An intentionally defective grantor trust (IDGT) is irrevocable and completed for transfer-tax purposes but 'defective' for income tax — the grantor is taxed on trust income under IRC 671-679. That mismatch is the feature: the grantor's payment of the trust's income tax is a tax-free transfer to beneficiaries, and transactions between grantor and trust are income-tax nonevents (Rev. Rul. 85-13).
- Grantor pays income tax on trust earnings, letting trust assets grow untaxed — an ongoing, gift-tax-free wealth shift.
- Sales and swaps between the grantor and the IDGT are ignored for income tax: no gain recognized on a sale, and interest on a note is not taxable income to the grantor.
- Common grantor-trust triggers: a swap/substitution power (IRC 675(4)(C)) or a power to borrow without adequate security — chosen to avoid estate inclusion.
The grantor sells appreciating assets to the IDGT in exchange for an installment note at the IRC 7872/1274 applicable federal rate (AFR). Future appreciation above the AFR accrues in the trust free of transfer tax, and because the grantor and trust are the same taxpayer for income tax, the sale triggers no capital gain and the note interest is disregarded.
- Seed gift: fund the trust with equity (commonly ~10% of the purchase price) before the sale so the note is respected as debt, not a retained interest under IRC 2036.
- Use the AFR (typically lower than the 7520 rate required for a GRAT) — an advantage over GRATs.
- Unlike a GRAT, an IDGT sale has no mortality-term inclusion problem and is GST-friendly (allocate GST exemption to the seed gift).
- Consider a self-canceling installment note (SCIN) or private annuity for a grantor with a shortened life expectancy — with a mortality premium and its own risks.
Open questions
The income-tax consequences of a note outstanding at the grantor's death (when grantor-trust status ends) are unsettled; potential gain recognition is a live risk. Basis is carryover, not stepped-up — weigh the freeze against lost step-up, especially for non-taxable estates.
Key takeaways
- An IDGT is estate-excluded but income-taxed to the grantor; the grantor's tax payments are tax-free transfers.
- Sales/swaps between grantor and IDGT are income-tax nonevents, enabling an installment-sale freeze at the AFR.
- Seed the trust (~10%) so the note is respected; IDGT sales avoid GRAT mortality risk and are GST-friendly.
- Carryover basis and the death-of-grantor note question are the principal cautions.
Authorities
- IRC 671-679, 675(4)(C), 2036; Rev. Rul. 85-13; Rev. Rul. 2004-64
- IRC 1274 / 7872 (AFR); IRC 453 (installment method)