Suppose you have a problem.
It’s a very nice problem to have.
You own a business, investment portfolio, real estate, or other assets that have become extremely valuable.
You expect them to become even more valuable.
And then your estate-planning attorney says something you never expected to hear:
“We need to figure out how to make you poorer.”
Excuse me?
You spent 40 years building wealth, and now the estate plan is designed to make you poorer?
Sort of.
For families potentially exposed to estate taxes, one of the central objectives of advanced estate planning is to reduce the amount of property ultimately included in the taxable estate—preferably without simply handing millions of dollars outright to the children.
And there is a wonderfully strange estate-planning tool designed to help accomplish exactly that.
It’s called an:
Intentionally Defective Grantor Trust
Or IDGT.
Yes.
Defective.
On purpose.
Only tax lawyers could invent a sophisticated wealth-planning strategy and market it by calling it defective.
But the “defect” is actually the clever part.
An IDGT can potentially allow a wealthy person to move assets—and, critically, future appreciation—outside the taxable estate while continuing to personally pay the income taxes attributable to the trust.
That combination can make an IDGT an extraordinarily powerful wealth-transfer tool.
So let’s open the hood and see how it works.
First: What Exactly Is “Defective” About It?
Nothing is broken.
Your attorney didn’t accidentally draft the trust incorrectly.
The word defective refers to an intentional mismatch between different parts of the federal tax system.
Here’s the basic idea.
A properly designed IDGT can potentially be treated one way for estate and gift-tax purposes and another way for income-tax purposes.
For estate-planning purposes, the grantor may have transferred assets sufficiently so that the trust property is potentially outside the grantor’s taxable estate.
But for federal income-tax purposes, the trust can be drafted so the grantor is still treated as the owner.
That makes it a grantor trust.
And that means the grantor generally reports the trust’s taxable income on the grantor’s own income-tax return.
Read that again.
The trust may own the assets, but you may still pay the income taxes.
At first that sounds terrible.
Why would anyone voluntarily agree to pay taxes on income generated by assets they gave away?
Because, in the right circumstances, that’s precisely where the magic happens.
Imagine a Trust With a Rich Uncle Paying Its Tax Bill
Suppose your trust owns investments generating significant taxable income.
Normally, taxes reduce the amount available to reinvest.
Earn $100.
Pay tax.
Invest what’s left.
But imagine someone else pays the tax bill for you.
Now the entire $100 can potentially remain available inside the trust.
That’s essentially what can happen with a grantor trust.
The trust’s assets may continue growing while the grantor personally handles the income-tax liability attributable to the trust.
From the family’s perspective, something interesting is happening:
The trust grows without being depleted by that income-tax payment, while the grantor’s personal estate gets smaller because the grantor is paying the tax.
That is why sophisticated planners sometimes describe the grantor’s payment of the trust’s income tax as a kind of additional “tax burn.”
The grantor is reducing his or her own wealth by paying taxes while allowing the trust assets to remain intact.
And under established federal tax treatment, the grantor’s payment of income tax attributable to a grantor trust generally is not treated as an additional gift to the trust beneficiaries merely because the grantor paid that tax.
That’s an enormously important feature.
Meet Our Fictional Entrepreneur: Susan
Let’s make this easier with an example.
Susan is 62.
Thirty years ago, she started a company.
Today, her interest is worth approximately $10 million.
Susan believes the company could eventually be worth $30 million.
She has plenty of other assets to support her lifestyle, so she doesn’t necessarily need to personally own all of the company forever.
She has two children and four grandchildren.
Susan has a question:
“If I’m eventually giving this wealth to my family anyway, why should I wait until I die?”
Excellent question.
Because if Susan continues owning the business and it grows from $10 million to $30 million, that additional:
$20 million
may eventually become part of Susan’s estate-tax problem.
So instead of focusing only on today’s $10 million value, Susan and her advisors focus on something else:
Who should own the next $20 million of growth?
That question is at the heart of sophisticated estate planning.
Move the Tree Before It Grows
Think about Susan’s business as an apple tree.
Today the tree is worth $10 million.
Susan expects it to produce another $20 million worth of apples over the coming years.
She has two choices.
She can keep the tree.
If she does, she keeps the future apples too.
Or she can potentially transfer the tree into an appropriate trust.
If properly structured, future growth may occur on the trust’s side of the fence.
The estate-planning objective isn’t merely:
“Give away $10 million.”
It’s:
“Move the asset before it becomes worth $30 million.”
That’s the concept.
Sophisticated estate planning frequently focuses less on moving existing dollars and more on moving future appreciation.
But Susan Doesn’t Want to Give Away $10 Million
Fair enough.
