For large estates, an Intentionally Defective Grantor Trusts or IDGT is a very effective tool in estate planning due to its unique structure. This type of trust is set up as an Irrevocable Trust that is rendered “defective” due to the intentional retention of interest that violates the Grantor Trust rules. The ensuing arrangement creates an optimal estate transference arrangement which allows the grantor to place assets outside the estate yet obliges the grantor to pay income taxes on these assets. This structure creates further “tax-free” gifting opportunities for the grantor. Since neither the trust nor its beneficiaries are responsible for any tax on the trust’s income, the trust and its beneficiaries enjoy tax-free growth.

How it works:

Due to disparities in the estate tax and gifting laws a situation is created whereby the grantor is allowed to remove assets from his/her estate for estate planning yet retain an interest in these assets for income tax purposes. Careful drafting of the trust document is required to effectively create this unique trust. Then through gifts and installment payments the trust begins its estate transference arrangement.

To start, the grantor will establish this trust then gift approximately 10% or more of the fair market value of the assets that will be “sold” to this trust. The gifting is required since the trust must have some liquidity in which to make initial interest payments to the grantor.

Once the gift has been made the grantor will “sell” an asset to the trust for a note. This note will signify an installment sale has been created between the trust and the grantor.

The grantor will initially start receiving interest payments from the trust. These payments will be “tax-neutral” since the IRS views this transaction as an occurrence between the grantor and their own assets; no second party is recognized. The installment sale is usually structured as interest only payments for a set amount of years and a balloon payment at the end.