Intentionally Defective Grantor Trusts (IDGTs) and non-grantor trusts are two popular types of irrevocable trusts. How do you know which one is right for you? This article explains what these trusts are and when they make sense.

Key Highlights and Takeaways

• Two Powerful Estate Tax Strategies: IDGTs and non-grantor trusts both save estate tax, but they’re used in different circumstances.
• IDGTs are Tax-Efficient, Flexible Trust Structures: IDGTs are highly estate-tax efficient and make a lot of sense for people who are interested in transferring wealth to future generations and have not used their entire lifetime gift tax exemptions. A grantor can loan to, sell to, and borrow from an IDGT.
• Non-Grantor Trusts Avoid Both State Income Tax and Estate Tax: A non-grantor trust can be a valuable tool for taxpayers in high-tax states who are looking to transfer wealth to future generations, as non-grantor trusts can avoid not only future estate tax but also state income tax.

What is an IDGT?

An IDGT is a type of irrevocable trust that is optimized for estate-tax efficiency. A person (the “grantor”) creates an IDGT for the benefit of one or more loved ones — such as children, grandchildren, a spouse, or siblings. The grantor funds the trust using a portion of his or her lifetime gift and estate tax exemption. Once an asset is in the trust, that asset is outside the grantor’s estate and will never be subject to gift tax, estate tax, or generation-skipping transfer tax as long as it remains in the trust. Any resulting appreciation will also be outside the grantor’s estate. Because an IDGT is a “grantor trust,” the grantor has the option to pay the trust’s taxes without that being considered a gift, which is a way to transfer additional wealth to the trust. This makes IDGTs even more estate-tax efficient than they would otherwise be. (You can learn more about IDGTs here.)

IDGT Example

Imagine that Teresa is a New York City resident with a $25 million net worth and a portfolio that generates 9% annual returns (divided equally between capital appreciation and cashflow). If Teresa sets up an IDGT for the benefit of her daughter and then contributes a $6 million asset to it, she will use up $6 million of her lifetime gift tax exemption, but the asset will be able to grow outside of her taxable estate. Teresa will also be able to pay the trust’s income taxes, allowing the trust to generate 9% annual post-tax returns and shifting more wealth out of Teresa’s taxable estate. After 25 years, the IDGT’s assets will be worth about $51.7 million! And if Teresa dies in Year 25, she will have saved her daughter about $20.4 million of tax that she would have otherwise owed.

Benefits of IDGTs

1. Estate Tax Savings: The primary advantage of an IDGT is its ability to use a grantor’s lifetime gift tax exemption to efficiently shift assets out of the grantor’s estate for estate-tax purposes. The grantor can pay the income tax on the trust’s income, effectively shifting even more wealth into the trust and out of the grantor’s estate. Finally, the grantor can lend to the trust free of any tax consequences — loans are another powerful tool that taxpayers use to shift wealth out of their estates.
2. Asset Protection: An IDGT, as a separate legal person, is generally not subject to liability for actions taken by a trust’s grantor or beneficiary. So the grantor’s or beneficiary’s creditors won’t be able to access the trust’s assets even if they win a lawsuit against the grantor or beneficiary. In addition to protecting assets from lawsuits, IDGTs can help shield inherited assets from a divorcing spouse.
3. Tax Optionality: IDGTs can be transformed into “non-grantor trusts” after a few years if the grantor decides that non-grantor trust tax treatment is desirable.
4. Relative Liquidity: Compared to many other tax strategies, IDGTs have little impact on a grantor’s liquidity. Though the grantor will have transferred some portion of his or her assets to the trust, the grantor can borrow from the IDGT without any tax consequences. Moreover, if the grantor’s spouse is a beneficiary, he or she can receive distributions from the IDGT if necessary.
5. Ideal for Illiquid Assets: IDGTs work well whether funded with liquid or illiquid assets.
6. GST Efficiency: A person can allocate generation-skipping transfer (”GST”) tax exemption to a IDGT when the trust is first funded. As a result, the IDGT is a popular form of dynasty trust.

Drawbacks of IDGTs

1. No State Income Tax Savings: IDGTs don’t save state income tax unless they’re converted to non-grantor trusts.
2. Irrevocability: When a grantor makes a gift to a non-grantor trust, the gift is irrevocable (though the grantor can swap assets in and out of the trust at any time, as long as the swapped assets are exchanged for other assets with equal value).
3. No Direct Control: Typically the grantor does not act as trustee of the IDGT, though he or she can remove and replace the trustee at any time, lend money to or borrow money from the trust, get reimbursed by the trust for the trust’s tax liabilities (if the grantor doesn’t want to pay), and swap assets with the trust.

What is a Non-Grantor Trust?

A non-grantor trust is a type of irrevocable trust that is treated as a separate taxpayer for income-tax purposes. By setting one up in a no-tax state, taxpayers can avoid state income tax. Properly structured non-grantor trusts also help families avoid estate tax, since assets gifted to them (and any appreciation after the date of the gift) will be outside the grantor’s estate for estate-tax purposes.