Susan may not want to make an outright $10 million gift.
And she may not have enough available gift-and-estate-tax exemption to do so without significant consequences.
This is where another sophisticated IDGT technique enters the conversation:
The Sale to an IDGT
Instead of simply giving the entire asset to the trust, Susan may potentially sell an asset to the IDGT in exchange for a promissory note.
Now we’re getting interesting.
Imagine Susan creates the trust and properly funds it with sufficient initial capital.
She then sells a valuable business interest to the trust.
The trust doesn’t hand Susan a suitcase containing $10 million.
Instead, the trust gives Susan a legally enforceable promissory note.
The trust now owns the business interest.
Susan owns the note.
The trust agrees to pay Susan according to the note’s terms, including an appropriate interest rate.
So what has happened?
Susan hasn’t simply written her children a giant check.
She has exchanged an appreciating asset for a fixed-payment asset.
That distinction can be incredibly important.
The Freeze
Here’s the concept wealthy families love.
Suppose Susan transfers a business interest currently worth $10 million in exchange for a properly structured $10 million note.
The note does not suddenly become worth $30 million because the business explodes in value.
The trust owns the appreciating business.
Susan owns the note.
If the business grows from $10 million to $30 million, the excess growth potentially occurs inside the trust rather than in Susan’s estate.
Estate planners sometimes call this an estate freeze.
You’re essentially attempting to freeze the value remaining in the grantor’s estate while shifting future appreciation elsewhere.
Susan’s side:
The note.
Trust’s side:
The appreciating asset.
If the asset significantly outperforms the interest required on the note and other costs of the strategy, substantial value can potentially accumulate for future generations.
Why the Interest Rate Matters
The trust can’t simply say:
“Thanks for the $10 million business, Mom. We’ll pay you back someday. Maybe.”
This needs to be a real transaction.
The promissory note needs legitimate terms.
Interest matters.
Valuation matters.
Documentation matters.
Payment history matters.
The applicable federal interest-rate rules matter.
This isn’t Monopoly money.
The transaction needs to be respected as an actual sale.
And here’s the economic bet behind the strategy:
Can the transferred assets grow faster than the required interest rate on the note?
Suppose the note carries a hypothetical rate of 5%.
And suppose the business appreciates at 12%.
That difference can create an opportunity for wealth to accumulate inside the trust.
But reverse those numbers and the strategy becomes far less exciting.
An IDGT isn’t a magic money machine.
It works best when the economics cooperate.
Now for the Really Weird Part: Selling Something to Yourself
Remember that the IDGT is intentionally designed as a grantor trust for income-tax purposes.
For federal income-tax purposes, transactions between a grantor and the grantor’s wholly owned grantor trust generally aren’t treated the same way as transactions between two unrelated taxpayers.
In appropriate circumstances, the sale can therefore occur without immediate recognition of capital gain merely because the grantor sold an appreciated asset to the grantor trust.
That can be extremely powerful.
Imagine Susan’s business interest is worth $10 million but has a very low income-tax basis.
A normal sale to an unrelated person might generate substantial capital gain.
A properly structured sale to Susan’s grantor trust can receive different federal income-tax treatment because, for income-tax purposes, Susan and the trust may effectively be treated as the same taxpayer.
Once again:
Different tax systems are looking at the same trust differently.
That’s the “defective” part doing its job.
And Susan Keeps Paying the Income Taxes
Now suppose the trust’s assets generate taxable income.
Who gets the tax bill?
Susan.
At first Susan might say:
“Wait. I sold the asset. Why am I still paying the tax?”
Because that’s exactly how the grantor-trust structure was designed.
And remember what happens every time Susan pays that tax personally.
Susan’s estate decreases.
The trust doesn’t have to use its own assets to satisfy that particular income-tax obligation.
Potentially more remains in the trust to grow for Susan’s descendants.
Imagine this continues for 10 or 15 years.
Susan may pay hundreds of thousands—or potentially millions—of dollars of income taxes attributable to the trust.
That can feel painful every April.
But from a transfer-tax perspective, those payments may effectively allow additional family wealth to accumulate outside Susan’s estate without each tax payment being treated as a new gift to the trust beneficiaries.
It’s one of those rare estate-planning situations where someone might say:
“Congratulations! You get to pay the taxes!”
And actually mean it.
Why Not Just Give the Kids the Money?
Because giving children millions of dollars outright creates other problems.
Your son gets divorced.
Your daughter gets sued.
A child makes terrible investment decisions.
A beneficiary develops a gambling or substance-abuse problem.
A grandchild is too young.
A beneficiary has special needs.
