Understanding an Intentionally Defective Grantor Trust

An intentionally defective grantor trust is a type of irrevocable trust used primarily to reduce estate taxes. It’s intentionally drafted so the assets that are transferred to the trust are removed form the grantor’s estate, but the grantor continues paying income taxes on the trust’s earnings.

This combination, assets removed from the estate but income taxes still paid by the grantor, is what makes the trust “intentionally defective.”

Here’s an example to illustrate how it works:

Let’s say John transfers $1 million into an irrevocable trust for the benefit of his wife, Mary. That $1 million gets invested, earns dividends, and generates capital gains. Instead of the trust paying its own income tax bill, John pays the income tax personally.

That may sound counterintuitive, but it’s incredibly beneficial from an estate tax standpoint.

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Why Would Anyone Want to Pay a Trust’s Income Taxes?

Because doing so creates two major estate planning advantages:

It reduces the size of the grantor’s taxable estate

When John pays the taxes out of his own pocket, he’s lowering the value of his estate, which means less subject to estate tax at his death. However, these tax payments are not considered gifts so no gift tax issues arise.

Trust assets grow without being reduced by taxes

If the trust had to pay its own income tax, its overall value would shrink. Instead, all earnings stay inside the trust, compounding tax-free and growing outside of John’s estate. For affluent clients, this can result in substantial long-term savings.

This “tax burn” strategy allows the trust assets to grow while the grantor’s estate shrinks, an ideal combination for families subject to Minnesota estate tax.

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How an IDGT Is Structured: The Swap Power

One of the legal provisions commonly used to create intentionally defective grantor trust status is something called a swap power.

A swap power allows the grantor to:

• Substitute assets of equivalent value between themselves and the trust.

This flexibility is important because it allows the grantor to turn off the defective status later if needed. If John no longer wants to pay the trust’s income taxes, perhaps he lacks the liquidity, revoking the swap power can shut off grantor-trust status.

Because of this, attorneys must consider the grantor’s liquidity before recommending an IDGT. Someone whose wealth is tied up in real estate or business assets may not be a good fit unless they have enough liquid funds to cover ongoing tax obligations.

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Frequently Asked Questions

1. Is an intentionally defective grantor trust revocable or irrevocable?

It is always an irrevocable trust, meaning assets transferred into it are permanently removed from the grantor’s estate. However, certain powers, such as the swap power, can create grantor-trust status for income tax purposes.

2. Why is it called “defective”?

The trust is intentionally drafted so that the IRS considers the grantor the owner for income tax purposes,but not for estate tax purposes. This “defect” is actually a strategic advantage.

3. Do I need significant assets to benefit from an IDGT?

Generally, yes. IDGTs are most useful for affluent clients with taxable estates or fast-growing assets. They are not usually necessary for smaller estates.

Author

Claire creates wills and trusts which provide security and peace of mind. She compassionately listens to her clients’ dreams, goals, and fears and then fashions plans that best meet their needs. It is important to Claire that her clients understand different options and make decisions that are right for them. She loves to educate clients by drawing out complicated concepts.

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