposure to liability such as from their business.

How do you set up an IDGT to maximize estate planning benefits?

Setting up an intentionally defective grantor trust involves working with an estate planning attorney to draw up a trust agreement that specifies the terms of the IDGT. In crafting the trust, your client will determine the beneficiaries’ rights and restrictions, choose a trustee to manage the trust assets, and define the scope of the powers they will retain to ensure that trust meets the defective grantor status. 

When funding the IDGT, the settlor must decide whether to gift or sell their assets to the trust. 

If they plan to sell the assets to the trust, it’s important to create a formal sales agreement, outlining the terms of the sale and any interest rate on the promissory notes used. If they plan to gift the assets into the trust, they should be aware of the gift tax consequences this may cause. We explore each option in more detail below.

Using a promissory note to transfer assets into an IDGT

In order for the transfer of assets into an IDGT to not trigger capital gains or gift tax consequences, the assets can be sold to the trust at fair market value in exchange for an interest–bearing promissory note payable by the trust. 

Let’s say your client owns a house they purchased for $100,000 a few decades ago but is now worth $700,000. By selling it to the IDGT for a promissory note at fair market value, your client avoids the large capital gains on the sale because the sale is treated as if the settlor sold the assets to himself or herself. 

When setting the interest rate for the promissory note, it’s beneficial to use a low interest rate such as the Applicable Federal Rate (AFR). Doing this reduces the present value of the promissory note which reduces the value of the gift for gift tax purposes.

Gifting assets into an IDGT

Another way to transfer assets into an IDGT is to place them into the trust as a gift. Clients can consider gifting strategies such as leveraging the annual gift tax exclusion to reduce the taxable gift value so they don’t use up too much of their gift tax credit.

In this way, an IDGT could also be an effective strategy to help clients who want to effectively plan for the 2026 estate tax exemption sunset. This is because it might allow them to use the higher exemption that’s in place before it is significantly reduced. Any gifts made before 2026 allow clients to use the current estate tax exemption of $13.61 million per individual or $27.22 million per couple. 

Potential drawbacks of setting up an IDGT

One of the primary drawbacks of an IDGT is that once assets are transferred into the trust, the transfer is irreversible. So even while an individual who’s considering an IDGT will be able to retain some of the powers outlined above, they need to be comfortable with no longer having full power or day-to-day control over the assets or distributions of the trust.

In addition, establishing fair market value for the assets to be transferred into an IDGT is not always straightforward, particularly for assets that don’t have readily available market prices such as business interests or personal property such as art or jewelry. Clients seeking to gift or sell such assets into an IDGT should seek out a professional to advise on any potential valuation discounts such as minority interest discounts or lack of marketability discounts.

Because of its more complex nature, an intentionally defective grantor trust should be created with the help of an estate planning attorney. As such, it might have higher set up costs than other more standard trusts that may sometimes be crafted with online tools or estate planning software like Vanilla. Failing to include one of the retained powers in the trust document, for example, could cause the trust to no longer be “defective,” rendering it as a standard irrevocable trust that pays its own taxes.

How to use an IDGT to help clients with estate planning

Intentionally defective grantor trusts can be a great estate planning tool to help your clients minimize taxes, transfer ownership of highly appreciated or fast-growing assets to the next generation, or facilitate business succession planning for business owners.

If clients are seeking to use an IDGT to leverage the currently high estate and gift tax exemption amount before the 2026 estate tax exemption sunset, encourage them to speak with an estate planning attorney now so there’s enough time to set up the trust properly.

Use our estate planning checklist in client meetings to facilitate powerful estate planning conversations that can help you uncover whether an IDGT would make sense for any of your clients. Then, help your clients visualize the difference that using an IDGT strategy could make in their estate plan with a custom estate planning report from Vanilla.

FAQs

Who owns the assets in an IDGT?

The IDGT owns the assets for property law and trust distribution purposes. However, for income tax purposes, the assets are treated as though they still belong to the grantor. This means that even though the assets are technically owned by the trust, the grantor will account for the trust’s income, deductions, and credits on the grantor’s income tax return. 

Despite this income tax treatment, a properly structured IDGT removes the assets in the trust from the grantor’s estate, providing potential estate tax benefits. 

Does an IDGT file its own tax return?

It depends. Generally, an IDGT does not file its own tax return. In most cases, the trustee will use one of the three optional reporting methods allowed by the IRS for reporting. In some cases, a trustee may instead file a trust income tax return (Form 1041) that summarizes the trust’s income tax activity.

Although each filing method is slightly different, they all result in the same outcome: income generated by the trust, as well as any allowable deductions and credits, are reported on the grantor’s personal tax return rather than a separate trust tax return.

How is income from an IDGT reported?

Income generated by an IDGT is ultimately reported on the grantor’s personal income tax return. The trust itself usually does not file a separate tax return. If the trustee uses one of the three optional methods allowed by the IRS for reporting, then the grantor will receive 1099s or other similar statements showing the income. If the trustee files a trust income tax return (Form 1041) summarizing the trust’s income tax activity, then the trustee will provide an attachment (commonly called a “grantor letter”). Whether it’s on 1099s or a grantor letter, the grantor will report the trust’s income, deductions, and credits on their own tax return as if the trust’s income were their own. This allows the grantor to pay taxes on the trust’s income at their individual tax rate, rather than at potentially higher trust tax rates.

 

The information provided here does not, and is not intended to, constitute legal advice or tax advice; it is provided for general informational purposes only. This information may not be updated or reflect changes in law. Please consult with your financial advisor or estate attorney who can advise as to whether the information contained herein is applicable or appropriate to your particular situation.