Or maybe your children are perfectly responsible, but you simply don’t believe a 28-year-old needs unrestricted control over $5 million.
A properly designed irrevocable trust can potentially provide substantial long-term protection and control.
The children can be beneficiaries without necessarily owning every underlying asset outright.
This brings us back to one of the most important concepts in sophisticated estate planning:
Benefiting from wealth is not the same thing as personally owning it.
The Trust Can Potentially Continue for Future Generations
Now imagine Susan’s IDGT isn’t designed only for her children.
It’s designed with grandchildren and later generations in mind.
Depending upon the trust terms, applicable state law, generation-skipping transfer-tax planning and other considerations, assets might remain in trust for a very long time.
Susan’s children may benefit.
Later, grandchildren may benefit.
Potentially, future descendants may benefit.
Meanwhile, the trust structure may provide various degrees of protection from creditors, divorcing spouses and future estate taxes, depending upon the circumstances.
Now we’re no longer talking about moving $10 million.
We’re talking about creating a multigenerational wealth structure.
That’s how families begin thinking in decades rather than years.
But There’s a Catch: Basis
If you’ve read our other estate-planning articles, you knew this was coming.
Tax planning almost always involves a tradeoff.
And one of the biggest IDGT tradeoffs involves:
Income-tax basis.
Suppose Susan bought her business interest for very little and it’s now worth $10 million.
If Susan retains an appreciated asset until death and the asset qualifies for the basis adjustment under Internal Revenue Code Section 1014, the basis generally may be adjusted to its fair market value at death.
That can potentially eliminate enormous amounts of built-in capital gain.
But what happens if Susan successfully transfers that asset outside her taxable estate?
The asset may not receive the same basis adjustment merely because Susan dies.
That’s potentially a big deal.
You might save estate tax and create a future capital-gains problem.
Estate Tax vs. Capital Gains Tax
This is why sophisticated planning isn’t:
“Get everything out of the estate!”
That’s too simplistic.
The actual analysis is closer to:
“Which assets should we remove from the estate, and which assets might we intentionally keep?”
Imagine an asset with enormous future appreciation potential but relatively little existing built-in gain.
That may be a compelling candidate for certain transfer strategies.
Now imagine an asset worth $10 million with a basis of $500,000 that isn’t expected to appreciate much further.
Keeping it until death to potentially obtain a basis adjustment may be extremely valuable.
Every asset has its own tax personality.
A good estate plan recognizes that.
Can Susan Turn Off the Grantor-Trust Status?
Potentially, depending upon how the trust is drafted and the circumstances.
Sophisticated IDGT documents may include provisions designed to provide flexibility concerning grantor-trust status.
Why might Susan eventually want the trust to start paying its own income taxes?
Maybe Susan’s personal cash flow changes.
Maybe the trust has become enormous.
Maybe the annual tax burden becomes uncomfortable.
Maybe the tax law changes.
Flexibility can be valuable.
But toggling grantor-trust status can have significant tax consequences and should never be done casually.
This is another reason an IDGT is not a document you download from the internet on Sunday afternoon.
What Happens If Susan Dies While the Note Is Outstanding?
Excellent question.
Remember, Susan sold the asset to the trust in exchange for a promissory note.
If Susan dies while she still owns that note, the note itself may be an asset of Susan’s estate.
The treatment of the trust, note and underlying assets can become technically complex.
That means the term of the note, Susan’s age and health, expected cash flow, repayment structure, trust liquidity and broader estate plan all matter.
The strategy isn’t simply:
Create trust. Sell asset. Done.
It needs to be modeled.
Valuation Is a Very Big Deal
Let’s return to Susan’s business.
We casually said:
“The business interest is worth $10 million.”
How do we know?
Privately held businesses don’t come with a stock-market ticker.
Real estate partnerships don’t display their value every second on CNBC.
A qualified appraisal may therefore be critical.
The valuation may need to consider:
- company financials;
- expected cash flow;
- comparable transactions;
- market conditions;
- the exact interest being transferred;
- voting rights;
- transfer restrictions;
- lack of marketability;
- lack of control;
- and other relevant factors.
If the IRS later concludes the property was worth substantially more than the sale price, the supposed sale could include a taxable gift.
This is why advanced estate planning often involves a team.
Attorney.
CPA.
Financial advisor.
Valuation professional.
Trustee.
Insurance professional, where appropriate.
The more sophisticated the strategy, the less attractive the phrase:
“My neighbor said this worked for him.”
Who Is a Good Candidate for an IDGT?
