An IDGT is an irrevocable trust designed so the grantor is still treated as the owner for income tax purposes, while transferred assets are generally outside the grantor’s estate for estate tax purposes. That split treatment is intentional. The grantor pays income tax generated by the trust, allowing trust assets to continue growing without being reduced by those tax payments. IDGTs are commonly used for assets expected to appreciate significantly or generate substantial income. Assets may be transferred to the trust by gift, by sale, or through a combination of the two methods, depending on the grantor’s goals.
The grantor, rather than the trust, generally pays the income tax generated by IDGT assets. That creates an additional estate-planning benefit because those tax payments reduce the grantor’s remaining estate without reducing the trust’s value. Beneficiaries therefore receive the benefit of assets that can continue compounding without the trust bearing the tax expense. In effect, the grantor is covering a cost that otherwise would reduce assets available to beneficiaries. This feature can make IDGTs particularly useful among long-term wealth transfer strategies, provided the grantor has sufficient assets outside the trust to continue paying the resulting income taxes.
The grantor may first fund the IDGT with a seed gift. A 10% funding level is sometimes used as a planning guideline, but it is not an IRS requirement. The grantor then sells appreciated or high-growth assets to the trust for fair market value in exchange for a promissory note. If the trust is properly structured as a grantor trust, the sale is generally disregarded for federal income tax purposes. The note becomes an asset of the grantor, while future appreciation of the transferred assets can accrue to the trust beneficiaries outside the grantor’s estate. This is sometimes described as an installment sale trust strategy.
The promissory note should reflect a real loan rather than simply a transaction on paper. Assets sold to the trust must be valued at fair market value, sometimes using a professional appraisal. The note’s interest rate must equal or exceed the applicable federal rate in effect when the sale occurs. The loan should be secured, typically by the transferred assets, require regular payments, be documented in writing, and have a term that does not exceed the grantor’s life expectancy. The trust also needs enough cash flow to make required payments. These formalities help establish that the grantor received full and adequate consideration for the assets sold.
An IDGT may be preferable to a Grantor Retained Annuity Trust (GRAT) when the goal is to transfer appreciating assets without retaining an annuity interest. It can be especially effective for high-growth assets, closely held business interests, or assets that may qualify for a discount for lack of marketability (DLOM). An IDGT also can provide greater flexibility for long-term family wealth transfers because the grantor can sell assets to the trust in exchange for a promissory note. By contrast, a GRAT may be more attractive when the grantor wants to retain an annuity and minimize gift-tax exposure through the GRAT’s valuation mechanics.
Who pays income tax on an IDGT’s earnings each year?
The grantor generally pays the income tax attributable to the IDGT’s earnings each year. This is one of the structure’s central benefits because the trust can keep more of its assets invested while the grantor’s separate taxable estate is reduced by the income tax payments.
How does the applicable federal rate affect IDGT planning?
The AFR establishes the minimum interest rate generally used on the promissory note. The transferred assets need to appreciate faster than that rate for the sale strategy to produce its intended estate-planning benefit. If growth falls short, the transaction may become less effective.
Can life insurance be purchased inside an IDGT structure?
Yes. Life insurance can be owned by an IDGT, with the trust purchasing the policy and receiving the proceeds. Proper structuring is important because retained “incidents of ownership” can cause the proceeds to be included in the grantor’s estate.
What if the IRS recharacterizes an IDGT sale as a gift?
If the IRS recharacterizes an IDGT sale as a gift, the excess of the property’s value over adequate consideration may be treated as a taxable gift. The grantor may need to report the transfer on gift tax returns and potentially pay gift tax.
For more than four decades, Bennett Thrasher has provided businesses and individuals with strategic business guidance and solutions through professional tax, audit, advisory, and business process outsourcing services. Contact Jonathan Swartz, partner in Bennett Thrasher’s Trusts & Estates Planning, or call us at 770.396.2200.
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