The purpose of estate tax planning is to maximize the assets you pass on to future generations by minimizing gift and estate taxes. Estate-tax strategies revolve around the use of irrevocable trusts. This article discusses the most common types of irrevocable trusts that are used to minimize gift and estate […]
An intentionally defective grantor trust (“IDGT”) is a type of irrevocable trust that is optimized for estate tax savings. The key feature of IDGTs is that they are disregarded for income-tax purposes but not for gift and estate tax purposes. This article provides background on what intentionally defective grantor trusts are, their advantages, and their limitations, with numerical examples.
IDGTs are popular with individuals who either:
One of the main alternatives to an IDGT is a type of trust known as a “non-grantor trust.” In general, the estate tax savings that IDGTs create outweigh the income tax benefits that non-grantor trusts generate. But, individuals in high-tax states who expect to be close to the lifetime exemption amount may be better off with a non-grantor trust since non-grantor trusts are able to avoid state income tax on their income and capital gains.
However, many other estate planning solutions are available, each offering unique benefits depending on your goals. If you’re unsure which solution is best for you, try out our Guided Planner
Most people are focused on minimizing income tax. That’s understandable considering that income-tax rates top 50% in many U.S. jurisdictions. Non-grantor trusts, charitable remainder unitrusts and private placement life insurance are some popular income-tax minimization vehicles. But for high-net-worth individuals, minimizing estate taxes is their most important tax priority. The federal estate tax rate is currently 40% on assets in excess of $13.61 million per individual taxpayer (or $27.22 million for a married couple). Under current law, the $13.61 million lifetime exemption amount will be cut in half on January 1, 2026, meaning that individuals will be forced to pay gift tax or estate tax on transfers in excess of ~$7 million. A number of states impose their own estate taxes as well, bringing the combined federal/state estate tax rates to as high as 52% in some parts of the country.
In New York, which actually has lower estate tax rates than some other U.S. jurisdictions, the estate of a person who dies with a $100 million net worth and hasn’t done any tax planning will owe about $44 million of estate tax. Let’s walk through those numbers.
Assumptions:
Calculations:
Imagine spending decades of your life working long hours in the office and fine-tuning your investment portfolio in your spare time, with the aim of building generational wealth for your children and grandchildren, only for 44% or more to disappear upon your death.
In fact, it gets worse: There’s a second layer of federal estate tax — called the generation-skipping transfer tax — that applies to gifts to your grandchildren. It is levied at a rate of 40%, which means transfers to your grandchildren could be subject to an effective tax rate far in excess of 50%, even if you live in a low-tax state like Florida.
That’s obviously painful, so let’s explain how IDGTs can help minimize estate taxes starting with the basics of how IDGTs work.
An IDGT is a type of grantor trust. Grantor trusts are ignored for income-tax purposes, just like a single-member LLC. As a result, income from a grantor trust flows right onto the grantor’s income tax return as if the income was realized by the grantor individually. In contrast, non-grantor trusts are treated as separate taxpayers for income-tax purposes — they have to file taxes and report income separately. Whether a trust is a grantor trust or a non-grantor trust is based on the specific terms and provisions in the trust agreement creating the trust. (Here is a deep dive comparing grantor and non-grantor trusts.)
The “defect” referenced in the name “intentionally defective grantor trust” refers to the inconsistency between how the trust is treated for income-tax purposes (it’s ignored) and how it’s treated for gift and estate tax purposes (it’s treated as a separate taxpayer).
The power of the intentionally defective grantor trust is its ability to exploit this inconsistency in ways that can save taxpayers’ heirs millions (or billions) of dollars of estate taxes.
Like non-grantor trusts, IDGTs can help minimize future estate tax liability by moving assets out of the grantor’s estate so that any future appreciation of those assets avoids estate tax. That in itself is very powerful. What makes IDGTs so special is the host of other strategies that individual grantors can use to save additional estate tax. These strategies fall into two categories:
1. Indirect Gifts. An IDGT’s grantor can pay the trust’s taxes without those payments being considered gifts. Because the trust isn’t responsible for paying its share of income taxes, the trust’s assets are able to grow at a much faster rate than would be possible if the trust were paying its own taxes. The grantor is still on the hook for those taxes, but that’s okay: by paying the trust’s taxes, the grantor reduces his or her taxable estate, which (unlike the assets in the trust) will be subject to estate tax eventually. The estate tax savings from just paying the trust’s taxes can easily reach into the tens of millions of dollars or more.
2. Tax-Free Transactions. The grantor can loan, sell, or exchange assets with his or her grantor trust without any income-tax consequences. In each case, the goal is to shift wealth from individuals to the IDGTs they create, free of gift tax or estate tax.
There are other major non-tax benefits of intentionally defective grantor trusts:
Need some help to understand how an IDGT can help you save taxes?
Intentionally defective grantor trusts are a tool often used by high-net-worth individuals and families for estate tax planning, protecting assets, and providing structure for passing on wealth to the next generation. If you’re unsure whether an intentionally defective grantor trust is right for you, try our new Estate Tax Solution Comparison Calculator to find the ideal strategy tailored to your specific needs.
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From picking the best strategy to taking care of all the setup and ongoing overhead, we make things simple. The results are real: We have helped create more than $3 billion in additional wealth for our customers. If you would like to learn more, please feel free to explore our Learning Center. You can also see your potential tax savings with our online calculators or schedule a time to chat with us!
