'Idjits': Get to Know Intentionally Defective Grantor Trusts.

• Author: Fukuto, Erin S.
• Position: Estate planning

Intentionally defective grantor trusts (IDGTs--pronounced "idjits") have become popular in estate tax planning techniques in recent years. This article will serve as an introduction for those who are unfamiliar with this type of trust entity and its use in estate tax planning stratagems.

What's an IDGT?

An IDGT is a term used to describe a specific type of trust. Conceptually, it's a trust entity that's set up to be an irrevocable trust. However, in drafting the trust agreement, certain provisions are "intentionally" included or excluded. Such provisions will allow the grantor of the trust to retain certain powers.

For example, a common power that may be retained by the grantor as a result of the defective provisions is the power to exchange assets within the trust for other assets of an equal fair market value. The retention of such powers by the grantor will violate the provisions for allowable grantor powers set forth in the IRC. This violation will cause the IRS to consider the trust to be "defective" and, by default, the trust will be deemed to be a grantor trust for income tax purposes, i.e., a trust that is disregarded for income tax purposes.

When the trust agreement is properly drafted, the result of this defective creation is a dichotomy in the treatment of the trust, the trust assets and the income and deductions arising from these assets. The IDGT will be treated differently for legal and estate tax purposes versus the treatment for income tax purposes. Because the trust has been created as irrevocable (and provided that none of the powers retained by the grantor would cause estate tax inclusion) it will be respected as a legally valid trust entity for estate tax purposes.

Simultaneously, because of the intentionally defective trust provisions, for income tax purposes it will be treated as a grantor trust and ignored as a separate taxable entity. It's these two disparate estate tax and income tax treatments that provide planning opportunities for the knowledgeable tax practitioner.

Installment Sale of Significant Rapidly Appreciating Assets to an IDGT

One possible transaction that can be structured using an IDGT is the sale of an appreciating asset (such as a profitable, closely-held family business) by the grantor to the IDGT. The IDGT will usually be initially funded with cash and/or other assets as a taxable gift from the grantor. The beneficiaries of the IDGT will generally be the grantor's children, This initial taxable...