Some business owners will want to explore the option of creating an Intentionally Defective Grantor Trust (IDGT). When the situation is right, it can be a smart way to limit tax liability when transferring wealth and business assets to heirs.
The first thing to understand is that an IDGT is a type of irrevocable trust. An irrevocable trust means that once it is created, it can not be changed. Therefore, it requires careful planning and execution to avoid potential mistakes. You will want to talk closely with your estate planning attorney and/or financial advisor before setting up any irrevocable trust.
An Intentionally Defective Grantor Trust is intentionally created with a flaw that provides tax benefits to the trust grantor and their beneficiaries. This is why it is called “intentionally defective.” It is considered defective because the grantor will still pay income taxes on any income generated by the trust, even though the assets are no longer part of the original estate.
This type of “defective” trust can actually be very “effective” when executed properly!
An IDGT will allow you to permanently remove specific assets from your estate. Those assets are then managed by an assigned trustee, who is a fiduciary responsible for controlling the trust on behalf of the beneficiaries. What makes an IDGT different from other trusts is how the taxes are treated. The assets are being transferred outside of your estate, which enables you and your heirs to avoid paying estate taxes and gift taxes on those assets.
The Intentionally Defective Grantor Trust essentially freezes the assets transferred to the trust. Those assets will stay in the trust until the owner dies because it is irrevocable. Meanwhile, the assets will continue to appreciate during the owner’s lifetime, yet are protected from transfer taxes. The owner will pay taxes on the assets while they are alive, but then there will be no gift taxes or transfer taxes when the trust’s assets are passed onto the beneficiaries.
In most cases, there is no estate tax upon death with an IDGT. It may depend on the value of the assets in the trust and whether or not the owner has used up his or her lifetime generation-skipping transfer tax (GST) exemption limit.
As you might expect, IDGTs aren’t ideal for everyone. They can be beneficial for business owners and other wealthy individuals looking to minimize tax liabilities on their estates. However, it is very important that you talk with an expert before exploring this kind of irrevocable trust as an estate planning option.
For help managing your wealth and building your estate plan, contact Illumination Wealth today.