Could Your Estate Benefit From an "Intentionally Defective Grantor Trust"?

By Jenna Ichikawa | Related Practice: Estate Planning & Administration

In simple terms a “grantor trust” is a trust that is treated as being the same as the creator of the trust (the “grantor”) for income tax purposes.  Put another way, grantor trusts are disregarded entities for income tax purposes and the grantor is taxed on all of the trust’s income, even if he or she is not entitled to any trust distributions.  As a result, any income tax associated with the trust’s income will be paid by the grantor.  Although this may not sound appealing initially, it is the equivalent to allowing the grantor to make a tax free addition to the trust in the amount of the income tax liability.  It also allows the assets inside the trust to grow tax-free for the beneficiaries; the grantor may sell assets to a grantor trust without recognizing gain on the sale; and the grantor can exchange assets with the trust without adverse income tax consequences. These can be powerful planning tools.

One of the most common grantor trusts is a revocable living trust.  People often use revocable living trusts as will substitutes.  Irrevocable trusts can also be grantor trusts if the grantor or another person holds one or more of the following powers over the trust:

• a reversionary interest in either the principal or the income of the trust;
• a power to dispose of principal or income without approval from any adverse party;
• a power to deal with trust assets for less than full and adequate consideration;
• a power to borrow trust assets without adequate interest or security;
• a power to substitute assets of equal value; or
• a power to add charitable beneficiaries.

Trusts that are intentionally structured to be grantor trusts are sometimes called “intentionally defective grantor trusts,” or IDGTs.  Originally grantor trusts were not favored due to former differences in the trust and individual income tax rates.  As a result, a trust that triggered the grantor trust rules was considered to be “defective.” 

Care must be taken when drafting a grantor trust to avoid having the trust included in the grantor’s taxable estate for estate tax purposes.  This can happen if the wrong power is used, or if a power is improperly drafted. On the other hand, with properly drafted grantor trusts all of the trust’s assets can escape estate taxation on the grantor’s death.

Grantor trusts are a valuable estate planning tool and can offer significant possibilities for estate and gift tax savings.  If you are interested in learning more about grantor trusts, please contact a member of the Stokes Lawrence Estate Planning Group.