An intentionally defective grantor trust (IDGT) is an estate planning arrangement that essentially freezes your assets for estate tax purposes. Established as a grantor trust, it has a loophole that lets you continue paying annual income taxes on certain trust property, allowing the trust to grow without using its assets to pay income taxes. As a result, the trust essentially receives a tax-free gift and you reduce your taxable estate by paying these income taxes yourself.
Assets that appreciate in value significantly, such as stocks or real estate, are ideal for IDGTs. Suppose you fund an IDGT with $20 million in assets that earns 5% annually over 30 years. In the absence of income taxes, the trust could exceed four times its original value. On the other hand, the growth of the trust would be significantly reduced if it had to pay income taxes from its own assets.
It is important to note that the transfer of assets to a trust may be subject to gift taxes of up to 40%. For 2022, the annual exclusion for gift taxes is $16,000, meaning that those who give away $16,000 or less to any individual (other than their spouse) do not have to report the gift or gifts to the IRS. Additionally, you can give away a total of $12.06 million per person during your lifetime before owing a gift tax. However, those who want to further minimize tax liability often opt to sell assets to the trust instead.
Selling Assets to Intentionally Defective Irrevocable Grantor Trusts
A sale strategy involves the grantor selling the assets to the trust for a down payment and a promissory note. Since the trust is not considered a separate entity, the transaction is not taxable. As a result, the grantor does not recognize a capital gain at the time of the transaction, as the assets do not receive a step-up in basis. Additionally, interest received from the note payment is neither taxable income for the grantor nor deductible for the trust.
Sales are traditionally used in one of two ways:
- To benefit grantors via the income stream produced by the promissory note.
- To help those who have reached their maximum allowable lifetime gift exemption avoid gift taxes.
To avoid the promissory note being included in the grantor’s estate, key considerations must be taken when structuring the note for a sale.
- Note payments should not be linked to income generated by the trust property.
- The note must be a personal obligation for the transferee.
- Property sold to the IDGT must not be solely responsible for the promissory note payments.
Conclusion
In 2022, the lifetime gift and estate tax exemption went up to $12.06 million, but for high net-worth individuals, this may not accommodate their estate planning goals. By transferring assets to an IDGT, any appreciation on those assets will not be subject to estate tax. Moreover, if you sell assets to an IDGT, your estate only needs to include the promissory note value or any proceeds from the sale.
At Waserstein & Nunez, our team has the skills and experience to help high net-worth clients preserve their wealth for the future. If you have questions about whether an IDGT is an appropriate strategy for you, call 305.563.1011 to schedule a consultation with an estate planning lawyer.
Waserstein & Nunez, PLLC
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