Wherever there is wealth, there must be protection. One of the cleverest tools in the kit intended for the protection and administration of the wealth of high-net-worth individuals (HNWIs) and ultra-high-net-worth individuals (UHNWIs) is the Intentionally Defective Grantor Trust (IDGT). An IDGT allows income to grow outside the grantor's taxable estate and affords the grantor some income tax benefits. It is an intricately sophisticated tactic for the elite few for whom a more concise solution is requested.

For now, let's look at a clear way of how this works, some of the benefits of an IDGT, and why this may be just the estate planning notion for you.

What Is An Intentionally Defective Grantor Trust?

An IDGT is a somewhat special kind of irrevocable trust. Its most unique characteristic? It is considered "defective" when it comes to income tax matters but fully functional for estate and gift tax purposes. This unusual combination allows the grantor to transfer the assets out of the taxable estate while retaining the obligation to pay the income tax on the trust once the trust is formed.

By virtue of paying income tax on the income of the trust, the grantor accomplishes two rather important outcomes:

Lowering the Taxable Estate:

Beyond the grantor's estate's reduction, income taxes paid on the trust do not incur taxable gifts.

Maximizing Trust Assets:

In sum, this means trust assets gain value on a tax-free basis due to their nature, thus becoming a powerful vehicle for growing wealth in their names. This comes down to a purposeful "defect," which has allowed this approach to be terribly effective: because it effectively allows the grantor to pass wealth down one generation after another while being responsible for whatever tax bill comes due.

Funding an IDGT: Two Strategies

IDGTs may be funded in two primary ways: by gifting or selling assets to the trust. Each of these methods features their own distinct advantages and requires a careful implementation.

Gifting Assets

It is the simplest method. The grantor makes certain that the assets are irrevocably given to the trust and, thus, out of his or her estate. While the value of this gift is subject to federal gift tax rules, the grantor's lifetime gift and estate tax exemption must be considered.

Benefits of gifting include:

• Estate Freezing: The value of the asset is appreciated post-gift outside the taxable estate.
• Tax-free Growth: The grantor’s income taxes paid become additional “tax-free” contributions to the trust.
• Simplified Structure: Gifting is a way to avoid the complex nuances of sales transactions and promissory notes.

One of the easiest ways to start taking advantage of an IDGT is to gift assets. The grantor essentially sets the table for huge tax savings and efficient wealth transfer by transferring appreciating assets out of the taxable estate.

But for those with larger estates or who want to take it just a little bit further, selling assets into an IDGT is a very powerful alternative.

So let’s take a look at how this works and why it’s such a good way to do substantial estate planning.

Selling Assets

In the case of larger estates, selling assets to an IDGT is often the employment of choice. It works like this:

• Initially, The grantor gifts a percentage (usually 10%) of the fair market value (FMV) of the asset to the “seed” the trust.
• The grantor then sells more assets to the trust in return for a promissory note with interest at the IRS determined Applicable Federal Rate (AFR).

This method permits the grantor to take highly appreciated assets out of his or her estate without using up the lifetime exemption. All future appreciation on these assets occurs within the trust and for the benefit of the beneficiaries. Furthermore, the interest payments contained in the promissory note can be set up to meet the trust’s income tax payments thereby maintaining liquidity.

Tax Implications of an IDGT

On the one hand, IDGTs are powerful tools, but they also create a large array of taxing events. Here’s what to expect:

Income Taxes

The income tax on the trust’s dividend, interest and capital gain income remains payable by the grantor. This may seem like a downside, but it’s actually a strategic advantage. These taxes are payable so that they reduce the grantor’s estate without trace additional gift taxes.

Gift Taxes

The grantor’s lifetime exemption includes assets gifted to the IDGT. The remaining exemption is reduced by any amounts over the annual exclusion, but future growth escapes estate taxes.

Estate Taxes

The grantor’s taxable estate does not include assets within the IDGT. But if the grantor dies before the promissory note is settled, the remaining amount may be counted into the estate.

