The ABCs of IDGTs

Out of context, a financial instrument with the word “defective” in its name isn’t likely to inspire confidence, but intentionally defective grantor trusts (IDGTs) can be powerful estate planning tools.

“Just because it’s defective doesn’t mean it’s not effective,” says Liz Ochoa, borrowing a phrase oft repeated in the trust world.

As a vice president of private wealth strategy at Raymond James, Liz helps advisors and their clients navigate the finer points of IDGTs. But the basics, she says, are pretty straightforward.

“This is ultimately a tax strategy with the goal of generating efficiency for the grantor and maximizing value for beneficiaries.”

Here, we offer a quick IDGT primer that dips into the instrument’s building blocks and benefits.

The assets

The key to an IDGT is how the assets that go into it are treated.

In typical grantor trusts, the held assets are considered substantially owned by the grantor, and as such, are part of their taxable income and will, ultimately, be considered part of their taxable estate. This is where IDGTs start down the path of intentional defection.

Intentionally defective grantor trusts behave more like nongrantor trusts, in which assets are considered a completed gift and removed from the grantor’s income and estate. For this reason, Liz urges investors who are considering this option to ensure whatever they contribute is something they won’t need to take back.

“When you’re thinking about what assets to place in the trust, anything you expect to grow in value over time – real estate, closely held business interests, stock – is a good option, but it should also be something you won’t need to fund your lifestyle in the future.”

Where IDGTs behave more like typical grantor trusts, however, is in their treatment of income taxes. In nongrantor trusts, because the assets are removed from the grantor’s control, the trust itself is responsible for income taxes. But in an IDGT, income taxes are paid by the person who established it.

While these features might seem more burden than benefit in isolation, their combination and potential impact on tax efficiency make the intention clear.

The benefits

The essential aim of IDGTs is to reduce the size of one thing while maximizing the size of another.

By making a completed gift, a grantor removes those funds from their taxable estate – potentially minimizing or avoiding future estate taxes. And by retaining the income tax burden, grantors can continue strategically depleting their overall assets.

On the other side of the income tax equation are the trust’s beneficiaries. In most cases, the taxes on a trust that isn’t controlled by a grantor (a nongrantor trust) are paid by the trust itself. However, because the grantor is paying the taxes on an IDGT, the assets inside it grow tax-free – maximizing value for beneficiaries, who can be heirs, close individuals, even charities.

And because trusts are typically taxed at the highest rates, this approach allows grantors to be taxed at their own – sometimes lower – rate, further reducing the overall tax drag on the assets.

Grantors can also make a trust intentionally defective through the power of substitution, which allows assets in the trust to be swapped with assets of equal value, offering additional built-in flexibility for tax planning.

The construction

Because IDGTs were created by taking an existing financial instrument and applying strategic and highly specific language to it, the structure of the trust documents will be extremely important.

According to Liz, “You want to work closely with attorneys and tax professionals on the terms and really think about who the trust is for, what you want for them and what they’ll want for themselves.”

You won’t be able to think of everything, she says, and terms are difficult to modify so it’s important to consider up front how the trust can be written to anticipate future needs.

“You want to think long term, because protecting long-term value is the goal.”

Raymond James does not provide tax or legal advice. Please discuss these matters with the appropriate professional.

Trust services provided by Raymond James Trust N.A. Raymond James Trust N.A. is affiliated with Raymond James & Associates, Inc., and Raymond James Financial Services, Inc.

Please be aware that there may be substantial fees, charges and costs associated with establishing and maintaining a intentionally defective grantor trust (IDGT).