Intentionally Defective Grantor Trust

What is an Intentionally Defective Grantor Trust?

A Trust can be subject to multiple kinds of taxes, and can be taxed in different ways.  To make sense of what an “Intentionally Defective Grantor Trust” is, we must consider two different kinds of taxes:  income taxes and estate taxes.  These two different taxes are imposed at different times, and at different rates, and upon different conditions.

The Typical Grantor Trust.

Most revocable trusts are what the IRS calls a “Grantor Trust.”  The “Grantor” is the person who creates the Trust, and can also be called the “Settlor,” “Trustor,” or “Trust Creator,” or “Trust Maker.”  A Grantor Trust is a disregarded entity for income tax purposes.  This means that the Trust itself does not have to file a tax return or pay taxes.  It is simply disregarded.  The Grantor or Grantors file the tax return and pay the income taxes.

Whether or not a Trust is a “Grantor Trust” is determined under IRC §671-679, which essentially provides that if the Grantor retains certain specific controls over the Trust income and/or principal, the Grantor is deemed to be the tax payer for income tax purposes.

While a Trust may start out as revocable, it is typically only the Grantor that can revoke or amend the Trust.  So when the Grantor passes away, the Trust by its very nature becomes irrevocable.  [This is one reason why it shows a lack of forward thinking to use the word “revocable” in the name of a Trust which will unavoidably become irrevocable in the future.]

The Typical Irrevocable Trust.

In general, when a Trust is irrevocable, it is a taxable entity for income tax purposes, and must get its own EIN (Employer Identification Number) or TIN (Taxpayer Identification Number).  When a Trust is the taxable entity, it must file a tax return and pay the taxes.  Trust income tax rates are “progressive” in that the rate goes up as the amount of income goes up.  Trust that have more income, pay taxes at a higher rate.  Trusts with less income, pay taxes at a lower rate.

Individuals also have progressive tax rates which vary based on the amount of income.  The difference is that Trusts get to the top rate at a much smaller amount of income than an individual does.  This means that if a Trust and an Individual both have the same amount of income, the Trust will pay more in income tax than the individual.  This creates a disincentive to have the Trust be the taxpayer.

Estate Taxes and Revocable vs. Irrevocable Trusts.

Estate taxes are NOT the same as income taxes.  Estate taxes are taxes that are triggered by the transfer of property resulting from a person’s death.  Income taxes are based on income, and are calculated and due and must be reported each year.  Estate taxes occur only once, when someone dies, and are based on the value of the assets of the person who passed away.

Estate taxes can occur on a federal and state level.  Currently, only a small and declining number of states have an estate tax.  Whether or not an asset is included in one’s estate for federal estate tax purposes is determined by IRC §2033-2044.

In most instances, a Revocable Trust will be included in and taxed as part of the Grantor’s estate for estate tax purposes.  The Grantor is deemed to be the owner of the Trust assets, and when the Grantor dies, there is an estate tax based on the value of the Grantor’s assets.  Because a “Revocable” Trust can be revoked or amended, the Grantor has the power to decide who ultimately ends up receiving the Trust assets.  The technical name for this ability to decide the disposition of assets is a “general power of appointment.”  It is that power inherent in a Revocable Trust that causes inclusion in the taxable estate.

One of the primary purposes for creating an Irrevocable Trust is to hold assets that are outside of or not included in the taxable estate of the Grantor.  With such an Irrevocable Trust, the Grantor does NOT have a general power of appointment.  For example, life insurance is generally income tax free.  However, it is subject to estate taxes if the policy is owned by the person who is insured.  “Ownership” means the insured person can decide who gets the benefits, which is a general power of appointment.  So, a common strategy is to form an Irrevocable Life Insurance Trust to own life insurance so that it is not included in the taxable estate of the insured person.

Estate Taxes vs. Income Taxes.

Such Irrevocable Trusts reduce estate taxes because they are NOT in the taxable estate of the Grantor.  However, they can result in higher income taxes because they are taxed at the Trust rate instead of the individual rate.  So by avoiding one tax, we can trigger another.  The goal becomes avoiding both the estate tax and the higher trust income tax rates.

With careful planning, a Trust can be structured so that its assets are NOT included in the Grantor’s taxable estate for estate tax purposes under IRC §2033-2044, but they are nevertheless taxed to the Grantor for income tax purposes under IRC §671-679.

Such planning is often done in conjunction with Generation Skip Tax Planning and multi-generational dynasty planning.

The Intentionally Defective Grantor Trust

The Intentionally Defective Grantor Trust (“IDGT”) exploits inconsistencies between the code that governs estate taxes and the code that governs income taxes.  This is referred to as a “defect” because the Grantor ends up paying income taxes on property the Grantor does not own.  Why would a grantor do this “intentionally”?

• The Grantor’s individual income tax rate will almost always be lower than the Trust tax rate, so the income tax liability will be less.
• Both appreciation of and accumulated income from the assets in the IDGT will NOT be included in the taxable estate of the Grantor.  This means the estate tax free assets grow from both appreciation and accumulation of income, and that increase is NOT subject to estate taxes when the grantor dies.  This is particularly beneficial for estates at or above the estate tax threshold.
• The Grantor’s ultimate estate tax liability at death is proportionally reduced by the income tax payments.  (Paying one tax reduces the other tax.)
• It greatly simplifies tax reporting and payment for smaller estates that may be below the estate tax threshold, the use of an Intentionally Defective Grantor as part of a business succession plan or for asset protection.

Politicians At Play

Not surprisingly, politicians have radically different views on the subject of “grantor trusts.”  Some think they are good for the country, others think they should be abolished.  There have been multiple proposals to do away with Grantor Trusts or to modify the rules in order to enhance tax revenue.  There is also a sense of “social justice” in the notion that only people who have assets have a Trust, and taxing people with a Trust more than people who do not have a Trust is somehow more “fair.”  Whatever the politics, it is important to remember that those who make the rules, can change the rules, and they probably will.

Most recently, early drafts of the failed Build Back Better Act eliminated the Grantor Trust.  It did not pass.  The grantor trust rules still apply.  But the prudent planner will watch to see what happens in the future.