An IDGT may deserve consideration when someone:
- has a potentially taxable estate;
- owns assets expected to appreciate significantly;
- owns a closely held business;
- has substantial real estate or investment interests;
- wants to transfer wealth to children or later generations;
- does not need all of the transferred property to maintain their lifestyle;
- has sufficient liquidity to pay income taxes attributable to the trust;
- wants trust-based asset protection for beneficiaries; and
- is willing to give up sufficient control to make the planning work.
That last point matters.
You cannot have sophisticated estate-tax planning while simultaneously insisting:
“I want to give everything away, but I also want complete control and unrestricted access forever.”
At some point, tax planning generally requires giving something up.
Who Should Be Careful?
IDGT planning may be inappropriate for someone who needs the transferred assets to support their lifestyle.
It can also be problematic if the grantor doesn’t have enough liquidity to handle the tax burden.
And if the assets are unlikely to appreciate meaningfully, the economic benefit of a sale strategy may be limited.
Age and health matter.
Family dynamics matter.
Asset type matters.
Interest rates matter.
Basis matters.
State law matters.
The federal estate-tax environment matters.
The trust’s long-term objectives matter.
An IDGT is a strategy.
It isn’t a product.
You don’t simply “buy an IDGT.”
Let’s Return to Susan
Remember our entrepreneur?
She began with a business interest worth $10 million.
Instead of holding that asset until it potentially became worth $30 million, Susan implemented an appropriately structured trust strategy.
She exchanged an appreciating asset for a promissory note.
The trust received the upside.
Susan received the fixed obligation.
The business grew.
Susan continued paying income taxes attributable to the grantor trust.
The trust assets weren’t reduced by those particular tax payments.
Over time, substantial value potentially accumulated for Susan’s descendants outside Susan’s taxable estate.
Was Susan poorer?
Technically, perhaps.
But look at the family balance sheet.
That’s the secret.
Sophisticated estate planning doesn’t always focus exclusively on:
“How wealthy am I?”
It may focus on:
“How much wealth does my family control across the entire structure?”
That’s a very different question.
The Billionaire Mindset Isn’t About Billions
You don’t need a private jet to understand the lesson.
Very wealthy families frequently plan around future appreciation.
They ask:
What do I own today?
What is likely to become dramatically more valuable?
Do I need to own that future growth personally?
Can my family benefit from it through a trust?
What will happen to the income taxes?
What happens to basis?
What happens at my death?
What happens when my children die?
And what happens when my grandchildren inherit?
That’s not merely estate planning.
That’s multigenerational planning.
So Why Is the Trust “Defective”?
Because tax lawyers have a strange sense of humor.
The trust is intentionally designed so that:
For certain estate-planning purposes, the assets may be treated as having been transferred away.
While:
For income-tax purposes, the grantor may still be treated as the owner.
That mismatch can create the planning opportunity.
The “defect” isn’t a bug.
It’s the feature.
The Bottom Line
An Intentionally Defective Grantor Trust can sound impossibly complicated.
At its heart, however, the strategy rests on several surprisingly understandable ideas:
Move appreciating assets before they appreciate.
Exchange potentially explosive growth for a more predictable asset such as a note.
Allow future appreciation to occur outside the taxable estate when properly structured.
Let the grantor pay the income taxes so more wealth can potentially remain in the trust.
Protect inherited wealth through a trust instead of necessarily handing it outright to beneficiaries.
And:
Always compare potential estate-tax savings with the income-tax basis consequences.
The goal isn’t to create the smallest estate possible.
The goal is to create the most efficient family wealth plan possible.
And sometimes the strangest-sounding trust in the estate-planning world can help accomplish exactly that.
So the next time someone tells you their estate plan contains something “intentionally defective,” don’t immediately recommend a new lawyer.
Ask whether they’re talking about an IDGT.
Because in sophisticated estate planning:
Sometimes being defective is exactly the plan.
Important Disclaimer
This article is provided solely for general educational and informational purposes and does not constitute legal, tax, investment, accounting, valuation or financial advice. IDGTs, sales to grantor trusts, promissory-note transactions and other advanced estate-planning techniques are highly technical and fact-specific.
Among other issues, these strategies can involve federal gift, estate, generation-skipping transfer and income-tax rules; valuation requirements; adequate trust funding; interest-rate requirements; basis consequences; state trust and tax law; and the terms and administration of promissory notes. Tax laws and exemption amounts can change.
A transaction that is improperly drafted, valued, documented, funded or administered can produce results very different from those described in a general educational article. Individuals considering an IDGT or similar strategy should work with experienced estate-planning counsel, tax professionals and other appropriate advisors before transferring or selling assets.
The best time to explore an IDGT is generally before the asset you want to transfer experiences the growth you’re trying to move outside your estate.
