If It Ain’t Broke, Break It! Intentionally Defective Grantor Trusts Can Lead to Tax Benefits

Estate Planner Jul-Aug 1998

In creating a trust, it is desirable, or at least logical, to avoid being taxed on trust property or trust income. In certain situations, however, an individual may actually benefit from retaining the tax burden of the property. To realize these benefits, the trust agreement can be drafted as a grantor trust.

What Is a Grantor Trust?

If a grantor exercises or retains enough control over trust assets, he or she is treated as the owner for income tax purposes. This is a grantor trust. Since the grantor retains these limited controls, he or she also retains certain tax savings. For income tax purposes, it is as if the grantor never contributed the property to the trust. For estate tax purposes, though, the transfer of the property can be treated as a completed gift, thereby removing the property from the grantor’s estate.

Intentionally Defective Grantor Trust

When an individual sets up a grantor trust so that he or she is taxed on the income generated by trust property, it is called an intentionally defective grantor trust (IDGT). There are several income tax advantages that can justify employing an IDGT:

A lower tax rate may be imposed. The highest marginal tax rate for both trusts and individuals is 39.6%. However, a trust reaches that tax bracket at $8,350 of income, while a married individual filing a joint return is not taxed at that rate until income reaches $278,450. Therefore, if the grantor wishes to create a trust, but avoid the 39.6% tax rate on trust assets, an IDGT may be a good idea.

Trust income may be offset. If the grantor has substantial current net operating losses, the income generated from the trust can be absorbed. If net operating losses have been carried forward for a number of years, they can now be used. Similarly, the grantor may be able to use large charitable deductions to offset the trust income.

The grantor can make leveraged gifts to trust beneficiaries tax-free. Since the grantor is paying the income tax on trust income and capital gains, trust assets will grow and accumulate without being reduced by taxes, and distributions can be made to the beneficiaries free of income tax. However, the Internal Revenue Service may argue that the payment of taxes is a gift to the beneficiaries and subject to gift tax.

The grantor can engage in transactions with the trust tax-free. Why? Because the grantor is treated as the owner of the trust, and the grantor is — in substance — dealing with himself or herself. For example, the grantor may sell an appreciated asset to the trust in exchange for a promissory note. In doing so, the grantor removes the asset from his or her estate — including all future appreciation. The grantor’s estate will include the present value of any remaining payments on the note plus the payments received before the grantor’s death. However, the grantor reports no gain on the sale and no income from the payments, and the trust receives no interest deductions.

Consider Using an IDGT

The grantor trust is a viable tax planning tool. It can be used to remove property from the grantor’s estate while allowing him or her to maintain limited control over the property and use suspended losses and deductions to offset the trust income. Call us to see how a grantor trust might be effectively employed in your estate plan.


How To Create A Grantor Trust

You can create a grantor trust if you retain certain interests or powers over the trust that are more than merely administrative. For example, if the you retain the power to substitute trust assets for other assets of equivalent value, the trust will be deemed a grantor trust. You also can establish a grantor trust by retaining the power to add beneficiaries. In both cases, the property you transfer to the trust will not be included in your estate but will be taxed as income to you. A person other than the grantor can, under certain circumstances, be treated as the grantor, but only if the actual grantor is not treated as such.

Also, if you retain the power to revoke the trust and get back the property, creating what is known as a revocable or living trust, the trust will be considered a grantor trust for income tax purposes. If you transfer property to a revocable trust, however, the property will be included in your gross estate for tax purposes.