Chapter 29 - § 29.4 • INTENTIONALLY DEFECTIVE IRREVOCABLE TRUSTS (IDITS)

• Jurisdiction: Colorado

§ 29.4 • INTENTIONALLY DEFECTIVE IRREVOCABLE TRUSTS (IDITs)

§ 29.4.1—IDITs in General

An IDIT is an irrevocable trust that is considered a "grantor trust" for income tax purposes pursuant to I.R.C. §§ 671 to 679. It is "defective" only in the sense that it purposely has not been drafted to avoid being categorized as a grantor trust. Because it is a grantor trust, the trust's grantor will be responsible for paying any income tax on the taxable income generated by the IDIT's assets. By paying the income tax, the grantor is in effect making additional transfers to the IDITs that are free of the gift tax. This further reduces the grantor's taxable estate. At the same time, this increases the value of the IDIT, because it grows free of any tax burden.

§ 29.4.2—Income Taxation of a Grantor Trust

Under the grantor trust rules, the grantor typically pays the income tax on the trust's income. In years past, practitioners often went to great lengths to avoid grantor trust status. However, there are many planning reasons for drafting an irrevocable trust so that it is classified as a grantor trust for income tax purposes. Hence, the term "intentionally defective grantor trust."

One potential disadvantage with an IDIT is that the grantor's marginal income tax rate will likely be higher than the beneficiaries' tax rates. Therefore, in years when substantial trust distributions are made to beneficiaries, a higher combined income tax may be incurred than if the trust and its beneficiaries were taxable under a non-grantor trust arrangement. However, this possible increase in income tax may be outweighed by the estate tax savings that result from the grantor paying the income tax attributable to the IDIT's assets.

The grantor trust classification only determines who pays the income tax on the assets owned by the irrevocable trust. It does not alter any of the estate or gift tax rules.

§ 29.4.3—How an IDIT Reduces the Taxable Estate

An IDIT reduces one's taxable estate in the following manner. First, the grantor reports the IDIT's income. The grantor then pays income tax on such amount, and therefore, the IDIT's assets grow free of the income tax burden. The grantor's estate is reduced by the amount of income tax paid as well as by the amount of the assets contributed. In essence, the grantor's payment of the IDIT's income tax can be considered an additional gift by the grantor to the IDIT, free of any transfer tax implications.

§ 29.4.4—Potential Gift Tax Consequences of...