Intentionally Defective Grantor Trust (IDGT)
An Intentionally Defective Grantor Trust (IDGT) is an irrevocable trust structured to be outside the grantor's taxable estate for estate tax purposes while remaining a grantor trust for income tax purposes, allowing the grantor to pay the trust's income taxes — effectively making a tax-free gift equal to the trust's annual income tax liability — while assets grow inside the trust free of income tax drag.
The IDGT is one of the most intellectually elegant structures in estate planning, exploiting a deliberate mismatch between estate tax and income tax rules. Under the estate tax rules in IRC Subtitle B, assets in an irrevocable trust that the grantor cannot unilaterally access or control are removed from the taxable estate. But the grantor trust rules under IRC Sections 671-677 require income generated by certain trusts to be reported on the grantor's personal income tax return when the grantor retains certain specified powers.
By intentionally including one of these grantor trust trigger powers — for example, a swap power allowing the grantor to substitute assets of equivalent value, a retained power to change beneficiaries among a class, or certain administrative powers — the drafter makes the trust a grantor trust for income tax but ensures the powers are harmless under estate tax rules. The result: assets are outside the estate but the grantor pays the income taxes. The grantor's payment of income taxes on behalf of the trust is not treated as an additional gift under Revenue Ruling 2004-64 — the IRS confirmed this — creating a powerful annual wealth transfer equal to the trust's tax burden.
IDGTs are commonly funded through installment sales. The grantor sells assets (often closely held business interests, real estate, or marketable securities) to the IDGT in exchange for a promissory note bearing the Applicable Federal Rate (AFR) interest. Because the IDGT is a grantor trust, the sale is disregarded for income tax purposes — there is no gain recognition on the sale and the interest payments are not income to the grantor. The promissory note freezes the value of the sold assets in the grantor's estate, while all future appreciation passes to trust beneficiaries free of estate and gift tax.
Like GRATs, IDGTs lose the step-up in basis at death for assets inside the trust. Estate planners sometimes weigh the estate tax savings against the lost step-up when advising clients with appreciated assets and long investment horizons. For assets expected to be held and never sold by trust beneficiaries, the loss of step-up may be acceptable; for assets likely to be sold, the income tax cost can erode the transfer tax savings.
The IDGT's efficacy has prompted periodic legislative proposals to force inclusion of grantor trust assets in the taxable estate or to treat sales between a grantor and their grantor trust as taxable events. As of current law, neither restriction has been enacted, though estate planners and their clients should monitor legislative developments given the political sensitivity of these strategies.