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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.
When Does an IDGT Make Sense?
IDGTs are popular with individuals who either:
Expect to be significantly over the lifetime exemption amount (we’ll get to what this exemption means below).
Live in a low-tax state and expect to be at least somewhat over the lifetime exemption amount.
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
Why is Avoiding the Estate Tax So Important?
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:
Estate Value: $100 million
New York Estate Tax Rate: New York has a progressive rate structure, with a maximum rate of 16%
Federal Gift Tax Exemption: $13.61 million
Federal Estate Tax Rate: 40% (current rate)
Calculations:
New York Estate Tax Liability: ($100 million estate value * [various rates]) = $15.5 million
Federal Estate Tax Liability: 0.40 * ($100 million estate value – $13.6 million federal estate tax exemption – $15.5 million state estate tax liability) = $28.4 million
Total Estate Tax Liability: $15.5 million + $28.4 million = $43.9 million
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.
What is a Grantor Trust?
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.)
What is the “Defect” in an Intentionally Defective Grantor Trust?
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.
Watch this 7-minute video explaining how an Intentionally Defective Grantor Trust works and its benefits!
How Do Intentionally Defective Grantor Trusts Reduce 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.
Loans. A grantor can loan money to an IDGT (at IRS interest rates) without having to pay income tax on the interest payments. How can loans to IDGTs reduce future estate tax liability? Imagine that the applicable IRS interest rate is 4% (the rate varies from month to month but is typically in the 2%-5% range) and that you are planning to invest $1 million in an investment that you think will generate 9% annual returns. Instead of making the investment yourself, you can loan the $1 million to your IDGT for 10 years so that the trust can make the investment. The IDGT will be able to generate a 9% annual return while paying you 4% interest. The principal will have to be paid back in a balloon payment due at the end of the loan term, but in the meantime, the IDGT will be able to capture the spread between the investment return and the interest rate. That growth will happen outside of your estate, not inside of it. In this example, the loan would transfer about $900,000 out of your estate relative to if you hadn’t made the loan. The resulting estate tax savings would be $360,000. The tax savings would be even greater if you had loaned a larger amount, generated a higher rate of return, or kept the loan in place for longer than 10 years.
Sales. A grantor can sell appreciated assets to, or buy appreciated assets from, his or her grantor trust without realizing any capital gain. How can sales to IDGTs reduce future estate-tax liability? Imagine a grantor sells a $1 million asset to his IDGT. If the asset is illiquid, it may qualify for valuation discounts (for lack of marketability and lack of control), which means the grantor may be able to sell it to the trust for about $650,000. Not only will the trust get a nice discount on its purchase of the asset, but the asset’s future growth and cash flow will be captured by the trust. If the asset is worth $2 million in a decade, the grantor will have transferred $1.35 million ($2 million – $650,000) to the IDGT without using any of his or her lifetime gift tax exemption.
Asset Swaps. IDGTs also have a unique income tax benefit relative to non-grantor trusts: it’s possible to swap low-basis assets out of them without any tax consequences. Why would you want to swap low-basis assets out of an IDGT? Because of what’s known as the basis step-up. When a person dies, the assets that he or she owns personally (not in an irrevocable trust) are stepped up to fair market value, wiping out any unrealized capital gains. For example, if you have a $1 million cost basis in a building that is now worth $10 million, then upon your death the $9 million capital gain will be eliminated and your heirs will be able to sell it for $10 million without paying any capital gains tax. This basis step-up on death is a huge tax benefit, but assets held in irrevocable trusts aren’t eligible for it since trusts don’t die. IDGTs, at least partially, solve this problem. Because assets in an IDGT can be bought back or exchanged from the trust without income tax consequences, it’s possible for a grantor to buy or exchange low-basis assets from their IDGT before their death, in exchange for cash or some other asset with a high basis. That way, the appreciated asset will be included in the grantor’s estate and get a basis step-up on the grantor’s death. Particularly for older grantors, it makes a lot of sense to move high-basis assets into IDGTs and low-basis assets out of IDGTs.
There are other major non-tax benefits of intentionally defective grantor trusts:
Non-Tax Benefits of Intentionally Defective Grantor Trusts
Liquidity and Access. As previously mentioned, IDGTs are more liquid than other types of trusts. You can borrow, sell and swap assets from an IDGT whenever you want, without any income tax consequences. Moreover, if your spouse is named as a beneficiary of an IDGT, your spouse can receive distributions directly from the trust. Keep in mind, however, that borrowing or taking distributions from an IDGT will reduce its overall tax savings. So, ideally, you wouldn’t use an IDGT to cover your living expenses.
Asset Protection. In the United States, litigation is one of the biggest risks to wealth preservation. A lawsuit can undo years of savvy financial management. Irrevocable trusts can help. Because an irrevocable trust is a separate legal person, it 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 their lawsuit against the grantor or beneficiary. In addition to protecting assets from lawsuits, irrevocable trusts can help shield inherited assets from a divorcing spouse.
Control. Trusts allow people to put rules and conditions around how the money they transfer to a trust is used, or give someone (the trustee) discretion over when to make distributions. This prevents 22-year-olds from blowing the money they inherit on frivolous purchases or bad investments. Trusts also make it easy to invest on behalf of minors (who cannot open investment accounts or sign purchase and sale agreements themselves).
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.
About Valur
We’ve built a platform to give everyone access to the tax and wealth-building tools typically reserved for wealthy individuals with a team of accountants and lawyers. We make it simple and seamless for our customers to take advantage of these hard-to-access tax-advantaged structures. With Valur, you can build your wealth more efficiently at less than half the cost of competitors.
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!
Mani is the founder and CEO of Valur. He brings deep financial and strategic expertise from his prior roles at McKinsey & Company and Goldman Sachs. Mani earned his degree from the University of Michigan and launched Valur in 2020 to transform how individuals and advisors approach tax planning.
