One commonly used vehicle in gift and estate planning is the intentionally defective grantor trust, or IDGT. An IDGT is a separate and distinct entity from the individual transferor (grantor) who establishes the trust. The transfer in trust is treated as incomplete or “defective” by using strategies that cause the grantor to continue to be the owner for income taxes. Therefore, this type of trust is established for gift and estate transfer tax purposes, but not for income tax purposes because the grantor trusts’ income is still reported by the grantor. Grantors purposefully retain enough control to not burden their heirs with income tax ramifications while still allowing lifetime estate planning transfer strategies.

Because the trust is irrevocable, the grantor has no personal legal liability for claims arising after the assets are held by the IDGT (other than for income taxes on trust income), and the assets held by the trust are not included in the grantor’s taxable estate upon death. Only the value on the date of the transfer is added back as part of the lifetime transfer reporting on the estate return. Accordingly, the post-transfer appreciation in value of trust assets is removed from the grantor’s taxable gross estate. 

For federal income tax reporting purposes the transfer to the trust is treated as incomplete or “defective” since the grantor is treated as continuing to be the owner of the trust assets. IRC Sections 673 through 678 set forth the situations in which a grantor is deemed to be the owner of the trust assets for income tax purposes. The three powers often used by an irrevocable trust to create a grantor trust are the power to substitute trust assets (Section 675(4)); the power to use income to pay life insurance premiums covering grantor or grantor’s spouse (Section 677(a)(3)); and the power to make loans to the grantor without adequate security (Section 675(2)). Although most states recognize federal grantor trust rules, Pennsylvania does not and imposes the fiduciary income tax rules on all irrevocable trusts. A number of ways to fund the trust exist, including a direct transfer or a sale in exchange for a note. The sale to an IDGT, as opposed to a gift, is typically used when the grantor does not have sufficient lifetime federal transfer tax exemptions remaining to make a complete tax-free gift, the grantor is not ready to part with all of the equity in the property, or the grantor still wants access to the revenue of an income-producing IDGT asset.

Because IRC Section 671 provides that the client, as grantor and seller, and the IDGT, as purchaser, are deemed to be one person for income tax purposes, no gain or interest is recognized as payments are received on the note. The trust retains the owner’s carryover basis in the property. If the property sold to the trust is a residence, for example, and the client rents the property, the rental income is not recognized by either party. The rental payments are typically structured to cover the cost of maintaining the residence and make payments on the note. If the fair rental payments exceed those expenses, the excess cash is a tax-free gift to the IDGT, further reducing the client’s estate. (Third-party transactions would be reported by the grantor.) The grantor must seed the trust to provide economic substance, and can structure a note to accomplish this by making a partial gift of at least 10 percent and the balance as a sale with a corresponding note. The client will then own the note, which can pay the lowest-permitted rate of interest under IRC Section 7520, thereby freezing the client’s estate to the extent the note is included in the client’s taxable estate as opposed to the residence. 

Under the traditional method of reporting, the trustee of a grantor trust files a Form 1041 U.S. Fiduciary Income Tax Return, typically due by April 15. The income is not reported on the return itself, but a legend indicates that the items of income and deduction will be reported by the grantor and is included as a summary. The grantor pays the income taxes without having to treat the tax payment as a taxable gift to the trust, which allows the trust to grow income tax free. Many practitioners recommend filing a gift tax return to report the sale as well, especially if valuation discounts apply.

Article published in the Pennsylvania CPA Journal, Volume 87, Number 4 (Winter 2017). To read on PICPA website click here.