How does an intentionally defective grantor trust (IDGT) work?

What it is

An intentionally defective grantor trust is an irrevocable trust drafted so that you are treated as its owner for income tax purposes, usually through a retained power such as a power to substitute assets of equal value under §675(4)(C), while completed gifts to the trust and the trust assets stay out of your gross estate for estate tax.

Because the income tax and transfer tax rules treat the trust differently, you can make gifts or sales to the trust, keep paying its income tax, and let its assets grow for your beneficiaries. The technique is often called an estate freeze, because the value you keep is fixed at the note amount.

What the law says

IRC §671 provides that when a grantor is treated as the owner of a trust, the trust's income, deductions, and credits are included in computing the grantor's taxable income. Sections 673 through 679 describe the powers and interests that cause grantor trust status. The IRS has ruled that transactions between a grantor and a wholly owned grantor trust are disregarded for income tax purposes (Rev. Rul. 85-13).

Rev. Rul. 2004-64 holds that when the grantor pays the income tax on the trust's income, the grantor is not making a gift to the beneficiaries. It also addresses tax reimbursement clauses: a mandatory reimbursement clause can cause estate inclusion, and a discretionary one generally does not unless other facts show an understanding or state law lets creditors reach the trust.

Rev. Rul. 2023-2 holds that assets in an irrevocable grantor trust that are not included in the grantor's gross estate do not receive a basis adjustment under §1014 at the grantor's death.

Requirements and tests

• The trust is irrevocable and the gifts to it are complete, with your retained powers limited to ones that create grantor trust status without estate inclusion.
• The trust has meaningful assets of its own besides the purchased asset, so the note is credible debt.
• The sale price is supported by a qualified appraisal, and the sale is reported on a gift tax return (Form 709) as a non-gift transaction with adequate disclosure to start the statute of limitations.
• The note carries at least the applicable federal rate (AFR) for the month of the sale under §7872 and §1274, and payments are actually made on schedule.
• You have the cash flow to pay income tax on all of the trust's income for as long as it remains a grantor trust.

How it works

You seed the trust with a gift, then sell an appreciating asset, often a minority interest in a family business, to the trust for a promissory note at the AFR. For income tax, nothing happens: you are selling to yourself. For estate tax, the asset is out of your estate and the note is in it. If the asset grows faster than the note rate, the excess accumulates in the trust.

Your estate still includes the note balance and every interest and principal payment you receive. Heirs take your carryover basis in the trust assets, so a sale after your death can produce capital gain that a step-up would have avoided. That income tax cost is part of the analysis.

Risks and IRS scrutiny

The IRS examines these sales on valuation, on whether the note is real debt or disguised retained equity (which can cause inclusion under §2036), and on whether the seed was sufficient. Other risks include the asset underperforming the AFR, the grantor's death while the note is outstanding (the income tax treatment of an unpaid note at death is unsettled), loss of liquidity to pay the income tax, and lost basis step-up.

Who it is not for

This is not for families whose assets are not expected to outgrow the AFR, who cannot afford the ongoing income tax, whose estate is comfortably under the $15,000,000 basic exclusion amount, or who need the transferred asset's cash flow for their own living expenses.

How ebotCPA helps

We model the sale against realistic growth and current AFRs, show the net amount shifted after note payments, estimate the lost basis step-up, test your cash flow for the income tax, and prepare the Form 709 disclosure. We coordinate with your attorney, who drafts the legal documents. We also work with the appraiser.

Book a $497 Case Analysis to have Ebot Mbi, CPA, EA review your facts before you act.

Primary sources

1. 26 U.S.C. §671. Grantor treated as owner: inclusion of trust items.

   Includes a grantor trust's income, deductions, and credits in the grantor's taxable income.

2. 26 U.S.C. §675. Administrative powers creating grantor trust status.

   Lists administrative powers, including the power to reacquire trust assets by substituting property of equivalent value, that make the grantor the owner.

3. Treas. Reg. §1.671-2. Grantor trust rules: applicable principles.

   Explains how income is attributed to a grantor treated as owner.

4. Rev. Rul. 2004-64, 2004-27 I.R.B.. Grantor's payment of trust income tax.

   “the grantor is not treated as making a gift of the amount of the tax to the trust beneficiaries”

   Holds that the grantor's payment of the trust's income tax is not a gift, and addresses reimbursement clauses.

5. Rev. Rul. 2023-2. No basis adjustment for excluded grantor trust assets.

   “the basis of Asset is not adjusted to its fair market value on the date of A's death under § 1014”

   Denies a §1014 basis adjustment for grantor trust assets not included in the grantor's gross estate.

6. IRM 4.25.5. Technical guidelines for estate and gift tax issues.

   Gives IRS examiners lead sheets for gift tax, valuation, and closely held business issues.

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