As high-net-worth clients age, they become more focused on how their accumulated wealth will be distributed to their heirs. Naturally, most parents want their children to inherit as much wealth as possible, which drives a quest to shield those heirs from unnecessary taxation when they inherit.
Currently, federal gift and estate tax laws are quite friendly to building generational wealth: Individuals can give or leave $12.92 million to their heirs, while for married couples, that amount doubles to $25.84 million. However, this is a temporary bubble, as the Tax Cuts and Jobs Act (TCJA) is due to expire in 2025. It seems unlikely this provision will be extended, and when it sunsets, gift and estate tax exemptions will be cut in half.
The incentives to take full advantage of tax laws become even greater if you live in one of the 17 states that have their own estate or inheritance taxes, especially considering exemptions in those states are considerably lower than the federal government’s.
The question then becomes, how can you transfer the most wealth possible to your heirs? Often, the answer is an IDGT.
What is an IDGT?
An intentionally defective grantor trust, or IDGT, is not merely one of the most amusing terms in personal finance, but also a powerful tool for legally transferring the most wealth possible to your heirs. Here’s how it works:
The more assets that are in your estate when you pass away, the more likely your estate will be subject to estate taxes. If your heirs live in one of the six states with an inheritance tax, too many assets in your estate will mean your heirs must pay taxes on what they inherit.
Logically, removing assets from your estate will lower or eliminate taxation on your estate and heirs. Enter the grantor trust. By selling assets from your estate to a grantor trust, they are no longer subject to estate taxes; the government can’t levy estate taxes against assets that are not in the estate! The trust will then pay you an installment note over a number of years, which you designate when you set it up.
IDGTs benefit your heirs in another way as well, which is where the “intentionally defective” part comes in. The trust is not actually defective: That term simply refers to the fact that the trust is not responsible for paying its own income taxes, but rather, they pass through to you, the grantor.
For example, consider an estate with $20 million in assets placed into an IDGT. This might generate a $500,000 tax bill, which you pay. This accomplishes two things. First, the $500,000 you pay in taxes is removed from your estate, further lowering your estate’s value and therefore lowering the estate tax it will be subject to.
Second, because the trust is not responsible for paying income taxes on the appreciation of its assets, it can grow faster. As a bonus, because the trust is not subject to estate taxes, any appreciation of assets within the trust will not add to the estate taxes that must be paid upon your passing.
IDGTs work best when you have an appreciating asset in your estate that will potentially create an estate tax liability in the future, but you still want to enjoy the benefit of that asset. If you have an income-generating property and you don’t want it to be subject to estate taxes, you could sell it. But you’d then no longer receive the income it generates. However, by selling it to a grantor trust, the income it generates still passes to you, and it gets removed from your estate.
The income does not pass to you from the income-generating asset. Instead, the installment note pays income to the grantor.
IDGTs and S corps
Many family-owned businesses are S corporations. S corps function to shield personal assets from business-related liabilities. In other words, if someone sues the business and wins, the judgment will impact the corporation’s wealth but is unlikely to harm your personal assets.
S corp owners hold shares in the corporation, and those shares can be transferred to an IDGT. When family members move their stock into the trust, ownership of the business transfers to their heirs free of estate tax. If the business grows between setting up the trust and your death, that growth happens separately from your estate, meaning there are no estate tax implications to continued business growth.
It’s OK to SCIN
In short, an IDGT accomplishes two things simultaneously: It removes assets from your estate and gives you cash flow in the form of installment payments to fund your retirement. Sharp-eyed readers, however, might have noticed a potential problem: What if you die before the installment term ends?
Ordinarily, if you die before the installment term ends, the trust pays out the rest of what it owes to your estate. That sum, therefore, increases the value of your estate and, potentially, also the estate taxes owed. To avoid that, you can set up the IDGT with a self-canceling installment note, or SCIN. The SCIN automatically cancels the trust’s obligation to pay installments upon your death, thereby keeping value in the trust’s assets and not adding to the value of your estate.
Is this legit?
A lot of people get hung up on the term “intentionally defective,” especially when they hear the trust is intentionally defective for tax purposes. They start picturing uncomfortable visits from stern-looking IRS agents. It’s important to know that IDGTs are entirely legitimate. As long as they’re set up properly, the IRS will have no reason to penalize you, because they’re completely legal.
Remember that you will be responsible for the tax liability of the trust. This means you have to be careful not to gift so many assets to the trust that you find yourself scrambling to pay the tax bill!
Intentionally defective grantor trusts are complex; this article barely scratches the surface of the details involved in structuring one properly. Poorly executed IDGTs may catch the attention of the IRS, which could disqualify your structure and remove all of the benefits you’d otherwise derive.
You will need expert help in creating one that both works as intended and doesn’t run afoul of IRS regulations. Consult with your financial professional and a trusted estate planning attorney to make sure your IDGT is well-structured and appropriate for your needs.
As Principal and Director of Financial Planning, Sam Gaeta helps clients identify financial goals and make plan recommendations using the five domains of financial planning -- Cash Flow, Investments, Insurance, Taxes and Estate Planning. He is responsible for prioritizing clients' financial objectives and effectively implementing their investment plans and actively monitors the ever-changing nature of clients' financial and investment plans.
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