An intentionally defective grantor trust (“IDGT”) is a trust whose income is taxed to the grantor but whose contributed assets are excluded from the grantor’s estate for estate tax purposes. The word “defective” is an historical misnomer as there is nothing defective about these trusts.
The IDT accomplishes four goals:
The first concept in planning an IDGT requires a working knowledge of grantor trust rules in IRC Subchapter J (incl. Secs. 671-678). This subchapter provides that if certain powers are present in a trust agreement, the grantor of the trust will include all trust income, expenses, and tax attributes on the grantor's personal tax return. Grantor trusts are treated for tax purposes as being not separate from the grantor. Correspondingly, all transactions between the grantor and the IDGT are disregarded for all income tax purposes; thus, the income tax transfer-for-value rule of IRC 101 also does not apply. (Rev. Rul. 85-13, 1985-1 C.B. 184, Rev. Rul. 2007-13, 2007-1 C.B. 684.)
The second concept in planning an IDGT requires a completed taxable gift to accomplish the estate exclusion, thus excluding the fair market value of the assets transferred and their subsequent appreciation in value, the freeze out. The issue is that a transfer to trust can be deemed an incomplete gift if the grantor retains certain powers over the trust, which must be avoided to obtain estate exclusion the purpose of the IDGT
The IDGT is an irrevocable trust that takes advantage of a disparity between the income and estate tax treatments offered generally through the use of IRC Sections 674 and 675, which allow a completed gift while the grantor retains certain “strings” allowing control over those assets. The following are grantor trust provisions which do not disturb a completed gift and which we provide in our trusts; however, you must select which powers you would like to retain:
Grantor trusts affirmatively enhance many common estate planning strategies by permitting the income earned by the trust to grow free of income tax because the tax burden is imposed on the Grantor, and the payment of the trust’s income tax liability by the grantor is not a gift. Rev. Rule 2004-64, 2004-2 C.B. 7. Our trust under the section titled “Authorization to Reimburse Income Tax Liability” provides this benefit to you as follows:
Notwithstanding the provision of any state law to the contrary, Grantor has no right to be reimbursed for any income tax paid by Grantor on all or any part of the trust’s income. An Independent Trustee may from time to time, however, distribute to Grantor or his or her Legal Representative, or elect to pay directly to the taxing authorities, so much of the income or principal of the trust as may be sufficient to satisfy all or part of Grantor’s personal income tax liability attributable to the inclusion of all or part of the trust’s income in Grantor’s taxable income. In exercising its absolute discretion with respect to such distributions, an Independent Trustee may consult with tax or other advisors and the Trust Protector but is not bound to follow any recommendation made by them
The difficulty is that at some time the tax attributable to the grantor may become too onerous; therefore, the Trust Protector is allowed to release the Grantor from the liability and make the trust responsible for it, i.e., the Trust Protector may remove the trust from grantor trust status. This is the “toggle” first referenced above. The wording in the trust provides as follows:
The Trust Protector may release any or all powers described in this Section at any time by delivering written instruction to the Trustee. The release will be effective upon its receipt by the Trustee, unless the release instructs that it is to be effective upon a later date. The Trust Protector may restore any power released at any time by delivering written instruction to the Trustee. In no event, however, may the Trust Protector restore any power within the same taxable year in which the power was released.
The tax consequences of releasing or restoring grantor trust powers are discussed in Tax Planning for Family Wealth Transfers: Analysis with Forms (WG&L) at 3.02[i][vii]. The author posits that the elimination of a specific power or powers would instantly terminate grantor tax status of the trust, relying on Madorin v. Commissioner, 84 T.C. 667 (1985). Therefore, it is suggested that if there is a release of a power effective for the next taxable year, one should release it effective at midnight on December 31 of the current taxable year.
Further to this, the IRS stated in Notice 2007-73, 2007-36 I.R.B. 545 (9/4/2007) that certain toggled grantor trusts are “transactions of interest,” the involvement in which might trigger disclosure rules, list maintenance requirements and possible tax penalties under Sections 6011, 6111 and 6112 of the Internal Revenue Code. In that Notice, however, the taxpayers toggled grantor trust status on and off within a tax year to avoid recognizing gain or claim an inflated tax loss. The question arises whether this Notice evidences a general concern by the Service about toggling grantor trust powers, or whether the Service will limit the ruling to its own abusive facts. In order to give you additional protection, our trust provides that the toggling may not be exercised to toggle on and off in the same year so as to avoid this issue.
This doctrine operates to avoid estate exclusion when using his and her IDGTs. To avoid this result, you must provide some variances between the terms of the two trusts.
First, one might use different types of trusts, e.g., an IDGT and a GRAT. Second and alternatively, use different distribution patterns and beneficiaries.