Intentionally Defective Grantor Trusts (IDGTs)

Engaging with any type of service or product with “intentionally defective” in its name is likely to give anyone pause; who wants to associate with a product that is literally intended to be defective? However, in spite of its undesirable name, intentionally defective grantor trusts are a sophisticated tool in tax-savvy wealth transfer.

The “intentional defect” of the IDGT refers to a mismatch of how the IRS views the trust for estate tax purposes vs. income tax purposes. Although often regarded as a wealth transfer tool, an IDGT can be a surprisingly effective engine for long-term charitable giving as well.

This article will explain in greater depth on what an IDGT is and what effect it can play in making a charitable impact.

An IDGT can be a powerful tool for wealth transfer and charitable giving

How the “Defect” Actually Works

The IRS has two separate views that it holds when it looks at an IDGT:

From an estate tax perspective, it recognizes that the assets within it are outside of your taxable estate. Any future growth on assets within the trust are protected from ever incurring estate tax.

From an income tax perspective, the IRS regards the trust as “transparent”; it looks through the trust as if it doesn’t exist and looks at you, the grantor, with the expectation that you will pay income taxes on the trust’s earnings.

Because you are paying the income taxes on behalf of the trust, the trust assets grow tax-free for your heirs. Essentially, your tax payments act as an additional, tax-free gift to your beneficiaries because you aren't using trust money to pay the IRS.

Two Funding Paths

There are two primary ways to fund an IDGT:

• The 10% Seed Gift: Think of this as the trust’s "down payment." By gifting 10% of your total goal amount, you give the trust the financial backbone it needs to be taken seriously by the IRS. You’ll use a portion of your $15 million lifetime exemption ($30 million for couples) to make this gift tax-free. This "seed" proves the trust has its own money to play with, which allows you to sell it more assets later. You could choose a future route of making further financial gifts into the trust.

• The Installment Sale: In this path, you will still have the initial seed gift. However, the next step is the sale of a high-growth asset (pre-IPO stock, real estate, etc.) to the trust in exchange for a promissory note.

As example, if the growth of the asset that you sold to the trust grew at 8%, but the interest rate on the promissory note is only 4%; that 4% difference stays in the trust for your heirs, free of any gift or estate tax liability.

Since the IRS ignores your trust for income tax, there is no capital gains tax on the sale of the asset to the trust. You are effectively selling the asset to yourself.

The Charity Angle

There are several ways to use an IDGT for charitable giving:

1. Directing the "Remainder" to Charity

You can design an IDGT where the assets grow for your family's benefit for a certain number of years, but any "excess" or the final remaining balance goes to a charity, or a donor advised fund (DAF). Because the assets grow without "tax drag" (since you are paying the income taxes personally), the pot of money at the end of the trust term is often significantly larger than it would be in a standard trust.

The Benefit: You fulfill your charitable goals with "tax-free" growth that happened outside your taxable estate.

2. Using the "Substitution Power" for Charitable Assets

One of the "defects" in an IDGT is the substitution power, which allows you to swap assets of equal value in and out of the trust. So, if your IDGT holds a highly appreciated asset (like a stock that went from $10 to $500), you can swap it out for $500 cash. You now own that high-growth stock personally again.

The Benefit: You can then donate that highly appreciated stock directly to a charity. You get a full fair market value income tax deduction, and neither you nor the charity pays capital gains tax on the $490 profit.

3. The "Power to Add" Charitable Beneficiaries

Some IDGTs are drafted with a provision that allows a "non-adverse party" (like a trusted friend or advisor) to add a qualified charity as a beneficiary of the trust. This allows the trust to pivot. If your heirs are already well-provided for, the trustee can begin making distributions directly to charities.

The Benefit: Since you (the grantor) are paying the taxes on the trust's income, you usually get to claim the charitable deduction on your personal tax return when the trust makes a donation.

Next Steps

An IDGT is a powerful yet complicated tool for wealth transfer to heirs and as an engine for charitable giving. There may be a variety of other giving vehicles that may make better sense for a donor, their family, and their giving. At Generosity Nexus, we have the expertise and experience to help you map out the variety of choices available and find the right fit for your wealth, your interests, and your giving.

Don’t hesitate to schedule an appointment to learn more about how we can help you.