What is a grantor trust that is intentionally broken?
Intentionally defective grantor (IDGT) trusts are a way to plan your estate so that you can freeze some of your assets for estate tax purposes only, not for income tax reasons. The deliberately flawed trust is set up as a grantor trust with a hole that lets the grantors get money from some trust assets.
When the grantor dies, the estate does not have to pay any estate taxes, but the owner does have to pay income tax on any income.
Understanding Grantor Trusts That Are Intentionally Broken
The Internal Revenue Service (IRS) can treat an irrevocable trust in some ways the same way it treats a changeable trust because of specific grantor trust rules. In these cases, people sometimes set up “intentionally defective grantor trusts.”
In these situations, the donor must pay taxes on the trust’s income, but the trust’s assets do not count toward the owner’s estate. But these assets would be part of a grantor’s estate if that person has a revocable trust since that person would still legally own the land.
Taxes on estates
How much the grantor’s estate is worth for estate tax reasons goes down with the amount of the asset transfer. The person will “sell” things to the trust in return for a promissory note, also known as an installment note, due over a certain amount of time, like 10 or 15 years.
The note will earn enough interest for the trust to be considered above-market, but the assets that back it up are projected to grow faster.
Those who benefit
People who receive IDGTs are usually children or grandkids. They will get assets that have grown without the grantor having to pay less in income taxes.
If set up correctly, the IDGT can be a helpful estate planning tool because it lets people lower their taxable estate while giving assets to recipients at a fixed value.
The person who sets up the trust can also lower their taxable estate by paying income taxes on its assets. This is the same thing as giving extra money to the recipients.
Because they are so complicated, an IDGT should only be set up with the help of a trained accountant, a certified financial planner (CFP), or an estate planning attorney.
Selling things to a grantor trust that is purposely broken
Because of how it is set up, an IDGT lets the donor give or sell assets to the trust. There might be a gift tax if you give an asset to an IDGT, so it would be better to sell the asset to the trust. Gaining cash when selling things to an IDGT is impossible, so no taxes are due.
This is the best way to eliminate assets that have increased value from the estate. The trust typically purchases the deal, with payments spread out over multiple years through a monthly note. When a donor gets loan payments, they can charge a low interest rate that is not taxed as interest income.
The donor is responsible for any money the IDGT makes, though. If the thing sold to the trust brings in money, like a rental property or a business, the donor must pay taxes on the trust’s income.
Questions People Ask Often
What is it about a grantor’s trust that makes it purposely flawed?
When something is intentionally flawed, the grantor no longer owns the assets in the trust because they are taken out of the estate. However, the grantor still has to pay taxes on any income from the assets in the trust.
How do you tax grantor trusts that are purposely flawed?
Because there is no capital gains tax, IDGTs are not taxed when assets are sold to them or when they go up in value. The donor must pay income taxes if there is income from the IDGT.
What Happens to a Grantor Trust That Was Intentionally Broken When the Grantor Dies?
If there was a monthly note, the grantor’s taxable estate includes the principal and any interest that has built up. If the assets were sold into the IDGT, they would not be considered part of the taxable estate. The recipients can then receive them.
Conclusion
- A person can keep some trust assets separate from income tax and estate tax treatment by setting up an intentionally faulty grantor trust (IDGT).
- It’s a grantor trust with a flaw meant to ensure the person keeps paying income taxes.
- An IDGT is typically utilized when the trust’s beneficiaries consist of children or grandchildren, and the trust’s creator has already fulfilled their income tax obligations on the funds that will be appreciated.
