LLG Blog

Monday, December 23, 2019

Intentionally Defective Grantor Trust

IDGT: This trust is supposed to “fail”

Trusts come in all shapes and sizes. However, from an income tax perspective, there are basically two types of trusts that are funded with assets: grantor trusts and nongrantor trusts. As the name implies, the earnings of a grantor trust are taxed directly to the grantor — the person establishing the trust — while a nongrantor trust entity pays the tax owed on the trust’s earnings.

So you might be surprised to learn about a variation that’s purposely designed to fail the grantor trust rules and result in income being taxed to the grantor. Appropriately enough, it’s called the “intentionally defective grantor trust” (IDGT).

How the trust works

An IDGT is treated as a separate tax entity for federal estate tax purposes. However, the trust is considered to be a grantor trust for income tax purposes. If certain requirements are met, it can be a powerful vehicle for affluent individuals seeking to preserve more wealth for their heirs.

First, you establish the IDGT as a legal entity under prevailing state laws and designate the trust beneficiaries, such as your children and grandchildren. Typically, you’ll transfer appreciating assets, such as securities or real estate, to the trust as “seed money.” Of course, the transfers are subject to federal gift tax, but you may benefit from current favorable conditions.

Income tax implications

With a nongrantor trust, the trust itself is taxed on the income received, except for amounts that are distributed to the trust beneficiaries. The assets transferred to the trust are treated as current gifts and removed from the grantor’s taxable estate.

The problem is the graduated income tax rate structure. Unlike the tax brackets for individual taxpayers, which are relatively wide, the tax brackets for trusts are extremely narrow. That means that the higher tax rates kick in at relatively low income levels, as opposed to the individual tax brackets.

For instance, in the wake of the Tax Cuts and Jobs Act (TCJA), the current top tax rate of 37% for individuals applies when taxable income of single filers reaches $510,000 and $612,350 for joint filers. In comparison, the threshold for the 37% rate for taxing trusts and estates is a mere $12,750.

Obviously, when sizeable amounts are involved, a trust will be required to pay more income tax than an individual grantor. Although the TCJA provides for future inflation indexing, a great disparity may still exist.

Usually, the interest income received by a grantor trust is reported on the grantor’s personal income tax return. You might not even have to file a tax return for the trust entity. The assets in the grantor trust are still included in the grantor’s taxable estate.

Best of both worlds

By including certain “defects” in the trust document, the trust is purposely taxed as a grantor trust. For example, the trust may provide that the grantor has no right to reimbursement for income taxes paid on trust income and that trust assets can’t be used to pay any legal obligation or debt of the grantor. The trustee can also certify that any asset substitution won’t change the benefits to beneficiaries.

Thus, the grantor pays income tax on interest income at more favorable rates than a trust would. However, the trust is still drafted in a manner that retains its characterization of an irrevocable trust for estate tax purposes. The determinations for income taxes and estates are addressed separately.

The resulting gift tax liability for the transfer is based on the assumed IRS interest rate (the “7520 interest rate”) at the time the trust is created. When interest rates are relatively low— as they’ve been the last few years—the gift tax consequences are favorable to the grantor.

Turn to your advisor

The IDGT is a valuable estate planning tool, but there are potential pitfalls in the drafting process. Clearly, this isn’t a do-it-yourself proposition. Rely on an experienced estate planner to handle the details.

SIDEBAR: Selling assets to an IDGT

With an intentionally defective grantor trust (IDGT), the grantor often transfers assets to the trust through lifetime gifts. Alternatively, he or she can arrange to sell asset to the trust. In this case, there’s no recognition of a capital gain, so no tax liability ensues.

The sale option often makes sense if you want to remove appreciated assets from the estate. Typically, the transaction is structured as a sale to the trust payable over several years through an installment note. The grantor receiving the loan payments can charge a reasonable low rate that won’t cause dire income tax complications. But be aware that the grantor is still liable for any income tax on the IDGT earnings.

In some instances, a grantor will gift assets to the trust at the outset and follow up with subsequent sales to the trust.

Which option is best for you? It depends on your personal circumstances. Discuss the alternatives with your estate planning advisor.

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