Valuation Discounts

Valuation discounts can further reduce the transfer’s taxable value when selling assets to the IDGT. Closely held business interests or hard-to-value assets without marketability are particularly relevant uses.

Benefits of an IDGT

IDGTs are tax cutters and have advantages in excess of tax savings. Here are some of the key advantages:

Generational Wealth Transfer

IDGTs are an excellent method to pass riches on to later generations. Grantors may withdraw appreciated assets from the estate so beneficiaries get the whole amount of the trust, estate taxes paid.

Asset Protection

An irrevocable trust, the IDGT provides an additional layer of protection for your family’s wealth, and your assets are protected from creditors and legal claims.

Control and Flexibility

Swap or substitution powers allow the transfer of property to the trust in kind – that is, by exchanging assets of equal value. It can then be used to achieve liquidity or strategic tax benefits (swapping high-basis assets for low-basis).

Probate Avoidance

Assets held in an IDGT avoid probate and are transferred to beneficiaries privately and smoothly. It saves time, legal fees and public scrutiny.

Valuation Discounts

Valuation discounts often apply when assets such as shares of a closely held business are transferred to an IDGT. These discounts, for lack of marketability or lack of control, permit the grantor to transfer a greater percentage of ownership for a lower taxable value.

As an example, this type of strategy works extremely well for family businesses or real estate holdings given that you can leverage partial ownership interests to reap a sizeable tax saving when transferring assets (such as a business or a real estate property) to family or friends for a nominal amount.

Creditor Protection

The assets held in an IDGT are protected from creditors of the grantor and the beneficiaries. This protection is priceless for a family or an individual who may worry about how a family will be affected in a future legal dispute, assuring that wealth is preserved for the reason for which it was meant to be had. 

In addition, that trust structure also protects beneficiaries from financial risk of a personal liability or business venture.

Continuity of Generational Wealth

The purpose of IDGTs is to transfer wealth across generations while retaining control over how that wealth will be distributed. Due to the nature of the irrevocable trust, grantors can create a set of rules about what to pay for asset management and what to account for after your demise and minimize risk of mismanagement or conflict among heirs. This means your wealth will continue to benefit your family for decades to come.

Post-Mortem Tax Benefits

An IDGT continues to deliver value even after the grantor’s death. Because the assets do not remain part of the taxable estate they escape the estate taxes, thus ensuring maximum wealth that is passed to the beneficiaries. The trust also offers trustees flexibility when making effective use of assets depending on what might change in tax laws or financial circumstances.

Simply put, an IDGT is a strategic way to preserve, grow and protect wealth over generations. When done ideally, it is an undeniable, unassailable shield for your legacy.

What to Know When Setting Up an IDGT

Although IDGTs offer some desirable benefits, they’re not the best answer for every situation. To succeed, we must plan properly. Here’s what to keep in mind:

Liquidity

Make sure the grantor has enough liquidity to pay income taxes and live their lifestyle. Selling or gifting too much of your wealth to the trust could make you have cash flow problems.

Asset Selection

Not all assets are appropriate for an IDGT. The best are high-growth, income-producing assets. The trust’s income needs may not be met by low-yield or illiquid assets.

Trustee Selection

If you want a trustee then they should be informed and honest. Since the trustee is in charge of this, the trustee manages the assets, hands them out and guarantees it follows all tax rules. So their knowledge and their honesty is very important.

Legal and Financial Matter Help

IDGTs have some problems. The first thing to do would be to hire estate planning lawyers and financial advisors if you have never planned your estate before. By doing it this way, you know that the plans you make are in line with the rest of your wealth strategy and that you aren’t violating any tax rules.

Why Dominion for Your IDGT?

An IDGT is not for amateurs. Not unless one has an adept and precise hand: legal and financial intricacies allow for no other option—and these are precisely where we are really good at. Dominion is where you will get the IDGT that most suits your needs. We shall not sell you cheap solutions or general advice. Rather, we will use decades of experience and a worldwide network of legal professionals to create structures that fairly work across jurisdictions. 

Call us today for a consultation. Unprotected assets, after all, remain an easy prey! Come see, at Dominion, why and how we make them invulnerable.