Using IDGTs for Wealth Transfer and Estate Planning
There are a few different vehicles to consider when contemplating passing on wealth to the next generation. Two of the most effective yet overlooked techniques are: 1) creating an intentionally defective grantor trust (IDGT) and 2) establishing a family limited partnership (FLP). These are more complicated than just gifting away cash or assets, which is why some families tend not to think of them for their estate plan. In this article, we lay out the basic components of the IDGT and how it could be used to ensure your estate planning is fully maximized for you and your family. In our companion article, you can learn all about FLPs and how to use them.
What’s an IDGT, and how can it be used to transfer wealth?
An IDGT is an irrevocable trust designed to preserve family wealth by transferring appreciating assets to the trust, which in turn reduces the estate of the grantor (i.e., the person creating and contributing to the trust) but allows the assets to be passed down to family members via the trust.
The reason it’s called an “intentionally defective grantor trust” is that the trust is defective for income tax purposes but accomplishes the goal of reducing a taxable estate for estate tax purposes. It accomplishes this by transferring the assets out of the grantor’s estate through gifting or by a sale of the assets to the trust. Transferring assets into an IDGT reduces estate taxes in two ways. First, it gets the asset out of the grantor’s estate by placing it into an irrevocable trust, and second, any asset appreciation after the asset is transferred into the trust will also be excluded from the grantor’s estate.
The grantor is responsible for paying any income tax that the asset produces (which can further reduce their taxable estate), but when the grantor dies, the assets will be excluded from their estate if the trust is structured properly. With the grantor paying the taxes on the income created by the asset, this asset essentially grows free of income tax. To sum it up, the trust is effective at reducing the grantor’s taxable estate, with the caveat that the grantor will be responsible for paying the income taxes that the asset produces.
Important considerations when creating an IDGT
Something to keep in mind is that the transfer of an asset into the trust will be considered a completed gift and, if large enough, may surpass the lifetime gift tax exemption amount ($13.61 million in 2024 and $13.99 million in 2025).1 With that said, there’s an alternative way to transfer assets into the trust and not run afoul of the lifetime gift tax exemption. Instead of gifting the asset to the trust, the grantor may sell the asset to the trust. The great thing about this strategy is that the sale will not trigger capital gains taxes because the grantor is, from the view of the IRS for income tax purposes, effectively selling the asset to themselves. But, if the trust ends up selling the underlying asset at any point, the grantor will be responsible for paying the capital gains taxes.
The sale of the asset to the trust can be executed with a promissory note, but the interest on the note cannot be below “market rate,” which in this case is the Applicable Federal Rate (based on the length of the promissory note). Furthermore, the asset must be sold to the trust at full market value; otherwise, portions of the sale/transfer may be deemed a gift by the IRS.
Another requirement when selling an asset to an IDGT is to make sure the trust is “seeded” with at least 10% of the value of the asset being sold to the trust, or the IRS may have a case that the “sale” is just a transfer and not a bona fide trust transaction. Finally, one last thing to keep in mind is that the seed money for the trust will use up some of the grantor’s lifetime gift tax exemption.
Bottom line
The intentionally defective grantor trust can be an effective estate planning technique to reduce a taxable estate and pass down wealth. However, it must be structured very specifically to ensure it’s implemented and maintained properly. If you’re considering this sophisticated technique for your estate plan, be sure to consult with a Corient Wealth Advisor in coordination with your tax professional and estate planning attorney.
ABOUT THE AUTHOR
Andy McNamara
Andy is a Wealth Advisor in our San Diego office. He joined legacy firm CI Dowling & Yahnke Private Wealth in 2020 as a Financial Planner. Prior to joining CI Dowling & Yahnke, he spent six years as an advisor and financial planner with two local investment management firms.
Andy holds the CERTIFIED FINANCIAL PLANNER™ certification and Certified Private Wealth Advisor® (CPWA®) and Certified Exit Planning Advisor (CEPA®) designations. He completed his Bachelor of Arts in Economics at the University of California, San Diego (UCSD).
Andy is a native of Southern California. He moved to San Diego to attend UCSD, where he was lucky enough to meet his future wife. They have lived in San Diego ever since and now have three daughters and a rescue dog.
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