Typically, a person (the “grantor”) creates a non-grantor for the benefit of one or more loved ones — such as children, grandchildren, or siblings. The grantor funds the trust using a portion of his or her lifetime gift and estate tax exemption. Once an asset is in the trust, that asset is outside the grantor’s estate and will never be subject to gift tax, estate tax, or generation-skipping transfer tax as long as it remains in the trust. Any resulting appreciation will also be outside the grantor’s estate. (You can learn more about non-grantor trusts here.)

Non-Grantor Trust Example

Imagine that Jim is a New York City resident with a $25 million net worth and a portfolio that generates 9% annual returns (divided equally between capital appreciation and cashflow). If Jim sets up a non-grantor trust and then contributes a $6 million asset to it, he will use up $6 million of his lifetime gift tax exemption, but the asset will be able to grow outside of his taxable estate. After 25 years, the non-grantor trust’s assets will be worth about $33.5 million! And if Jim dies in Year 25, he will have saved his heirs about $15.2 million of tax between state capital gains taxes and estate taxes relative to the counterfactual where he hadn’t funded the non-grantor trust.

Benefits of Non-Grantor Trusts

1. Estate Tax Savings: Non-grantor trusts use a grantor’s lifetime gift tax exemption to efficiently shift assets out of the grantor’s estate for estate-tax purposes. However, non-grantor trusts are a bit less estate-tax efficient than IDGTs.
2. State Income Tax Savings. In California, the top marginal state income-tax rate is 13.3%. In New York City, the top rate is 14.776%. In South Dakota, the top marginal state income-tax rate is 0%. Setting up a non-grantor trust in a state like South Dakota, and then putting investments that generate lots of investment income inside of that trust, can save a grantor’s family a lot of income tax over time.
3. Asset Protection: A non-grantor trust, as a separate legal person, is generally not subject to liability for actions taken by a trust’s grantor or beneficiary. So the grantor’s or beneficiary’s creditors won’t be able to access the trust’s assets even if they win a lawsuit against the grantor or beneficiary. In addition to protecting assets from lawsuits, non-grantor trusts can help shield inherited assets from a divorcing spouse.
4. QSBS Stacking. For founders or early startup employees who have QSBS-eligible stock, perhaps the biggest benefit of non-grantor trusts is the additional QSBS exclusion they receive. Non-grantor trusts are eligible for their own $10 million QSBS exclusions — a single QSBS-stacking non-grantor trust can save a family millions of dollars of capital gains tax.
5. Various Federal Deductions. Non-grantor trusts get their own federal deductions and exemptions such as the $10,000 state and local income tax deduction, excess business loss deductions, mortgage interest tax deductions, Section 199A small business tax deductions, and more. Collectively, these tax benefits can be quite significant.
6. Ideal for Illiquid Assets: Non-grantor trusts work well whether funded with liquid or illiquid assets.
7. GST Efficiency: A person can allocate generation-skipping transfer (”GST”) tax exemption to a non-grantor trust when the trust is first funded. As a result, the non-grantor trust is a popular form of dynasty trust.

Drawbacks of Non-Grantor Trusts

1. Illiquidity: When the grantor makes a gift to a non-grantor trust, he or she loses access to the assets in the trust. Unlike with IDGTs or some other trust types, with a non-grantor trust, the grantor cannot “swap” or borrow assets without income-tax consequences.
2. Irrevocability: When a grantor makes a gift to a non-grantor trust, the gift is irrevocable.
3. Spouse Cannot Be Beneficiary: Generally the grantor’s spouse cannot be the beneficiary of a non-grantor trust.
4. Potentially Higher Federal Tax Brackets: Non-grantor trusts are taxed at the highest federal tax bracket on annual income above a few thousand dollars. If the grantor is not a high-bracket taxpayer, gifting assets to a non-grantor trust may actually increase the effective federal tax rate paid on any income generated by assets inside the trust.
5. No Direct Control: The grantor cannot act as trustee of the non-grantor trust, though he or she can remove and replace the trustee at any time.

Should You Set Up an IDGT or a Non-Grantor Trust?

IDGTs and non-grantor trusts both save estate tax. They can both be set up as dynasty trusts that can benefit not only a taxpayer’s children but also their grandchildren, great-grandchildren, and beyond. But there are crucial differences. IDGTs are more estate-tax efficient. Non-grantor trusts can save state income tax, which is a big deal for people in high-tax states like New York or California.

You’ll often see people in high-tax states with $10 million to $25 million of assets setting up non-grantor trusts. These people tend to be more focused on state income tax than on estate tax. Non-grantor trusts are also desirable for people with QSBS stock, since they can claim their own $10 million QSBS exclusions.

IDGTs are popular with people who either live in low-tax states or who expect to be significantly over the estate tax exemption amount, and therefore are more focused on estate tax than on state income tax. Some people set up IDGTs because they want to name their spouse as beneficiary, since naming a spouse as the beneficiary of a non-grantor trust is much more complicated.

It is important to note that there are lots of other gift and estate tax strategies that may make more sense than an IDGT or a non-grantor trust, depending on circumstances. Those strategies are also worth exploring. Moreover, IDGTs and non-grantor trusts are not mutually exclusive; some people set up both.

Conclusion

IDGTs and non-grantor trusts are both powerful estate-tax strategies. Hopefully this article has given you a better idea of what each structure entails, and whether one or the other might be a better fit.

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